愛齊科技 (ALGN) 2013 Q3 法說會逐字稿

Welcome to the Align Technology third quarter 2013 earnings conference call.

At this time, all participants are in a listen-only mode.

A brief question-and-answer session will follow the formal presentation.

(Operator Instructions)

As a reminder, this conference is being recorded.

It is now my pleasure to introduce Shirley Stacy of Align Technology.

Ms. Stacy, you may begin.

Good afternoon and thank you for joining us.

I'm Shirley Stacy, Vice President of corporate communications and Investor Relations.

Joining me today is Tom Prescott, President and CEO; and David White, CFO.

We issued third quarter fiscal year 2013 financial results press release today via Marketwire, which is available on our website at www.investor.aligntech.com.

Today's conference call is also being audio webcast and will be archived on our website for approximately 12 months.

A telephone replay will be available today by approximately 5.30 PM Eastern time through 5.30 PM Eastern time on October 25, 2013.

To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 421424 followed by pound.

International callers should dial 201-612-7415 with the same conference number.

As a reminder, the information that the presenters discuss today will include forward-looking statements, including without limitation statements about Align's future events, product outlook and the expected financial results for the fourth quarter of fiscal year 2013.

These forward-looking statements are only predictions and involve risks and uncertainties such that actual results may vary significantly.

These and other risks are set forth in more detail on our form 10-K for the fiscal year ended December 31, 2012.

These forward-looking statements reflect beliefs, estimates, and predictions as of today, and Align expressly assumes no obligation to update any such forward-looking statements.

During today's conference call, we will provide listeners with several financial metrics determined on a non-GAAP basis for comparisons to previous quarters.

These items together with the corresponding GAAP numbers and the reconciliations to the comparable GAAP financial measures are contained in today's financial results press release, which we have posted on our website at www.investor.aligntech.com under Financial Releases and have been furnished to the SEC on form 8-K.

We encourage listeners to review these items.

We've also posted a set of GAAP and non-GAAP historical financial statements, including the corresponding reconciliations and our third quarter conference call slides on our website under Quarterly Results.

Please refer to these files for more detailed information.

With that, I will turn the call over to Align Technology's President and CEO, Tom Prescott.

Thanks Shirley.

Good afternoon everyone, and thank you all for joining us today.

I like to personally welcome David White, our new CFO, to Align.

I'm excited to have him join our executive team.

For those of you that have not met David yet, he started the first week of August just after reported Q2 results.

He has hit the ground running and is quickly coming up to speed in our business.

On the call today, I will provide some highlights from our third quarter results and briefly discuss the performance of our two operating segments, Invisalign Clear Aligners, iTero scanner and CAD/CAM services, including some color on our customer channels and geographies.

David will share more detail on our Q3 financials and discuss our outlook for the fourth quarter, and I will come back to summarize a few key points and open up the call to questions.

I am pleased to report another very good quarter for Align with revenue, gross margin and EPS higher than our outlook.

Further, we achieved record levels of revenue, Invisalign case volume and North American iTero scanner volume, enabling us to reach the low end of our long-term model for operating margin while generating strong operating cash flow.

The third quarter includes the seasonally slower period in Europe and North America for our GP dentists, along with the peak of the summer season for teenage orthodontic case starts.

We are pleased that patient traffic appears to have remained solid for our North American ortho customers this summer, which resulted in strong sequential and year-over-year growth for Invisalign volume, especially in the important teenage patient segment.

For Q3, total Invisalign case shipments increased to nearly 107,000 cases worldwide for the first time.

Year-over-year growth was driven by continued expansion of our customer base, as well as increased Invisalign utilization.

Improvements in product and technology over the past few years, including our new SmartTrack aligner material, are helping build even greater clinical confidence so our doctors will utilize Invisalign more often and on more complex cases.

Doctors continue to give SmartTrack aligner material high marks on performance, with 78% of doctors surveyed agreeing that SmartTrack supports better clinical outcomes.

SmartTrack aligner material also recently received the Top 100 product accolade from Dentistry Today and is the winner of a 2013 Pride Best in Class award which will be presented at the upcoming ADA meeting in New Orleans in two weeks.

Q3 results also reflect solid growth from our iTero scanner and CAD/CAM services business.

I'll start with a quick recap of a few key metrics for Invisalign, covering utilization, training and teenage ortho market penetration.

Rather than go into a lot of detail here, I recommend you reference our Q3 earnings slides posted on our website.

For Q3, total Invisalign utilization was 4.3 cases per doctor, a slight decrease from Q2 at 4.4, which reflects an increase in utilization by North American orthodontists offset by North American GPs and European doctors.

This is consistent with the seasonally slower period for these customers and geographies.

In Q3, we continued to expand our base of Invisalign providers, adding 90 North American orthodontists, 705 North American GP dentists, and 840 international doctors for a total of 1635 new Invisalign doctors.

During the quarter, total teenagers treated with Invisalign increased to 28,900, a year-over-year increase of 18% and a sequential increase of 23%.

For North American orthodontists, Q3 case volume of 41,600 cases increased 16% year-over-year and 5% sequentially, primarily reflecting continued increases in utilization along with some contribution from new orthodontist submitters.

These results reflect our continued focus on driving adoption and utilization of Invisalign into the very important teenage orthodontic market.

While we're still assessing the market data from the summer teen season, we believe we gained some teen share of overall orthodontic case starts.

