愛齊科技 (ALGN) 2005 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Align Technology's Third Quarter 2005 Financial Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If you would like to ask a question, please press "star, one" on your telephone keypad. If anyone should require operator assistance during the conference, please press "star, zero" on your telephone keypad. As a reminder, this conference is being recorded.

It is now my pleasure to introduce Barbara Domingo, Director of Investor Relations. Ms. Domingo, you may begin.

Thanks, Diego. And good morning everyone to -- and welcome to everybody on the line. If you haven't received a copy of the press release, please go to the Investor Relations page on our website at "Investor.AlignTech.com." And before we start the call today, I'd like to make some comments and forward-looking statements.

During this conference call, we may make forward-looking statements relating to Align's expectations about future events, products and its future results, including statements regarding expected financial results from fiscal 2005. Any forward-looking statements we make during this conference call are based upon information available to Align as of the dates hereof. Listeners are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to predict. As a result, actual results may differ materially and adversely from those Expressed in any forward-looking statement.

Factors that might cause such a difference include, but are not limited to, risks that are detailed from time to time in Align's periodic reports filed with the Securities and Exchange Commission including, but not limited to, the Annual Report on Form 10-K for the fiscal year ended December 31, 2004, which was filed with the Securities and Exchange Commission on March 3, 2005, and its quarterly reports on Form 10-Q. Align undertakes no obligation to revise or update publicly any forward-looking statements for any reason.

Please also note that on this conference call we will provide listeners with several financial metrics determined on a non-GAAP basis for comparisons to previous quarters. Most of these items, together with the corresponding GAAP numbers and a reconciliation to the comparable GAAP financial measures, where practicable, are contained in today's financial results press release, which we have posted on our website at "Investor.AlignTech.com," under financial releases, and have furnished to the Securities and Exchange Commission on Form 8-K. We encourage listeners to review these items.

Additionally, we've posted a 13-quarter GAAP and non-GAAP revenue model on our website at "Investor.AlignTech.com," under historical financial data. Please refer to both of these downloadable Excel spreadsheets for more detailed line item information. The other piece of information that we normally provide, which is titled "Additional Information" that had some utilization numbers, case metrics and ASPs, some people are having problem downloading that file. It is up there, and you might just need to clear your cache.

And with that said, I'd like to introduce Align Technology's President and CEO, Tom Prescott. Tom?

Thanks, Barbara, and welcome to everyone on the phone today and on the web. We're pleased to have shown solid progress in Q3. My goals today are to very briefly discuss key elements of that progress, provide some metrics on customers and case volumes, and discuss some of the Align team's important accomplishments during the third quarter.

During our last conference call, we lowered our expectations for the second half of 2005 primarily due to the disruption in our sales force, which resulted in gaps in effective coverage and disruption in key customer relationships. Despite these challenges, our sales team was able to regain momentum. While our Q3 results were down from Q2, they were well ahead of our expectations.

During Q3, we generated almost $51 million in revenue, an 11% increase over the same quarter 1 year ago. Our strong gross margin performance and focused spending on our highest priorities helped us narrow the projected loss to $1.3 million. Eldon will go through the P&L in more detail, so I'll shift to what's behind these numbers.

Over the past year, we've been working very hard to close the sales force coverage gaps that impacted us late in 2004 and early in 2005. The rebuilding of this team and their ability to generate sales growth has been among our highest priorities. So we have struggled with maintaining reasonable coverage of our expanding customer base, I am pleased to tell you that as of the end of Q3, our total headcount in the North American sales team was 105. This new team is comprised of outstanding sales talent, and I am certain they will be the best team in the industry.

We still have work to do in continuing their training, ensuring effective deployment and rebuilding numerous disrupted customer relationships. Over the next year, I believe we will start to see some real impact as these high-performing individuals begin to assert themselves in their territories. I want to give real credit here to the field sales management team led by Dan Ellis and his partners in Human Resources. The amount of effort to recruit, train and deploy these new people has been immense.

Though we expected to end the year with total sales headcount of 115 to 120, we may not need to further increase our headcount beyond 105 at this point. We believe with the caliber of people we are hiring and the way they are getting the job done, we are now fully staffed. That said, as our GP base continues to grow in 2006, we would likely add sales people to support that growth. For now, the combination of dedicated ortho reps, GP reps and dual channel reps in a number of territories, along with our customer service organization, is sufficient to give our customers the support they need to use in this line effectively and efficiently.

Outside the US, we have promoted Gil Laks to VP of International, leading our efforts in Europe, Asia Pacific and Latin America. The European team continued to show solid progress, albeit on a much smaller base. We expect to make incremental investments in key countries and markets with an eye to the future. An example is here is Japan. Just 2 weeks ago, at the JOS, the Japanese Orthodontic Society Conference, Align Japan launched Invisalign in this market. We intend to build a focused base of experienced stocks and use that base to expand to the broader market. This is a long-term investment in one of the most attractive country markets in the world.

Clinical education and support remains one of our highest priorities, and during Q3 we made significant progress. Align conducted nearly 130 clinical training events, including certifications, provider workshops and study clubs. We also certified over 1100 new GP dentists, bringing our total to 16,900. A key strategic element of clinical education has been to establish close relationships with the most influential dental schools in the country. Our goal is to become a partner with these leading academic centers and participate with them as they train future dentists and orthodontist specialists.

During Q3 we were able to move forward in this area, announcing such relationships with the University of Texas Health Science Center in San Antonio and Columbia University School of Dental and Oral Surgery. Several weeks ago, we also announced that Harvard School of Dental Medicine had integrated the training utilization of Invisalign into their research focus curriculum. And just this morning, we announced a partnership with the American Dental Hygienists' Association. Hygienists represents the front line of dental healthcare. We believe that they are critical partners in reaching and educating a wide range of patients about the benefits of treatment. We will continue building relationships like these with other universities and industry organizations.

