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Align Technology Inc. (NASDAQ:ALGN)

Q1 2010 Earnings Call

April 22, 2010, 4:30 PM ET

Executives

Shirley Stacy – Senior Director, Investor Relations

Tom Prescott – President and CEO

Ken Arola – Vice President and CFO

Analyst

Shawn Fitz - Stephens Incorporated

Tao Levy - Deutsche Bank

Matt Dolan - Roth Capital Partners

Jonathan Block - SunTrust Robinson Humphrey

Ben Forrest - Summer Street Research

Operator

Call Starts Abruptly.

… Technology First Quarter 2010 Financial Results. 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.

Shirley Stacy

Thank you. Good afternoon. Thank you for joining us everyone. I’m Shirley Stacy, Senior Director of Investor Relations. Joining me today is Tom Prescott, President and CEO; and Ken Arola, Vice President and CFO.

Before we begin, let me cover some house-keeping item. We issued two press releases today via global newswire and first call regarding our first quarter fiscal 2010 financial results, and a strategic change in the proficiency program. Both press releases are available on our website at investor.aligntech.com.

Today’s conference call is 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 p.m. Eastern Time through 5:30 p.m. Eastern Time on May 5th.

To access the telephone replay, domestic callers should dial 877-660-6853 with account number 292, followed by pound, and conference number 348442, followed by pound. International callers should dial 201-612-7415, with the same account number and 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 expected financial results for the second quarter of fiscal 2010.

These forward-looking statements are only predictions that involve risks and uncertainties such that actual results may vary significantly. These and other risks are set forth in more detail in our form 10-K for the fiscal year ended December 31, 2009. 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.

Please also note on this conference call we’ll 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 were practical, are contained in today’s financial results press release, which have been posted on our website, at investor.aligntech.com under financial releases and 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 reconciliation and our first quarter conference call slides on our website under quarterly results. Please refer to these files for more detailed information.

With that, I’d like to turn the call over to Align Technology’s President and CEO, Tom Prescott. Tom?

Tom Prescott

Thanks, Shirley. On the call today, I’ll cover some highlights from the first quarter, briefly comment on today’s announcement regarding a change in the proficiency program and provide an update on our strategic initiatives. Ken’s going to follow with some detail on our first quarter financials and outlook for the second quarter. I’ll come back with some closing comments and open the call up to your questions.

The first quarter was a strong one, representing the second consecutive quarter for record revenues, case shipments and gross margins. Combined with lower than anticipated spending, Q1 earnings were significantly better than our outlook.

As usual, let’s start with our key adoption metrics, the number of new doctors trained and utilization rates or what we call same practice sales of our product. During Q1, we trained 915 new doctors, up slightly from 870 in Q4 and down from Q1 last year. Of those, 390 were North American doctors and 525 were international doctors.

As expected, fewer doctors attended our CE1 course, due to their evolving understanding of the proficiency program and the commitment required to ramp activity and effort in their practice to meet those requirements.

If you recall last quarter, we indicated that the program would likely cause some doctors to put off attending our CE1 training course until they are really ready to begin using Invisalign.

Compare that to the past when many doctors would take CE1 for general information on Invisalign or for marketing benefits while potentially not yet being really committed to shifting a significant effort into practice.

In Q1, total utilization increased sequentially and year-over-year to 3.5 cases -- 3.5 cases per quarter up from 3.3 in Q4 and 2.9 in the same quarter of last year. Q1 utilization rates for international doctors decreased slightly around 3%, sequentially in line with expected seasonality in Europe and yet increased 14% from the same quarter last year. Reflecting continued strong adoption and growth outside North America.

The first quarter was a strong one for our North American orthodontist customers. Q1 utilization increased substantially approximately 11.5% sequentially and 20% from the same quarter last year, to a record 5.5 cases per orthodontist.

In the ortho channel, sequential case growth was driven by higher volume doctors. Q1 was softer overall for our North American GP Dentist customers with fewer submitters in the quarter and volumes up slightly sequentially.

Not withstanding the puts and takes I just mentioned, the utilization rate for GPs actually increased approximately 5% sequentially and 20% year-over-year. This increase is driven by the fewer number of low volume submitters in total. This is an example of the fluctuations in average utilization rates that we anticipated would occur as practices adjusted to the proficiency program.

By now, most of you have probably seen the announcement we made today, earlier today regarding the proficiency program. I’d like to take a moment to describe the changes to the program and explain our rationale for this action.

Simply stated, we are eliminating the annual case start requirement that has been the source of so much customer dissatisfaction. We will continue to focus on Invisalign training and education and are maintaining the annual CE requirement.

It’s fair to ask why we’re changing the program now. The answer is simple. We’re listening to our customers. We are still in the early stages of building a company that can become an industry leader. That leadership must be based on a foundation of satisfied loyal customers. And right now, the frustration and unhappiness from elements of the proficiency program represent a risk in that important foundation.

Despite continued effort and progress in meeting the proficiency goals many customers remain very frustrated with this program even our best partners. We knew that introducing this program would represent a big change for our customers but we did not anticipate the widespread concerns and questions it has created across the dental industry. Many doctors and the associations to which they belong agree with our objectives but believe the annual case requirement interferes with the way they practice dentistry.