For North American GP dentists, Q3 Invisalign case volume of 38,500 cases increased 11% year over year, primarily reflecting an expanded customer base along with increased utilization.

On a sequential basis, GP case volume was down slightly as expected given the seasonally slower summer period for most GP practices.

For international doctors, Q3 Invisalign case volume of 26,800 cases increased 22% year over year and was down modestly from Q2 as expected, reflecting summer holidays for our customers especially in the southern European countries.

We continue to see strong volume growth for our Asia-Pacific region, which was up sequentially and year-over-year.

That strong volume growth in Asia-Pacific came from our traditional direct country markets of Japan and China as well as our new direct country markets in Australia, New Zealand and Hong Kong.

Collectively, this region continues to represent a great growth opportunity for Align.

For Japan, Q3 was another record quarter for Invisalign volume.

Strong growth was driven by the continued increase in the submitter base.

We're also seeing positive trends in team submissions as a result of expanded training for Japanese doctors on the Invisalign teen product which began in July.

Product innovations like Invisalign G4 and SmartTrack really hit home in a market like Japan where the cases are very complex.

For China, Q3 was also a record quarter with strong sequential and year-over-year growth in design volume.

These results reflect continued good execution of our strategic investments over the past few years.

The China team continues to deliver outstanding clinical education, provide high-impact clinical and customer support, and facilitate peer to peer advocacy, all of which support our strong progress.

Much of this effort is being helped by key opinion leaders at the premiere government hospitals and orthodontic and dental schools.

As the dental market evolves in China, access to dental care is expanding.

Fueling part of that expansion is the increasing number of clinics serving the growing middle class.

Align is working closely with a number of these high-quality operators that are actively marketing Invisalign to consumers.

These clinics understand the value of the Invisalign brand and are working to make Invisalign a significant part of their practice.

On an overall basis in our direct coverage Europe region, case shipments increased in this region by 20% year-over-year, led by Spain, France, Italy and Germany.

Across the region, we've seen an increase in clinical confidence in our product along with further expansion of our customer base and increased demand for shorter, simpler treatments.

These trends combined with our continuous investments in education and customer expense improvements are continuing to great progress for Invisalign in Europe.

All country markets demonstrated strong year-over-year growth for Invisalign case shipments with the exception of the UK, which decreased slightly compared to Q3 last year.

While our team in the UK continues to work against some economic headwinds, we are seeing some initial signs of recovery among orthodontists in the UK.

Turning to our consumer program, late in Q2 we launched a new fully integrated consumer advertising campaign in North America, and Q3 was the first full quarter in the Market.

The Better Smile Every Day campaign continues our focus on women and moms of teenagers, and its launch was timed to coincide with the busy teen orthodontic season which runs from late spring to the start of the new school year.

We're pleased with the strong early metrics from the campaign which combines TV and digital advertising with social media and traditional media relations.

Web traffic at Invisalign.com continues at an all-time high and is a strong indicator of consumer awareness and interest in Invisalign.

As a result of great editorial coverage in key outlets such as Lucky magazine, Marie Claire and Working Mother, our year-to-date print and online media impressions are at an all-time high.

Over time, we expect to convert this awareness and interest into patient starts in our customers' practices.

Let's now shift to our scanner and CAD/CAM services segment, where we had a record quarter for scanner shipments in North America.

We are continuing to build our scanner installed base, and by our estimates, we are growing faster than our competitors.

These results reflect the selling leverage we are gaining from major Invisalign customer events, such as the Invisalign GP Summit held in July, as well as Invisalign orthodontic forums, an key clinical education event held throughout Q3.

This progress and the feedback we continue to receive from iTero customers supports our belief that we have the best scanner with the greatest utility in the industry.

An important part of our scanner business strategy is to improve the customer and patient Invisalign experience through the use of scanners to replace PBS impressions.

We are definitely seeing leverage as our case submissions from digitally screened, digitally scanned impressions continue to increase consistently.

As of Q3, the percentage of Invisalign cases submitted with a digital scan rose to 25% in Q3 compared to 22% in Q2 and 13% in Q3 a year ago.

Doctors, staff members, and especially patients are all happy about this trend as they see faster cycle times, better aligner fit and a far better experience.

And with that, I will now turn the call over to David for a review of our Q3 financial results.

Thanks Tom.

I appreciate the warm welcome.

It's great to be here at Align on my first quarterly earnings call, especially after such great results.

Before get into the details, I would like to note that unless stated otherwise, all the financial information I will discuss will be presented on a GAAP basis.

Now with that, let's review our third quarter results.

As Tom mentioned, our revenues for the third quarter amounted to $164.5 million, up slightly from the prior quarter and up 20.5% from the corresponding quarter a year ago.

Third quarter clear aligner revenue of $153.5 million was relatively flat sequentially and was up 21.2% year-over-year.

Sequential revenue growth was driven primarily by seasonal strength in the North American ortho market, which reflects a 27% sequential increase in the number of teenage cases in North America.

This was offset somewhat by a decrease in international cases and lower international ASPs.

North America ASPs were flat.

Our year-over-year growth reflected higher Invisalign volumes across all geographies, channels and products.

Turning to our third quarter scanner and CAD/CAM services segment, revenue was $11 million, half of which related to scanners and the balance of which related to services.

This represented a 4.1% sequential increase and a 12.1% increase year over year.