Another key initiative for Align in 2005 has been the launch of a new consumer marketing strategy and advertising campaign. We designed this to promote treatment using Invisalign branded aligners. A new website in approach for reaching and educating consumers and connecting them to qualified doctors was a major part of this campaign. This is a long-term strategy to expand consumer demand and to send focus referrals on those doctors with practices committed to Invisalign.

We expect to increase consumer interest and doctor referral activity. As these prospects turn into patients, we expect to see an increase in case volumes. So how are we doing? Well, our total responses, web traffic and call center activity, have more than doubled in the first 11 weeks. Total doc referrals have nearly tripled and conversion rates are substantially higher. This new strategy is definitely yielding more potential patients.

And how important do our customers view this investment? Well, recently completed research on consumers and doctors shows that 70% of doctors believe the new consumer campaign has generated additional awareness and interest in their practice. 77% of doctors believe the new consumer campaign will result in more consultations and cases for their practice. 72% of docs feel referrals are more motivated about the Invisalign process since the introduction of a new consumer campaign. And 85% of docs feel that direct-to-consumer marketing by Align is critical to increase Invisalign case volume. Good start.

Before I turn to some key statistics, let me say a few words about our focus on new product development. We are committed to delivering a pipeline of new products and product improvements that will significantly enhance the user experience. These will include enhancements of the intrinsic physical product through new materials and additions, such as the compliance indicator. These will also make advancements in software and customer-facing applications, designed to make it easier for docs to consistently get great clinical results. We have recently delivered examples of both.

ClinCheck 2.0 was announced just a few weeks ago, during the ADA conference in Philadelphia. This provides doctors with a suite of software features to make treating patients with Invisalign much easier. Early reports from the fields are that the doctors love the new software and can plan the cases more efficiently and effectively. Some of these specific features have been in the works for sometime as a result of customer feedback. By bundling these and other features together in ClinCheck 2.0, we now provide a robust new software release and a significant step forward in the user experience.

We launched Invisalign Express in mid August after some months of beta testing in three regions. Early feedback has been great. Doctors like the fact that they can send a case in, and if it doesn't qualify as an Express case, they can either upgrade to a full case or cancel. They are also very happy with the value proposition, as the price point for these simpler cases is much lower. They say that many more of their patients will likely undergo treatment for their malocclusion. A number of our doctors told us they believe that Invisalign Express can incrementally increase case starts by 20% to 30% in their practice.

Both of these initiatives point to how we'll deliver value to customers and their patients, as well as to compete in the marketplace. When we get together with you in January to discuss our Q4 and full-year 2005 results, I expect to provide some key milestones, so you can assess our successful execution in creating value-added offerings and product enhancements.

Turning now to the key customer and case volume metrics, we shipped a total of 29,200 cases worldwide. The breakdown is as follows. And these numbers are also posted on our website, as Barbara said. US ortho was 11,100, US GP was 14,000, Express cases were almost 900, and international was 3,200. Q3 utilization for US orthodontist was 3.91, for GP dentist it was 2.39, and for international it was 2.39 as well. The US ortho was lower the last quarter due to sales force disruption and disruption in our customer relationships.

In total, we continue to see an increasing number of doctors send cases to us. Last quarter 10,700 doctors worldwide sent in cases. Nearly, 1,300 of these doctors were first time submitters in Q3. The number of US orthodontists submitting cases was 2900, down a bit from 3000 last quarter. And 6400 US GP dentist submitted cases, an increase from 6000 last quarter.

As I mentioned earlier, we trained almost 1100 new GPs in the US alone. Out of that 33,900 doctors trained a worldwide, 21,800 doctors have started a case and 18,100, or 83% of those, have generated multiple cases. Before I hand the call over to Eldon, I have just a few more comments.

This morning we announced the Board of Directors has adopted a stockholder rights plan. As many of you are aware, several thousand US corporations have adopted a similar plan. The stockholder rights plan is designed to guard against partial tender offers and other coercive tactics to gain control of the company without offering a fair and adequate price and fair terms to all of Align's shareholders. The plan was not adopted in response to any efforts to acquire the company, and the company is not aware of any such efforts.

The details of the plan will be available on our website in the SEC filings section.

Last, just a few words about our new competitor OrthoClear. Between the past few quarterly conference calls and all the 8Ks and press releases, we have disclosed our legal activity to extent required. As there is nothing new to report, we will not provide a legal update at this time. Litigation aside, we have integrated the reality of having this this new competitor to our strategy. We fully intend to compete hard in the marketplace. We will successfully compete with better products, superior quality, outstanding service, real clinical and customer support, and a winning value proposition. Through good execution we will ensure that our customers and our shareholders are the one who ultimately benefit. With that said, let me now turn the call over to Eldon. Eldon?

Thanks, Tom. As a quick reminder, our third quarter press release and 8-K filing in the same document are available on our website. Q3 revenues, as Tom mentioned, were $50.9 million, down 5.7% from last quarter, and up 11.1% from the third quarter of last year. Third quarter revenues by channel were $20.3 million for US ortho, $22.9 million for US GP and $5.7 million for international. These channels represent 40%, 45% and 11% of revenues respectively.

Worldwide training and other revenues were approximately $2 million. Additionally, Invisalign Express represented 645,000 or 1% of the aforementioned total product revenue.

Gross profit for the third quarter of 2005, $5.9 million or 70.6% compared to $37.3 million or 69.2% last quarter. This also compares to a gross profit of $30.8 million or 67.4% for the third quarter of 2004. The sequential increase in gross margin was attributable to reduced manufacturing costs related to continued manufacturing process improvements. For comparison purposes, non-GAAP gross margin, which exclude stock-based compensation, was 67.7% last year.