Over the past 10 months, we’ve had extensive ongoing dialogue with dental associations like the ADA and the AAO, state dental organizations, academic and clinical leaders and many, many individual customers.

Based on those discussions, we have decided that we can better ensure a great treatment result for our doctors and for every Invisalign patient through initiatives that all of our customers and industry our partners can fully support.

Going forward, our focus will be on Invisalign training and continuing education, on product innovation and improvement and on programs that direct consumers to the most experienced providers.

We believe these changes to the proficiency program demonstrate our continued commitment to ensuring great results for Invisalign doctors and patients, as well as our commitment to listening to our customers and responding to their needs.

We intend to become an even more valuable partner to our customers and helping their practices grow and flourish. And in fact, our strategic initiatives are designed to do just that, helping our customers and their practices grow and be more successful.

So I’ll remind you that our strategy has a series of key elements that we typically touch on each quarter. The first is to continue to accelerate product technology innovation. Second, we still have many opportunities to enhance the customer experience.

Third, while we’re going after big opportunities on product and technology, we are increasing the effectiveness of our consumer demand creation process and have refreshed the Invisalign brand identity. And finally, we’re continuing to drive international growth, principally in Europe even while we’re opening up additional new markets around the world.

Starting with product first, I’m going to give you a brief update on Invisalign Teen. In Q1, case shipments for Invisalign Teen were 7400 or 11.6% of total volume, a slight decrease from 8200 or 13% of total volume in Q4.

On a year-over-year basis, Invisalign Teen volume increased nearly 90% from 3900 or 7.8% of total volume in Q1 last year. The sequential decrease in Invisalign Teen product line this quarter primarily reflects a mix shift from teen to full that we created by changing the Invisalign Teen promotion.

When we launched Invisalign Teen in July 2008, one of our key objectives was to encourage early trial and re-order rate to drive adoption. So, we offered a promotion that gave doctors their fourth and 12th Invisalign Teen cases free.

The great news, the promo worked and while it achieved our intended goal to drive initial adoption and increase confidence with these new teen features our long-term goal continues to be to gain share of this important market segment.

We know that some doctors utilized and many doctors utilized the Invisalign Teen promotion for some of their adult patients as we discussed on prior calls. Effective Q1, we changed the promotion, limiting the patient age to 19 years or younger and capped the number of free cases. So any doctor could only receive one free Invisalign Teen case per year.

Based on this, many doctors shifted their adult patients back to Invisalign Full. However, based on patient demographics that we track, the actual number of teenagers using Invisalign increased 3% sequentially and 29% year-over-year. Despite this being a seasonally slower quarter for teenage case starts.

Going forward, we’ll provide regular updates on number of actual teenagers using Invisalign. Not just Invisalign Teen, so you can track and assess our continued penetration of teenage orthodontic case starts. The teen promo side, many doctors do like the features in Invisalign Teen and some are using them on all their patients teens and adults alike.

In Q1, Invisalign Assist cases shipped were 3300 or 5.2% of total volume, compared to 2800 or 4.5% in Q4. On a year-over-year basis, assist is up more than two fold from 910 cases or 1.8% of total volume in Q1 last year.

Invisalign Assist continues to gain traction with newer customers as a result of our clinical education focus, as well as with customers needing a little more assistance and those using assist to achieve their proficiency goals.

On a consumer front, we continue to see strong interest, thanks to our integrated consumer marketing platform, which combines conventional media, public relations, event marketing and the evolving digital media and social networking environment.

Our goal is to leverage this platform to multiply the quantity and quality of Invisalign impressions in the market place especially with teens. So I’ll touch on each area quickly here.

In the conventional media area, we invested more in advertising this quarter than in Q1 2009, including a full quarter of advertising for Invisalign Teen on national TV networks such as the CW, Lifetime, MTV and U.S.A.

On the PR, front we kicked off an aggressive and exciting campaign for 2010. It continues the focus on programs that reach and educate perspective teen patients and their parents while also integrating adult product messaging.

In Q1, through two satellite media tours, Invisalign Teen was featured on morning shows and evening news programs in 26 cities and over 100 media markets across the country.

Event marketing is rich with opportunities to ensure that Invisalign Teen is visible where teens expense and their parents spent a lot of time. We ramped up the major event marketing activities in Q1 with sponsorship of the National Cheerleading Associations National Championship. These events provide a unique forum for teens and their parents to interact with excitement around the Invisalign brand, as well as local providers.

Social networking and digital media continue to provide a very effective forum for what we have termed myth busting. For example, myths that consumers may hear like Invisalign’s only for simple cases or Invisalign won’t work for me.

So a growing group of patient and parent advocates learn to blog about their treatment experiences, we continue to educate perspective patients through the influential circles of social networking and the increasing weight discuss our editorial content has on digital media and social networking environment.

Shifting to our international growth initiatives, overall the international team delivered solid results this quarter with slightly lower sequential case volume off a seasonally tough Q4 comparison.