Third quarter scanner volume was up 32% over the last quarter, which reflected record volumes in North America.

Moving on to gross margin and operating expenses, third quarter gross margin was 76.0%, up sequentially a half of a point and up 2.4 points over non-GAAP gross margin reported in the same quarter last year.

Clear aligner gross margin for the third quarter was 79.9%.

This was up 1.5 points sequentially and up 2.3 points when compared with gross margin reported in the same quarter last year.

The sequential increase was the result of two primary factors.

First, a more favorable product mix shift to higher-priced products.

And secondly, as a result of updating our midcourse correction policy last quarter, we experienced a modest increase in midcourse correction cases and a corresponding reduction in our warranty claims.

This necessitated a modest true-up of our revenue deferrals and warranty reserves, which actually resulted in a reduction in our overall gross profit of approximately $1.1 million.

However, the impact in gross margin was favorable by about 0.7 points.

Year-over-year increase in gross margins primarily reflects higher ASPs resulting from our price increase, which is effective at the beginning of 2013, as well as the aforementioned impact from the change in our midcourse correction policy.

Q3 gross margin for scanners and CAD/CAM services was 22.2%.

This compares to 33.9% in Q2 and non-GAAP gross margin of 21.6% in the same quarter last year.

The sequential decrease primarily reflects lower scanner ASPs as a result of a reduction in the list price of our current scanner combined with a promotion to sell our older scanners, as well as higher manufacturing cost.

Our year-over-year improvement in the segment's margins was primarily the result of lower manufacturing costs, which were partially offset by lower ASPs.

Q3 operating expenses were $83.6 million.

This was down $2.2 million sequentially as a result of fewer customer events in the quarter, as well as less media cost.

On a year-over-year basis, non-GAAP operating expenses were up $12.7 million, incidental to the growth of our business, as well as the impact of the medical device excise tax levied on our US revenues.

Our third quarter operating margin was 25.2%, up 2.1 points quarter to quarter and up 3.6 points when compared to a non-GAAP operating margin reported in the same quarter a year ago.

With regards to our third quarter tax provision, results for the quarter benefited from a one-time tax credit of $1.3 million related to a true-up of our 2012 federal income taxes.

Third quarter diluted earnings per share was $0.42 compared to $0.36 reported in the same -- in the prior quarter and non-GAAP diluted EPS of $0.26 reported in the same quarter of last year.

Moving on to the balance sheet, for the third quarter, accounts receivable was $109.2 million, down approximately 3% sequentially.

Our overall DSO was 60 days, a 2-day improvement sequentially and a 10-day improvement over the same period a year ago.

Capital expenditures for the quarter were $5.8 million.

Cash flow from operations was $55.1 million.

Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $49.3 million.

Our cash, cash equivalents and marketable securities including both short and long-term investments were $400.4 million.

This compared to $356.1 million at the end of 2012.

Now let's turn to our business outlook for the fourth quarter and the factors that inform our view.

While typically the third quarter reflects the peak season for teenage orthodontic case starts, the fourth quarter is often a slower period for North American orthos, as fewer teenagers start orthodontic treatment once the school year has started.

As such, we expect North American orthos to be down sequentially in Q4.

Offsetting this trend, our fourth quarter historically has been a stronger quarter for international doctors and North American GPs as they rebound from a seasonally slower summer quarter.

We expect volumes for both international and North American GPs to be up sequentially in Q4.

Our scanner business performed very well this past quarter despite an increasingly competitive environment, and we expect our scanner volumes to remain consistent with third-quarter performance.

Our strong Q3 results reflect stable patient traffic in our customers' offices, and our outlook for Q4 assumes this trend will continue.

With this as a backdrop, we expect our fourth quarter to shape up as follows.

Invisalign case volume is anticipated to be in a range of 109.7 thousand to 120.1 thousand cases reflecting a 21% to 24% year-over-year growth.

We expect revenues to be in the range of $169.1 million to $173.1 million.

We expect gross margin to be in the range of 74.7% to 75.3%, which primarily reflects higher training costs and mix shift to lower-priced Invisalign products, that is less Invisalign Teen and more Invisalign Express.

We expect operating expenses to be in the range of $83.8 million to $85.4 million, which primarily reflects continued investment in products and technologies, as well as continued market expansion.

Our operating margin should be in the range of 25.2% to 26.0%.

Our effective tax rate should be approximately 21%, and diluted shares outstanding to be approximately $82.2 million.

Taken together, we expect diluted EPS to be in a range of $0.41 to $0.43.

With that, I will now turn the call back over to Tom for his closing comments.

Thanks David.

There's a lot of good work going on by the Align Technology team, and I'm very pleased to see our strong results reflect that effort.

We continue to deliver solid execution of our long-term strategic plan and expect to continue those key initiatives which are at the core of our progress.

Our results also reflect stable patient traffic in our customers' offices and their willingness to let us becoming a more significant part of their practices.

Our goal is to become their best partner in practice, providing great opportunities for growth with every potential patient asking for Invisalign by name.

We look forward to seeing our investors during a busy time for conferences and industry trade shows as well as reporting back to you with our year-end results in January.

And with that, let's go with the question-and-answer session, operator.

(Operator Instructions)

Robert Jones from Goldman Sachs.

What a difference a year makes.

Tom, David, thanks for the questions.

Just looking at the ASPs, second straight quarter where we saw some strong support there on ASPs, some improvement across all the segments.