Operating expenses were $37.4 million for the third quarter of fiscal 2005. This compares to $36.1 million last quarter and $27 million for the same quarter one-year ago. For comparison purposes, non-GAAP operating expense, which excluded stock-based compensation last year, was $25.7 million. Operating expenses for the third quarter reflect a sequential increase and expenses related to litigation, and increases in the sales force partially offset by lowered purchase services cost in R&D.

Net loss for the third quarter was $1.5 million or $0.02 per share, compared to a net profit of $538,000 or 1% per share last quarter, and a net profit of $3.3 million or $0.05 per share in the same period one-year ago. For comparison purposes non-GAAP net profit last year was $4.7 million or $0.07 per share. Again, a full GAAP and non-GAAP income statement and a reconciliation of GAAP to non-GAAP financials are available in our press release and on our website.

Now, on to the balance sheet. Cash and cash equivalents and marketable securities at the end of Q3, 2005, were $79.6 million compared to $70 million at the end of 2004. Contributing to this increase in cash was days sales outstanding of 52 days substantially below our terms of net 60 days.

Now, I'll spend a few minutes on the fourth quarter and full year of 2005 guidance. We expect Q4 revenues to be in the range of $50 million to $52 million, resulting in full year expected revenues of $206 million to $208 million. Ortho channel, GP channel and international Invisalign cases are expected to comprise approximately 34%, 42% and 10% of Q4 revenues respectively.

Invisalign Express cases are expected to comprise approximately 10% of total product revenue. The remaining 4% approximates training and ancillary product revenues. Case shipment volumes are projected to be in the range of 33,000 to 34,000 cases. We believe that Express cases will comprise approximately 20% of our overall case numbers.

Our Q4 revenue reflects blended ASPs of approximately $1440 to $1460. These lower ASPs reflect trends in Invisalign Express, and additional discounting programs that will help us ensure our value proposition remains competitive. Q4 gross margins are projected to be in the 68% to 69% range. Gross margins are expected to be down slightly on a sequential basis, due to the aforementioned lower ASPs. Operating expenses are projected to be in the $36 million to $37 million range for Q4. GAAP net loss is projected to be in the $1 million to $2 million range, or a loss of $0.02 to $0.03.

Let me turn to guidance for full year 2005. Now that we have see a full quarter effect of OrthoClear's as competition, we are able to increase our full year revenue guidance slightly. 2005 revenue is expected in the range of $206 million to $208 million. Channel breakdown is estimated to be 41%, 42% and 11% of 2005 revenues for US Ortho, US GP and International Invisalign cases respectively. 4% of revenues come from training and ancillary revenues, and the remainder is expected from Invisalign Express cases. Case volume for the year is projected to be in the range of 122,000 to 123,000 cases.

Full-year GAAP gross margin is expect -- is projected to be between 69.4% and 69.7%. Full year operating expense guidance is expected in the range of $143 million to $144 million. This includes approximately $10 million to $12 million in OrthoClear related expenses. Bottom line therefore, is expected in the range of breakeven to a loss of $1 million or breakeven to a loss per share of $0.01. We believe 2005 will include approximately 1.2 million of state and foreign taxes.

Let me move on to balance sheet projections for 2005. We estimate our cash balances at year end to a range of $74 million to $76 million. DSOs are expected to average in the mid-50s. We project capital expenditure in the range of $17 million to $19 million for the full year.

Depreciation and amortization is expected to be in $10 million to $11 million range for full year 2005. Just a note on stock option expensing, as you know, all companies must implement the Financial Accounting Standards 123-R beginning in January. As we announced a few weeks ago, we have decided to accelerate the vesting of all unvested options with a strike price about $7.10. This enables a line to decrease the amount we would have had to expense beginning in January 2006, under FAS 123-R.

As a result, we believe that we can eliminate approximately $15 million in aggregate future expenses over the next 4 years, including unvested options above $7.10 strike price and new brands. We expect to record a stock option expense with the existing and new option programs in the range of $8 million to $10 million in 2006. We expect to call this out as a Non-GAAP item beginning in 2006.

We will go to the operator for questions and answers now. Operator?

Thank you. Ladies and gentlemen, we will now be conducting a question and answer session. If you would like to ask a question, please press "star" "one" on your telephone keypad. You may press "star" "two" if you like to remove yourselves from the queue. The participants using speaker equipment, it may be necessary to pick up your handset before pressing the "star" key.

Our first question comes from Tao Levy with Deutsche Bank. Please state your question.

Good morning, guys, and to Barbara. Just I had a couple of quick questions over here. It looks like you guys held up pretty well against OrthoClear in the -- over here in the third quarter. What are the trends that you are seeing heading into the fourth quarter? Is there more activity? Do you sense that they are gaining share on the cases side?

Good morning, Tao. I guess, what I would like to say about that is that the OrthoClear activity is been very, very focused, which is why we felt most of the suffering in the orthodontic channel, and why utilization was impacted because they got in the middle and disrupted those great relationships we had with those very experienced reps that went over there. I think, to the extent they are capable to go outside that focus, we may feel it elsewhere. But I think with our team rebuilt in place now, with our legs -- with getting our legs under us, with moving forward with the commitment to compete in the broadest possible way, product, quality, service, clinical support and pricing in terms of value proposition and beyond. We are comfortable that we can address that across the board. But again I think their focus was on our top orthodontists, and that’s where we felt it the most.

And have you seen any changes as we go through the fourth quarter, the same clients that have been using, continue to use the rest of your customers are not switching?

I think, what I guess -- and I’ve got a finite example of docs I talked to, but number one, we’ve seen some Orthos that have tried the products and have come back in a pretty significant way, for a whole set of reasons. Two, I think people will make a look and try a case or two and decide it may not be for them. But again, I think a lot of this distress for us was caused when we were dramatically under staffed, when those relationships were disrupted.

