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Executives

Shirley Stacy – Senior Director, IR & Corporate Communications

Tom Prescott – President and CEO

Ken Arola – VP, Finance and CFO

Analysts

Matt Dolan – Roth Capital Partners

Spencer Nam – Madison Williams &Company

Jonathan Block – SunTrust Banks Inc.

Drew Jones – Stephens Inc.

Robert Gold – Brigantine Advisors

Align Technology Inc. (ALGN) Q3 2010 Earnings Call Transcript October 21, 2010 4:30 PM ET

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Align Technology third quarter 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 Techology. Ms. Stacy, you may begin.

Shirley Stacy

Good afternoon and thank you for joining us. I'm Shirley Stacy, Senior Director of Investor Relations and Corporate Communications. Joining me today is Tom Prescott, President and CEO and Ken Arola, vice president and CFO. Before we begin, let me cover some housekeeping items.

We issued our third quarter fiscal 2010 financial results press release today via Global Newswire and FirstCall which is available on our website at investor.aligntech.com. Today's conference call is being audio web cast 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 November 4. To access the telephone replay, domestic caller should dial 877-660-6853 with account number 292 followed by pound and conference number 358000 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 fourth quarter of fiscal 2010. 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-Q for the fiscal quarter ended June 30th.

These forward-looking statements reflect beliefs, estimates and predictions as of today and Align expressly assumes no obligation to update any such forward-looking statement. Please also note that this conference call will provide listeners with several financial metrics determined on a non-GAAP basis for comparisons to previous quarters. Most of these items together with the corresponding GAAP numbers and a reconciliation to the comparable GAAP financial measures, where practical, are contained in today’s financial results press release, which we’ve posted on our website at 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 reconciliation and our third quarter conference call with slides on our website under quarterly results. Please refer to these files for more detailed information.

With that, I would like to turn the call over to Align Techology's President and CEO, Tom Prescott. Tom.

Tom Prescott

Thank you, Shirley. On the call today, I will cover some highlights from our third quarter and provide an update in our strategic initiatives. Ken will follow with some detail on our third quarter financials and outlook for the fourth quarter. I will come back with some closing comments and open the call up to your questions.

Q3 was a good quarter for Align with revenues, gross margin, operating margin and EPS, all above our outlook for the quarter. Q3 key shipments were within our guidance, but at the lower end of the range reflecting growth from the North American orthodontist and international doctors offset by greater than expected summer seasonality.

This softness has persisted into the fall, especially among our North American GP customers, who have reported lower dental visits and reduced demand for premium procedures, which we believe contributed to lower than expected case admissions for Invisalign as well.

It also appears the elimination of the case requirements announced in Q2 contributed to lower case submissions among some customers. In high insight, the stronger than expected results we saw in Q2 across our customer channels including low volume GP's masked the slow down among those practices that were striving to reach 10 cases per year.

We were probably too quick to believe that the Proficiency Program was completely behind us. It now appears that the potential impact initially described on the Q1 call in April regarding our uncertainty as to how customers might respond to the elimination of case requirements has taken longer to play out. Having said this, we continue to see interest from many GP's who want to make Invisalign a bigger part of their practices as well as other new GP's who want to add Invisalign to practice.

We will continue to work to expand the GP customer base. As we discussed previously, our strategic focus is on driving adoption Invisalign into existing practices while expanding our customer base in North America and internationally.

Let's review the key metrics that measure our performance. Utilization rates are what we call same-practice sales of our product and a number of new doctors trained. In Q3, total utilization decreased slightly on a sequential basis and increased year-over-year to 3.6 cases per quarter. This reflects a decrease of 1% sequentially and an increase of 18% from Q3 a year ago.

By customer channel, Q3 utilization was unchanged for North American orthodontist and international doctors at 5.8 and 3.8 cases respectively. North American ortho utilization remains solid but many practices have indicated they are working harder to get business and close cases.

North American GP dentist utilization decreased sequentially from 2.8 to 2.7 cases per GP reflecting less usage across among levels or tiers as compared to Q2. In addition, there are fewer low-volume GP's in Q3 than in the prior quarter.

On a year-over-year basis, doctor utilization of Invisalign increased across all customer channels, up 18% for ortho, up 16% for GP's and up 9% for international doctors reflecting continued adoption of Invisalign into practice.