Q1 results reflect rapid volume growth in Asia-Pacific region and good performance in core Europe despite that seasonality I just mentioned. Q1 international case shipments were at 13,000 or 20.4% of total, compared with 13.6000 or 22.2% in Q4. On a year-over-year basis, international volume increased 32% from 9.8000 or 19.6% of total.

During the quarter, our teams prepared for the launch of Invisalign Lite in Europe and international along with the large scale release of new and improved product features which were rolled out in North America in October.

Invisalign Lite, which replaces Invisalign Express, offers doctors a new option for less complex orthodontic cases such as short-term aesthetic cases, relapsed cases and pre-restorative treatments using a limited number of aligners at a more affordable price.

In addition, Invisalign Lite includes the new and improved features and functionality designed for enhanced clinical predictability, such as Optimized Attachments, Power Ridges, Velocity Optimization and a host of improvements like IPR, later in treatment for better clinical access resulting in less tooth removal.

With that launch and the release behind us, I’ll tell you that the team executed extremely well, excuse me and everything went very smoothly. Feedback from customers thus far has been very positive.

We believe these new features and improvements will give doctors greater confidence in what they can achieve with Invisalign and help deliver the outcomes doctors expect in more clinical application.

I’ll now turn the call over to Ken for more detail in our first quarter financials and our outlook for Q2 and I’ll come back for a few closing comments. Ken?

Ken Arola

Thanks Tom. Let’s review our first quarter financial results beginning with revenue. Q1 net revenue of $90.1 million increased 4% sequentially and 28.5% year-over-year. Case shipments of 63.6000 in quarter one increased 4.2% sequentially and 27.1% from the same quarter last year.

The sequential increase in revenue reflects higher case volume driven primarily by our North American orthodontists. This growth was partially offset by the typical sequential seasonality we see in Europe with Q4 being the strongest quarter of the year.

On a year-over-year basis, the increase in revenue reflects volume growth across all customer channels and higher ASPs resulting from foreign exchange rates as the euro strengthens against the dollar from the same period last year.

Additionally, recall we implemented a price increase in North America early in Q1 of 2009 and received a full quarter benefit in 2010, compared to a partial quarter benefit last year.

Q1 revenue by channel consisted of 41% for North American GPs, 31% for North American orthodontists, 22% for international and 6% for non-case revenue and reflects some mix shifts to North American orthodontists.

Q1 revenue by product consists of 73% for Invisalign Full, 10% for Invisalign Express, 9% for Invisalign Teen, 3% for Invisalign Assist and 5% for non-case revenue and reflects a shift towards Invisalign Full as mentioned previously by Tom.

Now let’s move on to the rest of the income statement. Q1 GAAP gross margin was 77.4%, compared to 73.7% in quarter four and 75.2% in the same quarter last year. Stock-based compensation expense included in gross margin was $435,000 in quarter one, compared to $400,000 in quarter four and $386,000 in the same quarter last year.

Excluding Ormco royalties, Q1 non-GAAP gross margin was 78.3%, compared to 78.6% in quarter four, primarily reflecting the manufacturing efficiencies, associated with higher case volumes. These efficiencies were somewhat offset by CE training costs of $630,000 that had been reclassified from sales and marketing expense.

Historically, with the exception of our initial training classes, CE1, our continuing education fees and costs for other education programs such as Invisalign provider work shops, practice development training, study club and Invisalign summits were charged to sales and marketing expense.

As a result of maintaining the proficiency program annual CE requirement, all training and education fees and costs in which CE credit is provided, will now be charged to revenue and cost sales respectively.

Q1 operating expenses were $49 million, compared to $49.2 million in quarter four and $47.4 million in the same quarter last year. Q1 operating expenses were listed in our original outlook due primarily to the timing of marketing programs, which were delayed to quarter two. As well as, the re-class of $630,000 of training costs just mentioned.

Stock-based compensation included in Q1 operating expense was lower than anticipated at $3 million and compares to $2.7 million in quarter four and $3.3 in the same quarter last year.

In Q1, we generated non-GAAP operating income of $21.5 million or 24%, compared to $18.9 million or 21.8% in quarter four and $6.2 million or 8.8% in the same quarter of last year. The sequential and year-over-year increase in Q1 non-GAAP operating income reflects continued leverage in our financial model driven by higher volumes and lower spending.

Q1 GAAP earnings per share was $0.19, compared to $0.15 in quarter four and $0.04 in the same quarter last year. Q1 non-GAAP earnings per share was $0.20, compared to $0.16 in quarter four and $0.05 in Q1 of last year.

Now let’s move on to the balance sheet. Cash, cash equivalents and short-term marketable securities were $205.4 million. This is compared to $186.5 million at the end of 2009. In Q1, we generated roughly $18.7 million in cash from operations, compared to $34.3 million in quarter four and $10.6 million in the same quarter last year.

Q1 DSOs were 59 days, compared to 57 days in quarter four and 66 days in the same quarter of last year. In Q1, deferred revenue on the balance sheet increased by $4.7 million or 14.7% sequentially to $37 million, this increase primarily represents continued revenue deferrals associated with Invisalign Teen and Assist.