Could you talk a little bit more about the drivers of ASP and how we should be thinking about the pricing power going forward?

Just trying to figure out how much of this is a result of comps versus an actual firming of pricing of your products in the market.

Hi Robert, this is David.

I will see if I can't answer that for you.

When you look at ASPs as we published on the website and so forth, those are aggregate ASP for the entire Company.

So one of the things you don't necessarily see in there is what impact the mix has on them.

As you look at our business quarter over quarter, our teen business is up very strongly sequentially, and that came at the expense of some of the lower end products that carry lower ASPs.

And so, that tends -- that mix shift there tends to cause the worldwide ASPs sometimes to look a little bit off.

As it relates to your question about the purchasing price or the purchasing power of our product and competitive pressures on our product, as you know we have made a slight increase in prices on our products at the beginning of the year.

Some of that was as a result of the new medical device tax and so forth, but at this point in time, we have not really made any further adjustments on pricing since then.

The effect I think you're seeing from an external standpoint has more to do with mix shift than anything.

Robert, if I could just pile on, this slide that Shirley and the team have put in here on the very last slide on our webcast slides really try to break out those effects net of mix.

And if you look at that in general, I would say pricing is stable net of mix and other factors.

It's not so much a comp issue.

We're actually -- pricing' s pretty stable.

Got it, and then if I could just move over to the case guide, 3% to 5% increase sequentially, seems like a big guide up especially in light of some of the uncertainties that seemed to be surrounding the consumer as we sit here in October.

Maybe more of a qualitative question, but wondering if you could talk a little bit of how you are factoring in some of the uncertainty in the marketplace and some of the pressures around consumer sentiment into your fourth quarter outlook.

Let me start, and then a pull up for David.

Since this is his first cycle with us, I think his objective view might be useful year.

I guess what I would first start with is that we have the same kind of visibility we always have in our business cycle, about 30 days or so.

And what you're seeing is a fundamentally solid business today with initiatives that are working for us.

And to take you back to early in the year, we made investments exiting 2012 in headcount and coverage and our geographies, Europe, North America, investments in new consumer programs.

We spent a little more money, we told our owners we are doing --purposely our goal was to generate volumes as we exited the year, and we are starting to see that, so we are gratified by that.

But it reflects what we're seeing in the business, and we are not smart enough to break apart all the elements going on.

But with that said, I think we have seen other data that patient traffic is stable to improving, dental consumables are improving a bit.

And when there's traffic in the offices, patients are willing to do a more expensive procedure and implant a restorative, then that means the road is wide open for us to get Invisalign growth.

Maybe with that I will let David build on his first cycle here preparing the guidance, not to throw you under the bus.

I guess I would -- when I first joined the Company, I would have thought that given 25,000 customers that we shipped to in a quarter that forecasting this business would lend itself to some econometric model.

But as you look under the hood, what you realize is we have a small number of doctors that have a very healthy practice with us that is fairly stable and relatively predictable.

But on the other flip side of that, we have a lot of doctors that do a small amount of business with us, and that particular segment of our business tends to be more difficult to project.

When I look at the process and so forth, we have a process that does a bottoms up view from the field in terms of where our territory managers are seeing as they talk to their customers.

We have a view from the top-down of the comp the which takes a look at our own statistical correlation of trends and so forth.

And as Tom was saying, we also look at patient traffic and so forth and some of these other external data points.

We triangulate across all of those to come up with our best view of the world.

From what I can tell and I think from what some of you have experienced, it is not perfect.

We would like it to get better, but a think what I can tell you at least from what I have seen and observed is I think we have a robust process, and I would say it's representative of best practices across many industries.

All makes sense.

Last one, David, to slide in on the back of that.

Any thought -- I know it's early days for you, but any thought about extending the outlook that you guys did provide?

I know its something that us on the sell-side and I'm sure investors would appreciate very much.

Not at this point.

We give a long-term operating model.

I think our operating model is whee we're steering the Company towards, and those are the results we are trying to head towards.

Probably not at this point.

Thanks for the questions.

John Kreger with William Blair.

David, maybe just a follow-on to Bob's question.

Any early thoughts on 2014?

Obviously you are not in the mode of providing full-year guidance, but there are any key issues that we think we ought to be thinking about that could be key swing factors, particularly around margins?

John, nice talking to you again.

What I have observed and I think what you have observed as well is our business does have some degrees of cyclicality in it.

Our business certainly from a revenue standpoint has seasonality, Q3 perhaps being the largest manifestation of that.

But further than that, there are other elements of the business that have cyclicality to it as well.

Our media expenses for example might run counter seasonal.

Then we make investments in the business that sometimes tend to be bulky and are done on an as-needed basis and are not -- don't follow a pattern of repetition.

When you look at our Q3 performance that we just announced and our Q4 guidance I guess the thing I would comment on is that I wouldn't use those two data points to extrapolate going forward.

Because of that seasonality and because those two quarters alone do not manifest I think all the cyclicality that our business deals with.

I think more representative of our business is our annual operating results.

I think that's probably the best guide because our annual results incorporate all of those cycles in them.

As you think about going forward, as I said in the prior question, our targeted operating model is 25 to 30 points.

And I think at some point as we get to being able to consistently land within that operating model, at some point we will want to update the model.

But at this point, I think that the best guidance I can give you is the operating model we have already talked about.