During Q3, we trained 825 new doctors, down from 960 in Q2, given the fewer number of training courses offered during the summer months. Of those trained, 550 were North American doctors and 275 were international doctors.

I will shift now to our strategic initiatives and remind you that our strategy has a series of key initiatives that we typically discuss each quarter. The first is to accelerate product in clinical innovation, which includes new products and significant evolution in features and functionality such as the recently launched Invisalign G3.

Second, continually working to enhance the customer experience which we typically address through evolutions in those customer phasing systems. Third, increasing the effectiveness of our consumer demand creation process and extending brand awareness. And finally, continuing to drive international growth principally in Europe while opening up additional new markets around the world such as China.

To start with product and clinical innovation, I’ll provide a brief update on the overall teenage orthodontic market segment and our Invisalign Teen product. We are pleased with our continued progress in the overall teenage segment. In Q3, teenage patients 19 and under using Invisalign products increased 11% sequentially and 24% year-over-year for a total of 16.4 thousand teenagers or 25% of total worldwide volume. This is compared to 23% of worldwide volume in Q3 2009 and 21% of total volume in Q3 2008, the first full quarter that included shipments for the Invisalign Teen product.

In addition to gaining share of the teenage product – in addition to gaining share of the teenage segment overall, we are also focused on increasing the number of younger patients, especially 11 to 15-year-olds that represent the bulk of teen orthodontic case starts.

In Q3, the average age of our teenage starts with 15 and a half which was unchanged from last quarter. We’d expect the average age of teenage patients to get a bit younger as our penetration in the segment continues and Invisalign Teen practice is designed to do just that.

Invisalign Teen which includes specific features that are intended to treat younger teens with mixed antition. In Q3, Invisalign Teen volume increased 11% to 7,590 cases or 12% of total volume from 6,810 cases or 10% of total volume last quarter.

On a year-over-year basis, Invisalign Teen was down slightly from 7,850 cases reflecting the change in the teen promotion that went into affecting Q1 of this year. We're pleased with our continued progress and growth in both the teenage segment and the teen product, but we’re not completely satisfied because we know there is still a lot of room to gain significant share with Invisalign.

Shifting to our most recent product announcement, during the Q2 call last quarter, we previewed the launch of Invisalign G3. Our collection of innovation that is engineered to deliver even better or predictable clinical results and make it easier for our doctors to treat more complex cases. As part of this launch, significant improvements in enhancements were made in our customer facing systems.

The Invisalign doctor site and ClinTec software to make it easier for our doctors and staff to communicate their treatment plan, reduce claim check treatment upon revisions and manage account details. I am pleased to report that Invisalign G3 was successfully launched in October 11 in North America and will be available internationally in Q2 of 2011.

I won't go into all of the details on today's call as I know many of you have already reviewed the press release issued on August 16th and some of you even dialed into the Ask The Expert Call rehosted for our customers on October 1st. Invisalign G3 is the largest evolution in our history touching every product in virtually every system at Align and I am pleased and proud of the hard work demonstrated by our employees to achieve this significant milestone.

We believe the new features and overall improved performance of Invisalign G3 will have a positive impact on utilization and continue to support more widespread adoption into our customer’s practices. Following the G3 Ask The Expert Call, 91% of the 4,000 doctor attendees said that they had confidence in Invisalign and 86% said they would recommend Invisalign more going forward, pretty amazing.

In addition, by the end of the first week of availability, over 75%of doctors were reviewing their treatment plans using the new ClinCheck 3.0 software. To date, there are over 215 cases and over 190 doctors utilizing the new precision cut features meaning that they were quickly trying these new features on more complex class 2 and class 3 cases, which is exactly what we had hoped for.

In Q3, we continued building awareness and driving action to our integrated consumer marketing platform of traditional media, event marketing and digital and social media. Under traditional print and broadcast media, we’ve just launched a new teen commercial that targets moms with teens in the household. You may have already seen the Twin’s TV spot which is airing primarily in prime time. The goal of the commercial is to raise mom's awareness there is an alternative to metal braces and prompt them to learn more.

The commercial will be supported with print ads in major women's magazines through the end of Q4. Invisalign Teen was also featured in many regional parenting magazines and TV news segments across the country with doctors serving as experts to offer parent’s tips onto the right treatment of their child. As part of this effort, Invisalign teen was also included in a summer satellite media tour that reached parents in14 market and garnered nearly 10 million impressions.