Now, let’s turn to our business outlook for the second quarter of 2010. There are several factors that contribute to our outlook, which I’d like to comment on briefly before we get to the details.

First, with the change that we’ve made to the proficiency program, it is uncertain how doctors, particularly low volume doctors will respond. It is likely that some practices that have been working hard to accelerate will want to take a breather. While others, who started to get that acceleration and enjoy the progress they made may want to continue at their new pace.

Second, in quarter two, we’ll be running a consumer rebate program through the end of the quarter, as well as, an additional volume rebate for elite and premiere providers. This is expected to have some negative impact on average selling prices and gross margin during the quarter.

Third, for our international business, Q2 is historically a seasonally stronger quarter sequentially and we expect it to be the same again this year. We do business in the euros and therefore major changes in quarter-to-quarter in foreign exchange rates can impact topline revenue and gross margin.

And last, June marks the beginning of the summer and we’re looking forward to participating in another full season of teenage orthodontic case starts and continue gaining share of share both at the tail-end of quarter two and into quarter three.

Now let’s go through more detail on the outlook. For Q2, we expect sequential case volumes to be flat to slightly up at 63.5 to 65.5000 cases and revenues to be in a range of $88 to $91 million. The incremental case volume is being offset somewhat by lower ASPs as a result of the consumer and volume rebates just mentioned and international revenues, which will be impacted as a dollar has strengthened against the euro.

We expect Q2 GAAP gross margin to be in the range of 75.6% to 76.4%, down sequentially from 77.4% in quarter one, primarily reflecting lower anticipated average selling prices.

We expect quarter two GAAP operating expenses to be in a range of $52.5 to $53.5 million. Consistent with the quarterly run rate comments I made last quarter. The sequential increase reflects the implementation of marketing programs that were delayed from quarter one, ongoing consumer advertising, customer events such as the AAO and CDA meetings that occurred during quarter two and a full quarter of compensation expense related to the actions implemented in mid quarter one.

In Q2, we expect operating margin to be in the range of 16% to 17.6% and earnings per share to be in range of $0.12 to $0.14. In Q2, we expect the effective tax rate to be in a range of approximately 28% to 30% and cash from -- and from a cash position we expect to pay minimal cash taxes, as we can utilize the net operating losses on our tax returns. We expect diluted share outstanding for quarter two to be approximately 78 million shares.

From the balance sheet perspective, cash on hand at the end of quarter two is expected to be approximately $225 to $230 million. For fiscal 2010, we’re updating our outlook for stock-based compensation expense to be approximately $17 million.

I’ll now call – I’ll now turn the call back to Tom for some closing comments.

Tom Prescott

Thanks, Ken. I’m pleased that we’re off to a good start this year and I’m proud of the good work our team is delivering. That said, I’m mindful of the difficult global economic environment and its impact on consumer behavior and spending, we’re going to continue to monitor this closely as the year evolves.

The Align team has worked hard over the years to build our business and the relationships we’ve with our customers. With today’s changes to the proficiency program we look forward to working even harder to become the best part of the industry and a source for great smiles.

And with that, I’ll open up the call for your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Thank you. Our first question is from the line of Shawn Fitz with Stephens Incorporated. Please proceed with your question.

Shawn Fitz - Stephens Incorporated

Hi, everyone. Good afternoon. Thanks for taking the question here.

Tom Prescott

Good afternoon, Shawn.

Shawn Fitz - Stephens Incorporated

Hi. I’m intend, just as we think about you all talking about some of the feedback you’re getting from your customer base. It seems as if there was a kind of a tremendous amount of upheaval and some ill will created from the very beginning with the proficiency program.

And so, I guess, I’m just trying to understand what’s changed as this program has evolved and you all’s willingness to implement has evolved. I mean, it seems to me to me there has been a tremendous amount of ill will created by this from the very get-go. So, I’m just trying to understand now what is different relative to six, eight months ago?

Tom Prescott

You know, that is a great question and you guys have done a good job of channel checking and seeing some of the same tones. The simple answer is, nothing has changed. It could have gotten better. It didn’t and as even with success in the program long-term success, it’s going to be hard to build on that without a whole industry that’s not against us. So, there is no tipping point. The business is doing well. It’s just that listening to our customers.

Shawn Fitz - Stephens Incorporated

Okay. And then Tom, I guess in light of kind of an evolving competitive landscape. Does this create an opening with your kind of your customer -- your existing customer base and does it diminish the franchise value in a way that puts you more risk to competitive entrants?

Tom Prescott

Boy, certainly, I think whatever competitors do is up to them, that either the timing of this or our decision had nothing to do with any competitor, current or prospective. The timing for this was really driven by -- this is our Q1 earnings call. We’re going to be out with thousands of orthodontists in a week and a half at AAO in Washington D.C., some weeks after that with tens of thousands of dentists at the CDNA.

We’re, the timing is really set by the fact that we had come to the view that we were going to make this change. The best time to do it was now. That has nothing to do with any competitor.

Maybe the second part of that question is at any point in time, multiple people have tried to go do this. We believe it’s hard to do, to do this in any scale and just for effectiveness, if you’re referring to the noise around DENTSPLY as a prospective entrant here.