Great, very helpful.

Thanks, just one last one and I'll stop.

Can you give us an update on how realign is faring with the Henry Schein sales force?

I'll take that one, John.

We're in very early days there.

The Schein team and the Align team are working hard to ensure that the early customers and the field reps that are moving this have great experiences, and we learn a lot from those cycles and make sure the product works perfectly for the patient and the doctor feels great in the practice.

We thought about the first year at startup, and we're right in the middle of that learning cycle.

We're collectively about to head off to a trade show at the ADA, there's greater New York, there's some important cycles where Align will be out there in the market and Schein will be out there in the market.

And we will have a chance to have that discussion with customers.

Very early days, not going to be material for a significant amount of time, but way more strategic than tactical.

I don't know if that's what you're looking for, but that's where I'll stop.

Are you still comfortable, Tom, that the margins on the product can be consistent with the rest of the business?

Yes.

Short answer is yes.

If we stack up the takeout in marketing, professional marketing, demand creation, go to market, our contribution margins will be similar to -- on a net basis similar, to say an express product for example where we have direct sales and marketing involved.

At the operating margin level, below gross margin for sure.

Great, thank you.

Thank you John.

Chris Lewis from ROTH Capital Partners.

Hi guys, congrats on the quarter.

Thanks Chris.

First, Tom, you mentioned the North American ortho case volume strength was driven partially by new ortho submitters.

Can you just talk a bit more about what is driving those new orthos coming on board?

Yes, it's really a couple things.

We've got more orthos coming out of their graduate program who maybe didn't get enough Invisalign in their program.

And as they're coming into a practice, they are very interested in starting to do Invisalign.

That is one.

Two is we have some great established ortho practices that maybe got trained 10 or 12 years ago.

I would say back in the early days we were not ready for prime time.

They didn't have a great experience with the product, couldn't address very complex needs.

And as they have seen our progression, they have come to the view that they need to get on board.

So we have had a number of terrific market-leading practices want to reengage.

In our mind, those are new practices; we have not done business with them for years.

And so that's the other part of the mix.

Both are very positive.

Small numbers, but what's more important is what those kinds of practices represent over the next three to five years.

Okay, great, and on the gross margin side for the fourth quarter guidance, it's down sequentially.

I think you had mentioned some product mix skewed to lower price products there, but can you just discuss a little further what other factors might be playing into that?

And longer-term, as we look out into 2014, how should we think about that gross margin trending?

Yes Chris, let me see if I can give you a little color.

As you look at our margins in the third quarter, they were almost a record, if not a record for the Company, on the Invisalign side of the business As we shift into Q4, however though, we're going to see a lesser mix of the top end of our product line.

And that's going to get displaced with more volume in the lower end.

That mix shift is going to bring margins down to some extent.

Then in my prepared comments, I made the comment that we had this mid-course correction that caused an adjustment to our deferrals, which was about 0.7 points of margin effect sequentially to Q3.

But that is nonrecurring in Q4, and so we don't have the benefit of that Q4.

We also will have more training events this quarter.

And when you -- our training business is not an 80-point margin business.

And so that will tend to drag the margins down a little bit as well.

And offsetting those three is the fact that -- our scanner margins should improve quarter over quarter as well.

So the net of that is that margins should be down sequentially a little bit.

As it relates to 2014, again, the best guidance I could give you would be to look at the full year results, look at the trends, and look at the operating margins, the business models that we talked about, and I would plan off of those things.

Great, and if I could sneak one more in.

Tom, just going back to the visibility end of the business, I was hoping you could talk about how that has evolved over the past 12 months.

Seems like I think you are talking about improving the visibility in recent quarters to some office surveys and other initiatives to gauge more of a month-to-month trend in patient traffic and other market trends.

How has that evolved over the past year compared to third quarter of last year, and how that contributed into the fourth quarter guidance that was given today?

Thank you.

I will take my shot with -- knocking on wood, we are glad to have a positive results.

I think that the starting point for all this is A, we have the same kind of visibility we have always had in the core flow of the business.

And then B, our customers don't forecast, so asking them forecasting questions doesn't necessarily lead you to a factual framework you can count on.

What is different, there are a few things different.

The evolution of business in Q3 and Q4 from last year is fundamentally different.

Patient traffic started declining in US dentist office in the middle of Q2 last year as we reconstructed all that.

Procedure started falling, and mix shifted to lower value procedures.

That really wasn't visible well into Q3, and we didn't really see it until summer didn't bounce back.

So that is different, and that's why we keep stressing that stable to slightly improving patient traffic mix and procedures is a really good thing for us.

It's a good thing for everybody, but it is really good for Invisalign.

To your second point about what we are doing differently, we are doing a lot more differently.

A lot of things differently, and when you get it wrong and you get humbled a little bit or get surprised, you ask yourself a lot of questions about what can we do -- everything is on the table.

We have instituted a whole series of what we internally call poll surveys, and it's not so much a forecasting, just observational.

We have not been at that even a full year yet now in detail, and I would say we are far short of predictable results.

Our goal over time is to be able to correlate some of that with other external factors like patient traffic, empirical data we can observe, but we're well short of what I would call predictive capabilities.

What is reflected in our outlook, what is reflected in our results is good execution of the business and everything we can control and a very solid environment out there in the countries that matter for us.

And a third factor is we have this very low penetration for Invisalign into a pretty big darn space, and we still have a lot of headroom.