Under event marketing activities designed to reach potential patients where they live and play, we partnered with Fox for the 2010 Teen Choice Awards. As the premiere sponsor of Fox's Teen Choice Awards which aired on August 9th to over 2.5 million viewers, Invisalign received significant consumer exposure.

A big part of our strategy was to leverage our partnership with Fox online which resulted in a 125% increase in Invisalign Teen website visits and a 40% increase in Invisalign Teen Facebook fans. Q3 also marked the official launch of Invisalign's studio, a new entertainment-based marketing platform to create excitement for Invisalign Teen. The studio is an actual orthondontic practice in Beverly Hills, staffed by one of the most experienced local orthodontists.

We’ve already recruited a number of celebrities as Invisalign patients. And they will begin to participate in a variety of marketing activities over the next several months including public relations effort with the press and social media activity online to promote the brand. If you want to hear more about our progress in the consumer area next week at our analyst meeting.

A shift to international, Q3 was a solid quarter with growth both sequentially and year-over-year. Q3 case volumes of 16.2 thousand or 24.5% of worldwide volume increased 2% sequentially and 34% year-over-year. The sequential increase reflects increased volume from the Asia Pacific region and normal summer seasonality, particularly in the southern European countries such as Italy, France and Spain.

The year-over-year increase reflects strong growth in core Europe. Of note, Spain has had a very strong year and was up over 100% in Q3 albeit on a small base. Q3 international revenues of $23.2 million or 24% of total increased 5.5% sequentially and 25.8% from the same quarter last year. Invisalign Light which replaced Invisalign Express outside North America and includes upto 14 sets of Aligners, continues to grow nicely across international and had a strong uptick in Asia Pacific and Japan this quarter, again off a small base.

Before I turn the call over to Ken, I would like to briefly comment on the additional news release we issued today, announcing that we have received regulatory approval to market and sell Invisalign in China and will begin commercial launch in the second half of 2011. This is a significant milestone and we are very excited of the opportunity and growth potential for Invisalign in China.

Prosperous Chinese are increasingly spending on discretionary items, particularly high on luxury goods. This combined with increased spending on healthcare, oral health and aesthetics makes China one of the fastest growing market opportunities for orthodontics over the foreseeable future.

There is still much work to be done, prepare to launch Invisalign in China. We will go into more detail in our upcoming analyst meeting in New York next week when our new VP of International, Richard Twomey will take me through our view of this tremendous long-term growth opportunity.

I will now turn the call over to Ken for more detail on our third quarter financials and outlook for Q4 and then I will come back for a few closing remarks. Ken?

Ken Arola

Thanks, Tom. Now, let's review our third quarter financial results beginning with revenue. Q3 net revenue of $95 increased 2.2% sequentially from Q2 non-GAAP net revenue of $93.9 million, an increase of 21% year-over-year. Recall that Q2 non-GAAP net revenue excludes the release of $14.3 million of previously deferred revenues within this our Teen replacement Aligners.

The sequential revenue growth reflects higher worldwide ASP's which were driven by lower deferrals associated with the teen replacement Aligners, lower levels of discounts and rebates and lower case refinements. On a year-over-year basis, Q3 revenue growth primarily reflects higher volume across all channels with worldwide ASP's remaining relatively consistent.

Case shipment of 66.2 thousand in Quarter three decreased 1.8% sequentially and increased 17.2% from the same quarter last year. The sequential decrease reflects lower than expected cases in North America particularly from the GP's. As Tom mentioned during the summer doctors experienced slower patient flow which had extended through the fall.

Additionally, some more volume doctors have not maintained their prior rate of case submissions which we believe is in the response to the elimination of the minimum case requirements. On a year-over-year basis, case shipments were up significantly across all channels, especially with North American ortho and International doctors, which were up 23% and 34% respectively.

In terms of customer mix, Q3 revenue consisted of 38.3% for North American GP's, 32.5% for North American orthos, 24.2% for International and 5% for non-case revenue, reflecting a slight shift from North American GP's to North American orthos and International doctors. Q3 revenue by product consisted of 59.5% for Invisalign full, 11.8% for Invisalign Teen, 9.3% for Invisalign Express, 4.4% for Invisalign Assist and 5% for non-case revenue.