I have remind you they’ve been making clear liners and clear liner technology for about as long or longer that Align has been around. They have their MTM, their minor tooth movement system that is a series of players and set down materials for the ortho’s lab, back office lab to make very small adjustments to retainer type single aligner products.

So, again, as we see that potential product, it’s likely that it probably goes more after Ormco’s, Damon Ormco’s Simpli5 than Invisalign’s Express. We do have great depth of understanding about how to move teeth with clear liners, how to do that with precision and give the fit and finishing control that orthodontists and patients need.

So, again, unless any player was to come into this space with a much more systematic offering that would project over on to what we do in a more complete way with all those IP issues, that’s a whole different kettle of fish.

But from what we understand, we don’t have any views of that and relative back to proficiency, your original question, the exact reason why we want to have a loyal, committed customer base and not be at odds in the industry especially with those that aren’t even Invisalign customers is because we want to have the kind of long-term relationship that ultimately makes a partner -- makes us a partner of choice.

Shawn Fitz - Stephens Incorporated

So, Tom, last question. Just on the consumer rebate side. Could you describe a little -- give us a little more detail in terms of what specifically is in the consumer rebate? And then secondly, have you all ever done a consumer rebate before?

Tom Prescott

I will answer the second part first. No, we tried a small teen referral program in the very early days of trying to market teen, where they could bring a friend in but there is nothing of any scale that’s ever been done. And maybe I’ll ask Ken to scope it for us in just a minute.

But, we’ve been looking at doing a test of some significance for awhile and we wanted to build out a test of this, after a solid step up in effectiveness of the broader consumer program. We think as we planned, this was the right quarter to do it with real significant progress made in Q1.

And so, this is targeted at primarily GP practices with patients that aren’t necessarily seeking a referral doctor and that want to accelerate around their use of things like Invisalign days and that sort of thing.

And what we’re really testing here is sizeable enough that Ken had to speak about it and I’ll let him build on that in a moment. But what we’re really testing here is a couple things. Is it possible to mobilize a considered purchase decision earlier and what kind of elasticity is out there at the end consumer level.

So we’ve never had an opportunity to do that. We’ve kind of been for, quite frankly, talking about how the best way to do that and this for us was the perfect time to roll it out given systems progress and other areas consumer, et cetera and maybe Ken if you can frame the relative size?

Ken Arola

Sure. Shawn, if you look at the program itself we’re looking at initiating the program here as we enter the quarter then run through the end of the quarter and it will be based on ClinCheck’s that get accepted by the doctor through the entire quarter based on this promotion.

It will be pretty much targeted towards doctors doing Invisalign day practices in their offices and as they get a patient into treatment, the patient will get a coupon to submit to us for rebate. Right now, as we look at it in sizes, obviously we looked at our net MPB return on a program like this.

And as we sized it right now it looks like roughly above, give or take a little about $1 million of rebates we would issue and we clearly understand the amount of cases we need to get out of this program to breakeven or make a slight profit on it at minimum. So I want to come back to that also in relation to the full quarter guidance of $88 to $90 million. Because this has one impact in the quarter, our case volumes were relatively flat to about a 3% growth quarter-over-quarter, where the revenue guidance is relatively flattish.

But, if you add back to the guidance we gave on revenue, this particular rebate, as well as, the -- a little bit of a kicker on the advantage rebate to preparing elite doctors for hanging in there with us through the proficiency program, as well as, FX impacts.

The total of those three is a little over $2 million of impact to topline revenue for the quarter. So, one could see our guidance potentially being $90 to $92 million versus $88 to $90 million as one can point that out. But roughly coming back to your original question, cost of rebate we sized it as roughly about $1 million.

Shawn Fitz - Stephens Incorporated

All right, Tom, Shirley, Ken, thank you.

Tom Prescott

Thanks Shawn.

Shirley Stacy

Thanks Shawn.

Ken Arola

Thanks a lot.

Operator

Thank you. Our next question is from Tao Levy with Deutsche Bank. Please proceed with your question.

Shirley Stacy

Tao?

Tao Levy - Deutsche Bank

Yeah. Can you hear me?

Tom Prescott

Yeah. We can hear you now.

Tao Levy - Deutsche Bank

Okay. Perfect.

Tom Prescott

Yeah.

Tao Levy - Deutsche Bank

The gross margin decline that you’re guiding for in the second quarter, is that purely a function of the rebate that you’re anticipating?

Tom Prescott

Yeah, Tao. It is predominantly the rebate itself. The fact that, we’re going to talked about $1 million rebate here.

Tao Levy - Deutsche Bank

Right.

Tom Prescott

And some additional now from the advantage rebate additional that we’re going to give. The other part that is impacting it is FX rates for European business. Last quarter FX rates quarter one ran about 1.4 to the dollar and right now the 1.33 to the dollar, so we’re certainly taking that in account as we’re looking at our guidance here for the quarter.

And then the last piece of it is there will probably be a little more training going on next quarter, which will impact gross margin. As I mentioned we’ve to record all that training and cost of sales on a go-forward basis.