And I think they probably will do a good job of holding on to some of those relationships. But there are lots of other docs out there that are interested in building practice with Invisalign; that’s where we’re focused on. So, I would say in Q4, I would like to think about getting some of those docs back. We are heading into our summit for orthodontists, our annual summit.

Next week, which is one of the best opportunities for us to get somewhere around 300 of our top practices together, and key members that are staff, somewhere approaching 1,000 people all together and have a very intensive peer-to-peer education environment with practices that are committed to Invisalign. So, that’s just about the best week of our year, and I’m really looking forward to getting up close and personal with these docs to talk about their experience and how we can help them go forward.

Thanks. And, Eldon, on the pricing side, I was surprised to see, especially in the orthodontist’s channel, that actually sequentially went up. Anything going on there? I thought there were some promos that would have brought that down. And then looking into the fourth quarter, I know you mentioned that you expect in aggregate everything to go down. But broken out by channel, do you expect the Ortho’s to go down or stay flat?

Well, Tao, to your point in the third quarter, we did start a volume based rebate program. We started with our highest echelon docs, so on a total average basis, it didn’t have any dramatic impact on the overall ASPs. Within Q3, we are planning on stepping that down deeper -- excuse me in Q4, we are planning on stepping down deeper into the stack of docs and expecting a wider base of participation. So that will skew our ASPs down some. In addition to the fact that we are expecting the volume share for Invisalign Express to kick up and on an overall basis that will also weight down our ASPs some.

And I don’t know if you called out the refinement impact in the quarter?

No. We didn't.

Do you want to?

It's not really a significant event, Tao.

Okay.

The subtle change that we've made in the third quarter overall is not having any significant impact on our revenue strength.

Okay. And then and, Tom, can you just talk a little more about Japan? It's good to finally see that in the back. Just what are the milestones? How are things going to develop there, when you start feeling comfortable that we're going to see some meaningful sales out of that geography.

Maybe I'll answer your specific question that's going to impact your model first and that is we aren't expecting any significant impact for some time. We look at this as a very important strategic initiative. We made a choice to focus on a finite group of a high quality, highly experienced orthodontist that are key influencers in Japan. We've done this in a careful, thoughtful way with full collaboration with the Japanese Orthodontic society. And we expect the milestones would be numbers of docs formally trained as we go through '06, case starts there to get started. And we'll report on that as a strategic matter, and not as it impacts number, but the goal would be to build a great base in the foundation of experienced docs. In out years, let’s say 3 and more years, we will take that out much more aggressively to a much wider base of docs and start seeking to substantially grow the market, but I wouldn't expect any financial impact other than some spending in the near term.

Okay. And then lastly just for clarification. My understanding was with Invisalign Express that if the patient came in, what if he get the Invisalign Express and they didn't qualify that the doctor could still give the -- provide the patient with Invisalign Express or at least that’s what some orthodontist had told me?

I want to make sure I understand your question. The way the process works today, a patient can come in, get records, get set up for Express. If the patient is an Express patient -- in other words, they can do the case in 10 stages, then they go ahead and they do Express. If the case cannot be done in 10 stages, then it comes back as a full case. The doctor and the patient have the choice to either cancel, which very, very few do or they can upgrade that to a full case, which most do in the event that occurs.

That flexibility -- and if you contrast that with our normal cases, if they set up the full case, the patients goes ahead and it’s a full case. If they cancel, there is a charge to the doctor. That allows the doctors in the front end to feel much more comfortable with the patients to take a look at doing the treatment, let the patient see what it would look like and then move forward. And so that’s how the process is working and it's -- that based on the feedback from our Beta testing we did with Invisalign with stage seven.

So there is no way for a doctor to provide Invisalign Express to a patient unless there are real candidates. So let’s say I needed 12 cases -- 12 stages and the doctor was (inaudible) 10 will get you to this. Are you okay with that? And if the patient says, yes, then they go ahead and do an Express instead of a full? There’s no way of that happening?

No. In fact, if the doctor and the patient agree and that's the end of treatment --

Yes.

-- and that's the treatment, well, the doctor is free to do that. And let me give you an example. If there is -- there’s many GP dentists out there that do a variety of things. They do some fixed appliances, they do some perio, they do other areas as a generalist, and they do restorative it. What they can do is perhaps use Invisalign Express to get better occlusion, but not trying to seek perfect occlusion, say, as an orthodentist would. But they are able to preserve healthy tooth mass, and then, in fact, do restorative, do less reduction of that healthy tooth mass, do restorative -- less extreme restorative work and put veneers on -- a healthier outcome for the patient, and far less expensive for the patient as well. So there are all different kinds of outcomes. But if the doctor and the patient agree on an end point, which is, say, not to full occlusion, not to a perfect finish, that's the doctor and the patient's choice. And if that can be done in 10 stages or less, then it can be done with an Express case.

Okay.

That makes sense?

Yes. No. That's perfect.

Okay.

Thanks a lot. And good quarter.

Sure. Thanks, Tao.

Our next question comes from Sean Smith with Stevens Incorporated. Please state your question.

Yes. Good morning. Just a follow-up on the question along the Express line of thinking. Could you just maybe provide a little bit of insight in terms of what your thoughts are if this product is actually growing your market opportunity or you feel like you're cannibalizing some of your full cases? And then also just your guess in terms of mix on the Express orthodontist versus GPs?

Let me start with the reverse order you just gave. So far we actually started out thinking stage 7 would be a GP product. What we found in the regions where we piloted at was that there were also Orthos that were interested in doing very mild malocclusions at a lower price and simply couldn't get there with our full case price. We are -- so we think it's both and the data for Q3 supports this both. It's roughly split down the middle between GPs and Orthos.