Thanks for the time.

Thanks Chris.

Steve Beuchaw from Morgan Stanley.

Good afternoon, thanks for taking the questions.

I wonder, Tom, if we are far enough along that you could give us a little bit more granularity on what you've seen with SmartTrack.

Have you been able to get a view of what kind of impact it is having in practices that were early adopters or beta testers?

Any discernible or hopefully quantifiable impact on how the mix there is impacted in terms of a percentage of cases that are going to aligners in those practices?

Sure.

Simple answer is, for the most frequent users of Invisalign, including some of those that were in the pilots even a year before we released and others that just quickly see the benefits, they have virtually all expanded case complexity and got most of the benefit out of it.

We are still I would say working for our complete customer base.

For a customer that does -- even a great orthodontist that is only doing 10 or 15 a year, it has taken them longer to see the benefits because they generally are treating simpler cases.

And they don't have the [avats] that a high-volume doc doing 200 or 300 Invisalign cases a year would.

But on those higher volume practices, their progression has been towards greater complexity and earning a bigger part of their practice, and they say yes to Invisalign more often when the patient asks.

That is the short answer.

Is there a case for five points of mix shift over some horizon?

Can you quantify any of this for us?

I wish it was as simple as that.

We actually have some internal ways we measure it, and we look at the incidence, what presents at an average orthodontist or dentist office for the malocclusion and put them into categories.

And then we look at what that incidences is and what they treat against that mix.

That same chart varies widely by the practice and how much they have adopted Invisalign.

So we have two things.

In our most ardent supporters, we get the biggest chunk of their class one crowding places, adult and even teens.

And again, teens have harder cases to seal because everybody's aiming for absolutely perfect.

And if they think they're making any clinical trade-off, they will be more resistant to use Invisalign.

But at least for adults, we're doing very well there.

If you get over towards straightforward class two or even hard class three, the doctors that have the greatest confidence and have had the greatest results with Invisalign are much more comfortable offering it to an adult patient.

There is a temporal framework that goes along that opportunity.

The least frequent users are the least penetrated in those indications would be most around class one, and the most frequent users have the greatest confident are doing it on much more complex cases.

It's not as simple -- I'm sorry to say, I wish it was -- to say there is a projection of growth or share, but both are being driven by evolution with SmartTrack and G4 that give us both greater confidence and because they're getting better results with those tools.

Got it, and then as my follow-up, I wonder if you could give us an update on your thinking around partnerships in the world of intra-oral scanners.

I wonder if there is any new thinking there, and I wonder now that you have a relationship with Henry Schein that has expanded if that might be a gateway.

If some of the Henry Schein partnerships might be more logical for you, and then I will drop, thanks.

Thanks Steve.

The update is when there is news to talk about for interim operability, will be happy to do so.

We think it strategically valuable.

You saw we keep going up around 250 to 300 basis points a quarter over quarter in cases coming just with the iTero base among our customers.

We know there is interest out there.

It's in our best strategic interest to have those partnerships, and you ought to assume we are interested in doing that.

But until we get there and can validate appropriate high-quality scanners, I don't want to project.

Chris Cooley from Stephens.

Thank you and appreciate you taking the questions.

Could you help us think a little bit more back towards gross margin, and specifically when we think about the contribution in the fourth quarter and after 2014 for more value-added product offerings like Express 5, how do we think about that in combination with the ramp of Realign?

I realize it is still in early days for now, but assuming it has to become a bigger part of the mix.

How do we weigh that and think forward on the gross margin guidance, and I have a follow-up.

Thanks.

Yes.

We've had a few questions about 2014, and I guess it's not surprising, given our results in Q3 and Q4.

As Tom said earlier, as it relates to Realign, it's too early to call to put a vector on that and to give any guidance as it relates to how the product will impact overall mix.

As it relates to gross margins, we have continued to comment I think that as we look over the long term that the percentage of cases that we treat, particularly for simple cases with adults and so forth, will increase, and that will potentially drive down margins -- drive down ASPs I should say.

And clearly, our margins are influenced by product mix.

But given that we are still growing well into double digits year over year, while that may have some bearing on the directional indicators of the margins, these gross margins, I don't think they will necessarily have an indication, an effect on operating margins.

So going back to the comments I made before, I think the best guidance for 2014 is again going to be our operating model that we talked about.

Fair enough, and just as a quick follow-up, when we think about the scanner business, 22.2% the gross for the quarter, could you give us a feel there in terms of the mix?

What is being placed versus what's actually being sold into the channel and how that may or may not be changing?

Thanks much.

I will see if I can take that one, and David can pile on if he wants to.

First of all, yes, the reported gross margins are nowhere near where that we want them to be or where we expect to get them over time.

If I understood your question, in terms of new systems going in versus services stream, was that the question?

Yes.

I think we spoke about roughly half-and-half in terms of the mix of services against new scanner placements.

Okay, thank you very much.

I would add to that is our scanners -- as we continue to penetrate the market with more scanners, that mix should go more favorably towards the service and licensing sides of that over time.

With higher margins, yes.

If I could Tom, just to follow on or clarify that, when the actual system is placed, is the system sold out right or are they placed on a volume commitment?

Just trying to tease out why the margin is at 22%.

Margin is at 22% because of our bill of material and cost of goods, we have the care in the market, and we don't make money on them.