Tao Levy - Deutsche Bank

Okay. Great. On the ortho side you made a great point in the presentation where you indicated that you know with the higher volume, orthos who were submitting cases where you saw the growth. How about on the GPs? Was there any trend that you saw there in the quarter was it the higher volumes that were driving the growth on the GP front?

Tom Prescott

It was all across the range, Tao, I guess in prior quarters with proficiency going forward we gave you a bit more data to triangulate what was going on with those segments, going forward, as we’re not doing that any more we’re not going to provide that level of specificity.

But that said, what we do know is where we direct the sales force focus and program focus, we move the needle. And significant part of that focus, during the last quarter or two was towards those practices that we’re trying to elevate and getting them going.

So, the contribution we wind up with a smaller number of total GP submitters, but and there were some puts and takes as I talked about in GP, so I won’t repeat that. Going forward we think that will change a little bit and probably more of the volume will come from the mid to the upper rang but we’ll see how that plays out.

Tao Levy - Deutsche Bank

And then last question. Yeah, based on your prior comments, your intel that you have right now in terms of competitive landscape, the potential product DENTSPLY start to introduce here in the next few weeks, is more kind of a red, white, blue Simpli5 competitor type product versus an express or full-on Invisalign?

Tom Prescott

Well, short answer is, yes. That’s our current understanding.

Tao Levy - Deutsche Bank

Okay.

Tom Prescott

From what we see and know. Now that said, look we don’t take anything lightly, DENTSPLY is a terrific company. They are a leader this industry. They’ve got far greater resources than we have and I guess, if, I’ll go back to what I said before. If you can be confident in your IP and capabilities and the great product you’ve got and yet paranoid about all your competitors that’s kind of where we’re.

Tao Levy - Deutsche Bank

Great. Thank you.

Tom Prescott

Sure.

Operator

Thank you. Our next question is from the line of Matt Dolan with Roth Capital Partners. Please proceed with your question.

Matt Dolan - Roth Capital Partners

Hey, guys. Good afternoon. Thank you for taking the call.

Tom Prescott

Good afternoon, Matt.

Ken Arola

Matt, how are you doing?

Matt Dolan - Roth Capital Partners

Another question on the proficiency program, looking at your case volume and Ken, I appreciate the detail there on where the revenue guidance would be on an apples-to-apples basis, but case volumes looking to be flat to up sequentially.

Maybe you guys could give us a feel for what the impact of the proficiency program has been to date in terms of performance, or put another way, Ken, I think you mentioned some customers taking potentially a breather while others hang on.

So, just help us maybe understand how big of an impact you might have seen from customers ramping up utilization due to the potential existence of the proficiency program?

Tom Prescott

I guess, let me speak to that a little bit here Matt. Again, a moment ago, I described that we -- there is not a point in going forward and providing a lot of granular detail around what those segments look like. But that said, we had, if I go through the spectrum of customers, we had terrific performance by orthos. Those practices engaged. Utilization was up. We had a range of revenue reaction from GPs and then we had, pretty darn good performance from international, again, significant growth in Europe again, both a tougher quarter against a very strong Q4, but really good growth year-over-year.

Down inside -- let’s go down inside the GP bubble. There is a full cascade of practices that were really on board and rolling and rolling right past kind of the June kind of requirements all the way to getting to 10 and 10. The focus, again, go back to where we focus programs, sales force effort, that’s usually where we see the needle move.

And a good part of the sales focus was on those 15,000 plus doctors in that extension period. So, well, Ken, so now in terms of your question was framed, I guess, in the sense of guidance. There is some uncertainty for us and which is why we framed it in the term of guidance.

We haven’t gone back and done a reforecast internally since we announced it since it was just today or actually to some customers, yesterday. Come back to that maybe in a minute, but we also haven’t been able to go back to see what they’re going to do now. Are they going to take that breather and our sense from the field team is some will take a little time off and go, okay, I like the revenue it fits in my practice now let’s get back and go. Others are going to say, boy, I’m now at one or two a month. Why pull back from that, we’ve a series of activities in the office that supports that, let’s just kind of make that level of activity our current level.

So what we don’t know yet and the reason to frame that in terms of guidance is. There will be some puts and takes. We think more sharply around the GP space and given the number of customers involved we just want to be thoughtful about how we describe that. I can’t give you any more than that.

Matt Dolan - Roth Capital Partners

Okay. Fair enough. And then Ken maybe on the expense side of things, looks like we have a pickup here in Q2 due to marketing. Can you walk us maybe through the plans from a marketing standpoint through the rest of the year? How does that budget play out?

Ken Arola

Sure. So, pretty reasonable increase from about $49 million to $53 million in quarter three, quarter two here. Predominantly most of that is marketing programs and most of that is in Europe. We had a pretty significant launch in Europe this quarter with Invisalign Lite product, as well as, rolled out features in Europe, much like we rolled out features back in October in North America as Tom referred to on the call. Probably the most significant rollout of product and features we’ve had in Europe for quite some time.

So what happened here is we had a team focused over there on commercialization of product and features and they really ended up focusing all their time on those two initiatives in the quarter and we actually deferred some what I’ll call secondary marketing programs to quarter two.