Now, just because of the larger number of GPs, over time, probably over some number of years, there will be a larger of Express cases being done by GPs. But we absolutely think the value proposition is right. Now, backing up further to your question about, is this a growth dynamic or is this a cannibalization of a fixed pie, the answer is this is absolutely a growth dynamic. And this is, we -- so we think -- let me tell you how we think about that without framing this in numbers.

The fact is that we -- when we did the pilots for stage 7 and when we launched Express, we could look at what we believed cannibalization would be and that would be ostensibly the number of cases that are, say, under 10 or 13 stages. In fact, the data is actually less than our expectations for cannibalization as more doctors, if they came to the case (inaudible) with Express or are actually upgrading to full case versus canceling. And there are some number of docs that may have been doing a case (inaudible) at double that are getting with Express, but that's a fairly small number.

What we have anecdotally so far, from many discussions with many doctors, is they are looking anywhere from 20 to 30% more cases they could do in practice as a result of Express. So we absolutely believe over time, this is going to add versus take away from the base number of cases. And again, maybe even stepping back further, Sean, we're still so early in the overall penetration of this broader market that this -- I don't that there is anything about a fixed pie. This is another way to help grow the market and expand the segment.

Okay. Tom, then just also thinking a little bit about some successes that you alluded to as it relates to the advertising campaign and in the new marketing strategy, when we juxtapose that, I guess, some of the utilization statistics and case starts, they don't really jive. And I guess I'm just trying to get some sense as to when you think we'll start to see the successes you're seeing in the early stage of advertising campaign manifest itself in terms of improving utilization trends and so forth?

Well, I’m going to step back from that factor and say something has changed in our world. What changed in our world was OrthoClear dropped in, took our most experienced reps, got in the middle of our relationships with those doctors in their practices, and that's the principal driver behind changes in utilization and more approximately towards the issues with orthodontists.

We believe we're going to get back at that. We believe we're going to drag some of these doctors back under the (inaudible) with the right value proposition, direct support, better product, all that stuff. That's going to be a stepwise process over time. And we're not afraid of competing for that business. But that's the big factor that skewed utilization and the market. And we've been pretty clear about that from the beginning.

When we launched the new consumer strategy in May of ’05 of this year, what we said was, this was not going to have a short-term impact to pop on case-starts. We thought this would be anywhere from, at the earliest, 3 months to more likely 9 months as kind of a tail to turn activity into case-starts. This is also true of our more traditional DTC approach, as we could actually track calls into the call center, fulfillment activity, on down to trail to case-starts.

What I will tell you is, we are hopeful because, so far, conversion rates are higher, activity is greater and so for increments of spend, we track that activity differently, but we believe we are going to get impact on that as we get out into Q1, Q2 and beyond. Again, this is not a tactical kind of squirt some spending into marketing and get some case-starts up into the pipe. This has an element of growth that we expect to see in numbers in '06 and beyond, but it also has to do with a fundamental approach about long-term demand creation and building the brand. And so I guess those two elements, brand development, long-term demand creation, we feel we are right on track with. We don’t feel we’ve really seen the wave of case-starts yet from this activity. Again, we are just barely a quarter into it. We expect to see this as we get out into '06.

You alluded to you guys gained some of your customers back that you lost early on to OrthoClear. Could you just talk about their motivations and their rationales to why they are coming back to Align after trying OrthoClear?

I want to be thoughtful here about the range of things we hear and I also want to say that we think OrthoClear is -- we have to respond to this, and what I say is we’ve integrated them into our strategy and we are competing with them in a very complete way. When I say a complete way, that means we are committed to better customer support, better clinical support, real clinical support, better product, better quality, faster cycle time, all the things that are important to doctors.

And after doctors had a chance to work with a competitive product, they come back and say, maybe it’s not everything I wanted. I don’t -- our assumption is not that OrthoClear (inaudible) the marketplace. Our assumption in terms of competing with them is they are here to stay and we are going be prepared to take them on in the marketplace in a very complete way. So the things we hear from docs are that our quality is better, our cycle time is better, we’re able to visualize the whole case, versus just seeing it segment-to-segment. And the kinds of things that got them excited about building their practice with Invisalign are the kinds of things that are bringing them back. But I don’t see (inaudible) way to that. I see us, as we rebuild our sales force and start to rebuild those relationships, I see us winning them back practice by practice.

Great. Congratulation on a good quarter in a difficult competitive environment. Thanks for your time.

Well, thanks John. We don’t -- we are not celebrating. We’ve got a lot of work to do.

Thank you. Our next question comes from Ryan Rauch with Jefferies. Please state your question.

Good morning and again, congratulations on a solid quarter

Thanks, Ryan.

And just a few question, Tom. Maybe you can walk us through your sales force expectation? It’s been reined in a little bit. Is that just through productivity gains that you are seeing in your current sales force? And then, number two, there is some concern in the market that on October 27th, you are going to have a rash sort of set of departures based on your agreement with the courts in San Francisco on OrthoClear. Can you walk us through any retention programs, or what your thoughts are generally about your sales force going forward and then what you expect to see October 27 and beyond?

What I will talk about is the sales force and then maybe I will just ask Roger George, our General Counsel, to comment on the specifics of the second element. The first issue is, we -- first of all, we’re competing for talent in our Company with every other employer out there, not just OrthoClear. So we think about this in terms of creating a great place to work, with a focused set of priorities for the Company and a winning game plan and again, a culture where people want to be, where employees get to contribute and get recognized for their contribution and grow.

So that’s an issue we face everyday anyways with lots of other employers in Silicon Valley. There’s lots of other people out there hiring or trying to attract our talent away. So this is not just OrthoClear this year. This is about how do you build a company, how do you create a great culture in a competitive environment, period. OrthoClear bought a very specific set of objectives. They tried to take our wheels out from under us by taking our most experienced reps and they got most of them, especially on the ortho side. In response to that, we put together retention programs that were covering us for the full year. And the great news is, even though a lot of these reps got put on guarantee and there was always retention effects put in place, most of these reps are beating the heck out of their numbers.