And with pricing that has come down over the last year and half, two years, with a lot of competitive entries, we have met that pricing.

Pricing is actually stabilizing a bit in the scanner market, and rates are coming up a little bit.

And we do things scanners will be ubiquitous.

We think it's critically important for us to be at chairside in the middle of the clinical discussion with the patient right there, and then creating advantages for our Invisalign franchise and other things we intend to do over the long-term.

With that said, the gross margins aren't anywhere near where we want them on the scanner.

We intend to fix that over time.

The services stream is better, and we think we've got some strategic advantage there over time.

But, it is just a bill of material that is expensive, and it is the best scanner in the market, which is a kick.

But we will fix that over time.

I would just add to that, as I said earlier -- maybe state it more clearly, is that that service element should grow.

It is in proportion to the installed base and not in proportion to the number of systems we're selling in any particular quarter.

The other thing is you are talking about the 22% gross margins in the third quarter.

Some of that was also the result of the fact that we were selling under promotional programs some of our older scanners.

So that had -- that promotion to remove some of that inventory had a dampening effect on margins in the third quarter, and that's one of the reasons why the margins in that business should be up in the fourth.

Chris, I just realized I didn't answer part of your question.

You were theorizing maybe there was placements instead of sales.

We really don't do that.

So those were all sales.

Whether there was a financing involved -- we don't finance either, but whether it was financed, for us it was a net sale, period.

Understood, appreciated responses, thanks so much.

Jeff Johnson from Robert W. Baird.

Thank you, good afternoon guys.

All my questions have largely been answered here.

Let me ask one.

A want to make sure I understand the timing comments on the DTC.

I was surprised to hear DTC spending may be down this quarter.

It flared up in the second quarter as you launched some of these new programs.

Is that a normal ebb and flow of that spending?

How are you thinking about DTC spending given that it seems to be generating some nice top line?

How are you thinking about that spending over the next several quarters to couple years?

Sure.

David was talking about the broader issue of the timing and mix of spending isn't always in the same cycle with volume expansion given cyclicality, seasonality, et cetera.

The example I believe was summertime is typically our strongest media -- traditional media, Digital media, everything else -- and it's often a softer quarter given the seasonality.

People on holiday in Europe and certainly in North America where we advertise most.

In general, there is a general consistency to our program spending on consumer.

And that is light in Q1, heavier exiting Q1, stronger into Q2, setting up for the summer season, heaviest spending exiting Q2 into the summer, and then pretty strong through all the summer, slowing as we exit Q3 into Q4.

And you probably shouldn't see us by the time Christmas advertising is on in general just because there's so much noise.

There is a parallel mix of digital, PR, integrated campaign.

For every TV commercial that you might see on Bravo or any other channel we work with, there's probably 10 times that activity through multiple other platforms.

Whether it's Pandora for radio, whether it's gaming, and other things.

That's the visible part in traditional media on TV, but again, there is generally the same profile for that spending in North America.

Does that get at your question?

That does.

Last year you had some timing shifts and some fall-off probably to that normal cyclicality given the Olympics and that.

I would assume looking forward nothing on the horizon we need to be thinking about that might shift the timing at least in the near to intermediate term?

The Winter Olympics is nowhere near the media frenzy of Summer Olympics.

We don't have an election year -- there's a lot of things you have to engineer around in the media world.

I don't know what normal is in the dental industry, but if we had to imagine normal, this feels like more of a normal.

The second thing is we were off the air a bit more exiting 2012 because were getting ready to launch a whole new campaign.

And I think when we spoke about our guidance in January for the year, we were talking about investing in new assets, creation of new creative and materials and all the associated element that go along on the digital side and everything else.

That's where the spending was.

It wasn't necessarily visible media that was part of the first half of the year profiling and greater spending.

Again, but in general, you should expect stepwise expansion investment, and the same kind of impact that we expect to get for payback year-to-year.

Understood, helpful, thanks guys.

Operator, we will take one more question please.

Two more questions.

We have time for two.

Brandon Couillard from Jefferies.

Thanks, good afternoon.

Hi Brandon.

David, just curious if you can give us an update on where we stand on NOLs and when you expect to have to begin paying cash taxes, whether that is anytime soon?

We do pay -- to be clear here, we do pay some cash taxes.

Typically those are in foreign jurisdictions and in states here in the US.

As far as our US federal return is concerned, we do have NOL carry forwards, and currently we are making money here in the US.

Those taxes, that income, however though -- the taxes on the income, we do have the benefit of R&D tax credits which offset that to some degree.

We also have the benefit of stock exercises and the ability to deduct some of that off of it.

It means that we use up less of our NOL than what we might have otherwise in the absence of those credits.

Altogether, our estimation is that our NOLs will probably run sometime into or through 2015.

Great, and just one more for you.

Given this is your first conference call as the new CFO, would be curious to hear your view on how you think about capital allocation and share repurchases in general with cash building on the balance sheet pretty substantially here.

I guess I would say philosophically that if a Company has -- is accumulating cash and doesn't have a need for that cash to either grow its business and just to run the business, then at some point, there should be a plan to figure how to return it to shareholders.

That said, we just finished at Align, as I'm sure you know, a $150 million stock repurchase plan in the June quarter, $93 million of which was spent in that quarter.

And so we're just completed one of those plans, and we haven't really quite come up for air yet.