So, as we move into quarter two here, the team is refocused back on those programs over in Europe and then we’ll have the additional advertising and media spend that we have going on in the business across Europe as well as North America.

And then, the other piece of it is related to compensation-related expenses, stock-based compensation and salary increases, that we implemented towards the end of February. We got just a little bit of that in quarter one spend, we’ve got a full quarter in quarter two. So those are the major drivers.

Matt Dolan - Roth Capital Partners

And they sustain through the remainder of the year?

Ken Arola

Predominantly, yes.

Matt Dolan - Roth Capital Partners

Okay. And then just to clarify on the rebate program, is that only a Q2 program or is that, again, go through the rest of the year?

Tom Prescott

Yeah, Matt. That’s just, that elapses at the end of the second quarter.

Matt Dolan - Roth Capital Partners

Great. Okay. Thanks, guys.

Tom Prescott

Thanks very much.

Operator

Thank you. Our next question is from the line of Jonathan Block with SunTrust Robinson and Humphrey. Please proceed with your question.

Jonathan Block - SunTrust Robinson Humphrey

Thanks, and good afternoon, guys. First one Tom, I’ll try to focus really just the big picture on the overall business. I mean, you just put up 27% case volume in a difficult environment. Maybe if you can just size up for us because the problem with your company I think is just there hasn’t been real comps in a while?

So when you look out what’s the true underlying growth rate case volume on a global basis? I’m not trying to pin you down to a number, but again, you just put up 27% and I think, if you look at models they probably call for high single digits maybe low double digits. So can you help us out there when you think about the overall business?

Tom Prescott

Over the long-term I can. I think what we described is over the short-term there is uncertainty specifically in North America. Over the long-term, maybe here is our thesis. We see the dental industry returning to health in some segments core dentistry faster than say some of the specialties.

There is some regional distress in North America. There is still some areas under water. But we see the dental industry pretty healthy again now and that probably, that continues for the foreseeable future unless something much larger happens in the economy than we’re imagining.

In sight of that we think the segments that had opportunities for growth at rates faster than the dental industry growth before all this happened, are the first ones that comes back and we think orthodontics is one of those and there are others, I’ll just restrict myself to our view of ortho.

For us, that expresses in two ways. One, with resurgence in growth in ortho, we have even greater opportunities to win, to wrestle share away from the big players from conventional brackets. Products like teen and our overall marketing efforts to teen.

And then secondly, we’re making significant improvement in the fundamental efficacy and performance of the product. Our customers notice it. They describe it and as we take away irritants like something that even frustrated our best customers, we believe overtime, we can we can generate the kind of growth at the edges of what’s possible. We don’t know what that is yet, but the boundary conditions for that are probably not quite established. I think we’d like to get a couple more quarters into see what kind of, what’s fast growth again.

Let’s get to the proficiency thing in North America and see what it looks like at the end of the year and then we’ll come back and revisit what our practical growth could look like into that. But we think we can get back to meaningful growth over the interim period.

Jonathan Block - SunTrust Robinson Humphrey

Okay. I guess you’re staying away from specifics there. Fair enough. Just, I mean, second question, maybe two parts. First of all, Ken you mentioned the $2 million due to rebates. So am I right when I think about the concern on 2Q EPS for whatever reason maybe that cost you approximately $0.02 in the quarter and like you said that promo is only being run through June and then so I can just slip it in.

Tom, just big picture and to give you a little bit push back on the proficiency here, I mean, why did you pursue such an aggressive course when you think about -- why didn’t you pursue something more of a tiered pricing structure where you could have, given the advantages to the real high volume guys and the guys that weren’t engaged -- you could still say you know what, you want to do Invisalign you have to pay us $2,000 or $2,500 on case instead of $1,500. Thanks guys.

Tom Prescott

Appreciate it. I’m going to come back and see if I can make sure we understood the first part. I think what Ken described was impact on -- impact forward for guidance was about $1 million for the consumer rebate. It’s a specific kind of segmented, targeted promotion and it will end by Q2.

You could and the bet for us was, we’d like to be able to do better than that. We know what our payback is incremental volume but I think as Ken described there is an impact on revenue on the guidance you forward. So I’ll just, Ken you want to add to that?

Ken Arola

I would just add, the $2 million your referring to, Jon, includes an FX impact quarter-over-quarter, as well as additional rebates on an advantage program for the elite and premiere doctors. And that’s how you get to the $2 million, so $1 million for the rebate program, $1 million for the other two components.

Jonathan Block - SunTrust Robinson Humphrey

Fair enough. I think it’s about a penny and a half, I can follow-up with you off line. And then, Tom, just bigger picture on proficiency why that strategy versus tiered pricing?

Tom Prescott

Sure, we actually have explored tiered pricing and do that through the advantage program and have considered a whole range of alternatives and I’ll give you one example. Our European team sells case packs. There is a minimum number of case packs. It is the way business is done in Europe. It’s not the way business is done in North America.

We’ve done it a whole range alternative ways. What we were, if you go back to what our original objectives were they were to ensure that any patient -- any potential patient, a consumer could go to any Invisalign practice get the smile they wanted with the treatment experience that was great.