They could have set back and got late starts every morning, got out to cover their customers. They’re out there in a race to wins president’s club, great trip at the end of year. They’re out there kicking it every single day. I was just at a customer reception not long ago, and I’ll tell you, a year ago, when we were struggling to get fully deployed and get up to speed in our coverage, I went to a customer event, I heard a lot of complaints from customers saying, I haven’t seen my rep and they aren’t getting out to see me often enough.

Several weeks ago, I was at a big customer event. They said, I love my rep, you guys have great coverage, you are taking care of our business. To me, that’s a great indicator of health in terms of our field team, in terms of their ability to provide effective coverage and I don’t think it’s related to productivityyet. We haven’t seen that. We hope to get some of that in ’06 because they will be in their territories for a while, they will be building those relationship and we hope to get some leverage out there in '06 and beyond. So I -- what I'd say is I don't have great concerns about October 27th or any other day. We are out there competing for talent every day against OrthoClear and everybody else. I asked Roger to comment specifically on that day relative to one element of the order.

Thanks, Tom. My comment is a pretty short one. On October 27, the legal fact is that OrthoClear's prohibition against soliciting Align Technology employees and that prohibition is set for the preliminary injunction; that prohibition expired. So as of that date, OrthoClear is legally free to solicit employees from Align Technology.

Okay. Perfect. And then, Eldon, can you just walk us though your gross margin? It was very strong. Sort of where do you see that heading going forward? As it was the strongest in your history, what kind of manufacturing efficiencies you're putting in and how much more you can drive that going forward?

Ryan, we've had an ongoing dialogue on the things that we are doing in manufacturing. We're continuing to work on piece improvements throughout our process with lot of emphasis this year on working on the backend of our process and aligner fabrication, particularly a lot of initiative work going -- that’s in process and the sterilization and packaging segment. We'll continue a chipping away at that and we'll continue to get step function improvements. I mean, that's part of what you saw in the third quarter; those carry on into the fourth. As far as our programs beyond that point in time, we'll come back around at the end of the fourth quarter and as Tom mentioned, and talk more about our milestones for the coming year.

Okay. And then finally, Tom, can you just walk through briefly, it looked like your international initiatives are doing well. You had a good quarter there. You’re just scratching the surface, it appears, but just walk through maybe how many sales people you have there and just the different initiatives and the success you're seeing internationally. And thanks a lot.

No problem. Let me -- we haven’t really provided visibility to kind of resources deployed outside the US, so I'm going to talk about this in a more general way. The focus is really kind of core Western Europe where we provide incremental resources to that team to grow and they provide incremental growth against that. I think one of the things -- that team has done very well this last year, which was part of the specific game plan, learning from our experiences in US was instead of trying to go more broadly, go wide.

They've tried to go deep as we are trying to do and that starts with clinical education and clinical understanding. So we added resources over there. We created a clinical director role. This group has done a terrific job of raising the experience level of facilitating peer to peer learning, of holding workshops and study clubs and summits and a whole series of clinical education events that really get at accelerating the clinical understanding and excellences of Doc. That, in a focused way with more focused coverage in the key countries, has led to some solid incremental growth. I want to put this in perspective. We’re not trying to step on gas there.

At this point in time, we are trying to have that team get those incremental resources and deliver that incremental growth. At some point in time, we will be ready to do more internationally and, frankly, if it hadn't have been for some of the OrthoClear issues and our focus on legal spending and the realities of our world, we probably would be extending the investments in Europe, in Asia at this point of time. But we want to be thoughtful about the overall P&L envelope, and so we are asking those teams to do well with incremental resources and they've done that very well.

Thank you. Our next question comes from Taylor Harris with JP Morgan. Please state your question.

Good morning.

Hi, Taylor.

Hi, there. So first question just on Invisalign Express. It sounds like -- I believe you said you're going to have 20% of case volumes in the fourth quarter from the Express product. Can you maybe comment on how that's trending? Is it -- will it still just be in the ramp stage and then looking into 2006, any expectations?

I will answer the question about how is progressing now. And I’ll let Eldon talk about any numbers behind that. We think it's a traffic launch. It's everything we want it to be. We continue to see great feedback from docs. They see it as a margin expander and that's how we are looking at it, so we are committed to that and if that drives fundamental demand growth in concert with our efforts to broaden the market through consumer marketing, great, and that's what we're trying to create. I won't give any numbers now we already described for Q4. I’ll let Eldon talk more broadly, but he is going to comment.

As far as what we are looking at, they’re at 20%. I think Tom stated it well that, I think we're pleased at how the product has come out of the gate. We started mid-quarter. We've seen a lot of interest. We see the product growing, stepping up to being approximately 20% of our volume in the fourth quarter and also early in that product we'll have see how it evolves and see the direction it goes. We are pleased at that level and we haven't set any hard milestones or boundaries about where we thing the product can grow, but we are very happy to see it at that level and an opportunity to start getting step function expansion in the market.

Okay. So no comment at this point on what the penetration could look like in '06?

Well, as Tom mentioned, we'll be back at the end of the fourth quarter to talk about our milestones for next year.

Okay. And maybe, just one more time back on the growth versus cannibalization question, if doctors are saying 20 to 30% new cases potential and you're looking at 20% of your volume in the fourth quarter, I mean, I guess -- is it fair to assume that we are still -- there is a split between growth and cannibalization? But it's not just all growth or is that wrong?

What we've said is it will be -- if you -- and the way we think about it is any full stage, any full case, they was, say, 10, 12, stages or less, you would assume, right of the top, we would lose. That's a fairly small number. And part of the reason why it’s a small number is doctors were trying to find other ways to move those very, very mild malocclusions, whether they did a suck-down in their office, or whether they put a fixed appliance or a spring retainer in place or something. They were -- because it was hard to justify the cost they would have to charge the patient, when they have to pay us our full case price.