I would tell you that as we look at our annual plan for next year, and our five-year strategic plan, we are right now pulling together what we think our investment requirements are going to be for the Company, and clearly those investments well at some point are going to the manufacturing capacity.

Market expansions, we're going to have both domestic needs as well as international needs.

And at this point, we haven't really assimilated how that will fit together.

But at some point we will in the not too distant future here, and to the extent we come to a conclusion, at least with the board, that we have excess cash that we don't need as a company, we will figure out what plan we are going to do with it.

But right now as of today, we're just not ready to declare what that next step will be.

I think if you can be patient with us, we will probably have more to say about that in the not-too-distant future.

Great, thank you.

Jon Block with Stifel Nicolaus.

Great, thanks guys.

Good afternoon.

And maybe I can slip in two or three questions.

The first one, on the investment side, I'm guessing people are going to stop asking if you're sticking by your long-term margin guidance.

On the investment side, you did a ton in the past 12 months.

APAC, you've added North American reps, you did some work on the international side, and you are starting to obviously post the leverage.

I think in the past, the spend has been very lumpy, and so Tom, can you speak broadly about incremental investments from here?

Maybe not detailing what exactly they're going to be, but again, will you pull back at all?

Will they be as lumpy as they have been in the past?

Any color would be great.

I guess I have to start with the word lumpy.

From our perspective, the business cycle itself here in the dental industry is cyclical.

Maybe use that instead of lumpy.

And in many areas these investments -- it doesn't make sense to line up investment choices that are multi- year in nature and have strategic value to fit them perfectly.

Maybe fit them generally, yes, but not fit them perfectly into that annual cycle we see.

Q3 being a great example of one that is softer.

Where we choose to make investments that during a quarter or two would take operating margins down a little bit as we did in Q1 into Q2 as well where we talked but it with year-end results in January of this year.

We also made the commitment that we expected to be able to generate volume growth, and I think David said it well earlier.

We think looking at the model in terms of annual performance is the right way to look.

The question is going to be -- we know it's not how you have to model on a quarterly basis and reports you put out, but from our perspective, we are trying to deliver an annual result with the quarters that make sense.

And some of the spending -- an example is consumer, is going to be in advance of that volume step up.

And in this case it was also on top of substantial headcount investment that we had all completed by end of Q1.

All that headcount was in North American sales force on an incremental basis, and virtually none of the volume was coming in yet.

We had a new consumer campaign going on with very little impact felt.

So that is a great example of where it is the right thing to do and the timing is better to get at it quickly and get it in.

So simply stated, I think we will continue to be a little more cyclical in our total operating margin profile.

But where we are on the lower side of that, I believe we will continue to articulate what the spending is going towards so that our owners can understand the kinds of things we are investing in we have high confidence will lead to either increasing earnings in the case of the right kind of factory, or increasing volume and ultimately operating margins on an annual basis.

Okay, and then just shifting gears over to teen, it was up 18% year over year, and it looks I some of that was a little bit lower on teen growth from GPs.

Certainly good numbers, but it's a second quarter in a row where you had a decelerate into the mid- to high-teens level, and it was mid- 20s in 2012.

Just trying to find something to pick on.

What do you think about growth in teen going forward?

You mentioned they're looking for perfection.

SmartTrack, starting to give them better conviction that they can get there with Invisalign?

Again, any thoughts would be great.

Sure.

If this is the only thing we have given you to pick on, I am really happy as CEO.

First of all, we are thrilled with the progress we're making.

We said for a long time that earning that marginal teen case is the hardest case to wrestle away from brackets and wires, which is still standard of care.

So we have to be better than brackets and wires in many ways, and we're getting there.

I think there was a question earlier that I answered that was comparing where each practices in their adoption, their clinical confidence.

A practice that uses a lot of Invisalign on adults and teens doesn't even worry about it.

They will lead with Invisalign.

A practice that is more conservative, that is just now starting to get SmartTrack and is starting to do more complex crowding cases on adults.

Our goal over time is to move practice by practice this progression through, and have them see that experience first hand, have the patients be thrilled, get those great results, and that reinforces their own journey.

It's literally that practice by practice process that we are encouraging.

On the numbers basis, we get big enough, the denominator gets tougher, 18%, 21%.

We are in the right neighborhood, and we are thrilled with the process.

SmartTrack is a big part of that, G4, all the rest of it.

We can't do enough consumer advertising if they're not confident the product works.

The right coverage and clinical education and clinical support, the right product evolution and the right consumer, those three legs of the stool go together really well for the teen market.

And we are very confident over the mid to longer term.

Our goal is to become standard of care in orthodontics.

The teen market is the last place we will get there.

Last question if I can jump in there.

David, this is for you.

Internationally, and the slides are helpful, but international ASP looked like it was down sequentially despite what I believe was an extra month from APAC and a euro that went in your favor.

What am I missing on why international ASP would be down Q over Q?

You are right to pick up on foreign-exchange.

That was a benefit to us of about $1 million in the quarter.

But again, back to the comment I made before, when you look at these ASPs, it's an average across the mix of products that we are selling.

And so when that mix changes, the ASP can come down.

Even though -- you can point to examples where the price on every single product could go up quarter to quarter, but if the mix changes, the overall could look like it is going down.

Really no trend there that I think you should be concerned about.

It's really more of a mix shift than anything else I believe.

Great, thanks for your time guys.

Thanks very much Jon.

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