And at the same time, that any practice that was involved in Invisalign had both clinical success and commercial success and that hasn’t happened. So, we’ve a lot of data that relates how practices flourish and how patients feel about providers that have more or less experience and all that.

Now the good news is in orthodontics everybody gets finished. There isn’t the morbidity and mortality associated with some types of other medical devices. But all that said, we were solving this from a point of a logical way to say it is an evolving skill-based technique.

You need both the education and as well as at-bats and that was after a lot of consultation with academic dental educators, chairs of ortho and dental departments, et cetera. And we went back to look at how dental education is done and, again, we apologize, we didn’t mean to anger the industry or try to suggest we want to anger the industry, or try to suggest we want to get between them and the patient. Our goal was, our objectives were good. Our goals were there. Clearly this was a pretty significant change for the dental industry.

So, there are a whole range of ways we can engage this going forward. Our big goal is going to be to focus on education leverage and loyalty programs and make it even more valuable to be an Invisalign partner going forward.

And I think as you see over the coming months and quarters we’ll be explaining more of that to you. But there is a path forward but there actually was a logical framework with data and a rationale for doing this and we did test it with some -- with leading thinkers. Most of those have gone underground now with the broad industry reaction. But, that said, we’re comfortable with our path going forward and believe there are a number of ways we can continue to mobilize practices.

Jonathan Block - SunTrust Robinson Humphrey

Great. Thank you.

Tom Prescott

Thank you, Jonathan.

Operator

Thank you. Our next question is from the line of Ben Forrest with Summer Street Research. Please proceed with your question.

Ben Forrest - Summer Street Research

Great. Thank you for taking the question. Ken a follow-up on that last one. We believe that some physicians have gotten to a point where they are happy with proficiency. That is a way for them to differentiate themselves from their competitors. Are you concerned about what their reaction to today’s announcement is?

Tom Prescott

Yeah. The short answer is yes, we have large number of stakeholders here and some of harshest voices were those that had never even been trained on Invisalign. So, one of the things, Ken talked about briefly, we actually had been talking the last day or two with academic advisory board and clinical advisory board members and some of our staunchest supporters that believe this was the right direction that saw the leverage of getting a practice just starting up to get the experience the doctor and staff.

So, we’ve reached out to them. We make sure they understand our need for doing this and the reason, even while it was -- the program was being successful, that if we really want Invisalign to be well accepted broadly over the long-term as a standard of care and if we really want Align technology to have the opportunity to become the industry leader that they and we want, that we need to embrace the entire industry in ways that would work within the rules for lack of a better description.

So, there is a variety of things we’re doing for them and Ken talked about a little incremental rebate for them that adds to what they already get in the advantage program for those upper tiers that added to his the costs he talked about the impact on Q2 revenue.

But and I think, I’ve had, we’ve had a lot of good discussions over the last 24 hours with some of our staunchest supporters and even the strongest among them understand the reason for doing this. Know that our rationale for doing it was based on the right reasons and understand why we’ve made this adjustment.

Ben Forrest - Summer Street Research

Thanks for that. And then in the past, I’ve gotten the impression that the lower volume centers were centers that may be management didn’t feel like they needed to spend or didn’t want to devote too many resources to. Can you share any thoughts on how you might be viewing those centers any differently, any feedback you’re getting that way?

Tom Prescott

Well, it’s a good question and it really speaks to what our effort to engage with them during this period since June 2nd, last year when we announced proficiency, it was exactly those centers and we said please, we will break our backs to help you if you want to come along and here is our understanding of how this best works.

And there were a lot of practices that, in fact, maybe they went from one or two to five or six and they were still stretching to get to 10. There is no reason why that stops. There is no reason why the aggressive support and help from our team stops. If we’ve a practice out there that wants to make Invisalign a greater part of their practice, we’re going to be all over helping them.

At the same time, what I said, I believe earlier was, where we invest both sales focus of what we believe is the best sales force in the dental industry and program effort, we see the needle move. And some of that effort is going to move back towards the mid and upper ranges of those submitters and help their practices continue to accelerate.

So, overtime, we’ll find cost effective ways to support those practices that still are doing very few cases. But want to continue along with Invisalign and we’ll do our level best to support them.

Ben Forrest - Summer Street Research

Great. Thank you

Tom Prescott

Sure. Thank you

Shirley Stacy

Thanks, Ben. Operator, we’ll take one more question please.

Operator

Thank you. Our final question is from the line of Robert Gold with Brigantine Advisors. Please proceed with your question.

Tom Prescott

Robert, you there? Yeah, operator his line still there?

Operator

Mr. Gold your line is now live.

Shirley Stacy

Okay. Robert, we’ll follow-up with you it sounds like offline. Thank you everyone. This concludes our call today. If you have any follow up questions, please contact Investor Relations and we look forward to seeing you at some upcoming conferences here shortly. The Deutsche Bank Conference on May 5th and the Banc of America/Merrill Lynch Conference on May 12th. Thank you and have a great day.

Operator

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

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Source: Align Technology Inc. Q1 2010 Earnings Call Transcript
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