So, part of the good reason is we now get to play. We typically didn't play much there. We now get a chance to play with those fairly mild malocclusions; that's number one. Number two, that the cost for that is there is a few cases we lose that would have been full stage cases. We're perfectly happy with that. And if you look at the trajectory run, it’s way above what we used to get for those kinds of cases when we are talking 20% and those kinds of numbers.

So, we think, you know, we think in general this is a great opportunity for us and I think, what you should expect for us over the longer term, 2006 and out years is first to continue to expand the product line, to make the sure the value the proposition, price performance, and the whole job they are hiring us to do for them, meets their need across the spectrum of care. So, again, what are the ways we going to compete with new products, extensions to our product line, and new opportunities like Express. And if we can continue to do that with the kind of success we have with Express, we are going to be very, very happy.

Okay. Great. Eldon, on the gross margin front, can you comment on, at least at current volume levels, what -- how big of a difference there is between Express and the base business?

In terms of fundamental product margin?

Right.

The Express product, you know, given our ASP of $750, doesn't involve as much cost as our standard Invisalign product. But, overall, it is several percentage points of margin less than a standard Invisalign product. But it's not a dramatic difference.

Okay. Okay. Great. And then, just a last question on the discounting programs. Can you give us a sense of how deep into the volume level prescribed by a doctor you are going to be going with those programs in the fourth quarter?

We are not talking about exactly how deep we're going. And in all due respect, we are not avoiding talking about that from a standpoint of the analytics of the business. We are not talking about it from a perspective of specifically how many clinicians are deep into the list because there is knowledge in the industry of who our high volume docs are. And if we said exactly how many, that would create some excellent points of triangulation to know where the target audience is and that's competitive information that we are not going to disclose.

Sounds good. Okay. Thanks a lot, guys.

Sure. Thank you.

Our next question comes from Derek Leckow with Barrington Research. Please state your question.

Thank you. Good morning.

Good morning, Derek.

How are you doing? Just have a question here on the sales reps. I mean, you lost 17 sales reps last quarter, so it's kind of a surprise to see the revenue up as much as it was this quarter. And then you added, I think, a net of 8. Did you lose any additional reps in the third quarter?

Let me just bring you back a little bit. We didn't lose 17 last quarter. That really goes back to the first quarter of the year and there were a few that flooded to Q2. We actually had very little turnover in the sales force over Q3. We have been in a built mode all through the year and I’m going to maybe pull it back even further. As we exited Q2, a year ago, in 2004, we had -- we were -- the business, frankly, was surging. It was growing very rapidly. We were training lots of new docs and we were getting really good traction in the market. And we got behind on our sales force deployment. So, for the reminder of '04, we were chasing what we felt was a reasonable deployment level and that’s as far as the impact what I’ll call effective coverage, meaning touching customers' right, giving them the right clinical support, helping them grow their practice.

As I said, a year ago, at some conferences I was at, doctors were saying, I haven’t seen my rep, and so it's a simple indicator, right? When we exacerbate that and that got affected by OrthoClear picking off 17, 18 of our absolutely most experienced, especially ortho reps, that put us deeper in the hole. And so for most of this year, we have been chasing what I will call effective deployment and effective coverage.

On top of that, this competitor disrupted those relationships and that made it even harder. So I’ll now pull you back to the present. We really haven't lost any more reps. We're pretty stable. The team is pretty excited. They are rolling. We're feeling we are about properly staffed at this point. Again, if we continue to train substantially more docs, we’ll have to increment some headcount into that. But I feel like we are in reasonable shape as we sit here today.

And if I go back any further than that, if I look at back at '97, '98, I think a lot of those sales people that left were sales people that Align originally poached from Cybran (ph) isn't that right?

Well, I wasn't here then, but I think those people all came over pretty much en masse with the then VP of North American sales. And they decided to take their show to a different town more recently here.

And now the reps that are here you say that it's stabilized, you really haven't lost anybody and -- but you have taken down the number of reps you plan to add in the fourth quarter. And I'm wondering, have you changed anything in relationship to the compensation package or bonus programs? Can you talk about that a little bit as well?

Nothing has changed other than what we did -- as we began the year, we wound up with a rate on our hands and we put together all sorts of retention programs which are still in place. So nothing has been changed. What I’ve said is there's a number of reps having the best years of their lives and beating the heck out of their plan. And there's a horserace going on to see who are going to be the top reps that get to go on this great trip we do called the President's Club.

So I'm pretty excited to see that level of engagement and excitement in the field. We really don't have anything else going on. This group is getting their legs under them. Again, I've said earlier we have a lot more work to do and a number of them are fairly new in their territories. I think it's going to be into '06 before we really start to see kind of full effect of this coverage. And I see a solid progress, but no more.

Okay. Great. And then on the marketing expenditure, it looks like we are seeing a lot lower level of expenditures here. I wonder if Eldon can talk a little bit about the planning for next year and why we saw lower expenditures in Q3?

Let me address what we did talk about in Q3 and Q4. As far as our spending in Q3, we were up a bit sequentially. Specifically, as I mentioned, that we have put a lot of effort into launching our ClinCheck product and the Invisalign Express. And from an engineering perspective, we had some fairly expensive contract resources in to do that. And we finished that and rolled those resources off. So you will see on the P&L a little bit of a ripple from an R&D perspective.

Talked about that we spent a little bit of an uptick in our litigation expenses. So those are the key drivers in Q3. From a sales force and marketing perspective, we were up some in sales headcount and we continued our marketing programs through Q3. Now when I talk about in Q4, that our operating expenses are basically flat to slightly down in the range that I put out there, the only real change in the cadence of our business going into the fourth quarter is there usually is and we plan a bit of a step down in our marketing activity, particularly our media advertising, because in the fourth quarter, we don't try to compete head on for space with the Christmas crush, the advertising media.

So the fourth quarter tends to be our lightest quarter of the year for advertising spending. So that has a bit of a ripple in our business. Obviously, we're watching our operating expenses very closely, and at the same point in time, not to break the cadence of the business. As far as 2006, as we mentioned, we will back at the year and have more to say about our 2006 business.

Just from a strategy viewpoint, I think that you have said last quarter that you expected profitability again after you complete both the -- some of the litigation spending that's going to be coming up and as well some of the media advertising that was talked about. Do you anticipate now that this has been something that you would push off? It sounds like Q1 was when we’ll see a big increase in media spending. So just trying to gauge when we'll start to see the company to get back to a level of profitability?

Well, I think, what we said last time was it is our long term goal to run a robust profitable business. And that goal has not changed. We didn't talk specifically about when or where. But that is our -- that certainly is our goal. It's not our desire to run an unprofitable business for the long-term. That equation tends not to close very well. As far as the how's and what's of 2006, we will be back at the end of the year and have more to say at that time.

Okay. Thanks for the comments.

Very good. And Diego, we'll -- I think with time, we'll take one more question.

Thank you. As a reminder, if you would like to ask a question please press "star, one" on your telephone keypad. Once again to ask a question, please press "star, one."

Our next question comes from Abe Kim with MDD. Please state your question.

Thanks for taking my call. Regarding Invisalign Express, could you talk a bit about the number of cases submitted for Invisalign Express, consideration versus those that were ultimately accepted as Express cases?

So you mean what's the percentage of cases sent in that were ultimately accepted or going forward?

Right. Exactly.

Virtually all of them. The actual cancellation rate is very, very low. And the cases -- most of the cases that are set up -- that are sent in as Invisalign Express, but then sent back as, say, a 14 or 15 stage case. Virtually all of those have been up sold to full treatment.

Okay. And I don't know if you went over this earlier, but the breakdown between Orthos and GPs in terms of the 900 Invisalign Express cases this quarter.

We didn't go into detail, but I’d say there’s plenty of both for both sides there.

Okay. Could you talk a bit about some of the steps you are taking to ensure that doctors who are referred by you are actually promoting Align versus some other competing product?

It's a great question and one we spend a lot of time talking about with our customers. There is a whole series of actions in the marketplace, as with our sales force, with our programs. First of all, we're happy to have anybody to invite us into their practice and do cases with Invisalign and Invisalign brand aligners. We have a series of what's called increasing benefits for those practices that want to focus on Invisalign.

And our goal over time is to make that difference between dabbling a little bit with Invisalign and maybe other products and doing virtually all their business with Invisalign, make that difference much greater, which is why we've concentrated referrals on those doctors that are committed to Invisalign, which is why we have concentrated our programs, our volume rebate and discount programs and all those other issues, and have thoughtful discussions about how they position Invisalign with their patients. They do know that patients come into their office asking for Invisalign and they do know they have a responsibility to be honest and open with their patients about the products they are using. So this is a great opportunity for us to lead with integrity and move the market forward and we're having those discussions every day and every week out there in the market channel with our customers.

Okay. You talked about this briefly in your federal suit, but has this been an issue that's actually impacted business as doctors referred by you somehow promote a competing product?

I think that what I would say is that this will sort itself out and what's right is right. What's wrong is wrong, and if a patients comes in and asks for Invisalign and a doctor without knowledge for that patient puts him in a different product, then that patient is right to feel that they have been misled. So what we're trying to do is find that right balance between and lead by example and lead with integrity, so that our customers can respond in a positive way to our programs, respond in a positive way to our value proposition and if there are some bad actors out there, sort that out in a whole separate way.

In a whole separate way. What might that be?

So I think if doctors are baiting and switching, they've got some problems with that. Maybe I'll ask Roger to amplify, just a moment.

Hi, good morning

Hi, Roger.

The topic of baiting and switching involves consumer protection laws as well as ethical obligations that dentists are under in every state in the country. And if we become aware that there are doctors who are actively baiting and switching, then we make sure that as a legal matter, we help patients and that's how we find out about it because the patients call us.

Okay. And lastly on some of the new products OrthoClear has announced not too long ago, what have you heard from your GP sales force about some of the impact that they’re seeing or they potentially might see, as a result of some of the aggressive pricing here on some of these new products, namely the products to address Invisalign Express and (Direct Clear) product.

I guess what I'd say is, I'm not surprised by anything I see from this competitor and we’re comfortable with our value proposition and our product. We seem to be doing very well with it. The feedback we get from doctors is for that difference in price, it just doesn’t matter. And for the comfort, the quality, the service, the clinical support, the cycle time for delivery, all those factors together say "why take a chance" and that's pretty consistently the message we are hearing.

Are they going to go out there and get a little bit of business here and there? I guess they are. They hired a bunch of reps. They are also trying to make a living, although I guess they all are on guarantee and their pricing has been all over the math, including free. So I guess a free price -- zero price is kind of hard to scale a business around. And I would say so far what you are seeing with the results in Invisalign Express, it doesn’t seem to be an issue. But we are committed to competition. We are committed to make sure the value proposition works and we continue to push that forward everyday.

Did you say OrthoClear out there offering their products for free?

Yes, we've seen some of that.

Okay. Thank you so much.

All right. So I guess that's it. I would thank you for your time and attention on this busy morning. We thank you for you listening in and we look forward to meeting with you in the coming weeks and months to talk about the Company. Thank you, operator.

Thank you. Ladies and gentlemen, this concludes Align Technology's teleconference. You may disconnect your lines at this time. Thank you all for your participation.