Now, let's move on to gross margin. Q3 GAAP gross margin was 78.1% compared to 80.4% in quarter two and 74.4% in the same quarter last year. Gross margin for quarter two reflects – for quarter two, 2010 reflects the fateful impact from the release of previously deferred revenue for Invisalign Teen replacement liners and quarter three 2009 gross margin includes a charge of $1.9 million for royalties related to the ongoing settlement.

For Q3, non-GAAP gross margin was the same as GAAP at 78.1%. This compares to Q2 gross margin of 77. 4% which excludes the Invisalign Teen deferral impact and Q3 2009 non-GAAP gross margin of 76.8% which excludes the Ormco royalty. The sequential increase in gross margin was primarily driven by higher ASP's. Additionally, we have fewer training courses during the summer and gross margin benefited from lower training revenue which carries nominal gross margins.

Q3 GAAP operating expenses were $53 million compared to $41.7 million in quarter two and $119.2 million in the same quarter last year. Q3 operating expenses include litigation settlement costs of $3.3 million related to the Leiszler class actions settlement which was announced earlier today in a press release.

Q2 operating expenses include an $8.7 million credit for an insurance settlement related to the OrthoClear litigation in quarter three 2009 operating expenses include litigation settlement costs of $69.7 million related to the Ormco settlement. For comparative purposes, non-GAAP operating expenses exclude the Leiszler settlement costs and the credit for the insurance settlement related to OrthoClear.

Q3 non-GAAP operating expense was $49.7 million compared to $50.3 million in quarter two and $40.5 million in the same quarter last year. Q3 non-GAAP operating expense was relatively unchanged from quarter two and Q3 of last year and reflects lower than anticipated spending related to sales system, International marketing program and lower than expected headcount additions.

Q3 GAAP operating income was $21.9 million and compared to $45.3 million in quarter two and a loss of $50.2 million in Q3 a year ago. Q3 non-GAAP operating income was $25.2 million or 26.3%. This is compared to $22.4 million or 23.8% in quarter two and $11.4 million or 14.4% in the same quarter last year. The sequential increase and non-GAAP operating margin reflects higher gross margins and lower spending.

Q3 GAAP diluted earnings per share was $0.22 compared to $0.42 in quarter two and a loss of $0.72 in the same quarter last year. Q3 non-GAAP diluted earnings per share was $0.25 compared to $0.21 in quarter two and 13% – $0.13 in Q3 of last year.

Now, let's move on to the balance sheet. Cash, cash equivalent and marketable securities were $280.1 million. This compares to $186.5 million at the end of 2009. In Q3, we generated roughly $37.6 million in cash from operations compared to $42.6 million in quarter two and $10.8 million in the same quarter last year. Q3 DSO's were 60-days unchanged from quarter two and down slightly from 62 days in the same quarter last year.

Now, let's turn to our business outlook for the fourth quarter of 2010. There are several factors that I would like to outline that contribute to our view of Q4 case shipments and revenue. First, we have seen a moderate reduction in effort primarily among North American GP's following the elimination of the minimum case requirements.

Second, we had a slower than expected summer in North America, again particularly for GP dentists. This trend has persisted into the fall and lead to lower case received from which Q4 shipments are generated. Third, we expect Q4 international revenue to benefit somewhat from exchange rates compared to quarter three.

Lastly, we are being thoughtful about our near-term consumer sentiment and the potential impact on dentist visits and high-value procedures especially given the slow down we have recently seen. With these factors in mind, we expect Q4 case volumes to be in a range of 61.5 to 63,000 cases and revenue to be in the range of $90.5 million to $93 million.

We expect Q4 gross GAAP margin to be in a range of 76% to 76.5%, a sequential decrease in gross margins primarily reflects the cost for the Invisalign ortho summit which will be held November 5th and 6th. Beginning in Q1 2010, continued educational fees are recognized in revenue and the cost of the educational progress are being accounted for in the cost of good sold. As a result in certain quarters, when we have major customer events like the summit, gross margins will be unfavorably impacted.

These educational activities are highly impactful and extremely valuable to provide customers with access to the latest Invisalign education resources and enable them to network and gain valuable insight on treatment techniques and practice development ideas from their peers.

This year's ortho summit sold out on the first day of registration and we will host a record number around 1800 orthos and their staff. To a lesser extent, Q4 gross margin will be impacted by lower volume and the introduction of Invisalign G3 which includes the ability to slow down tooth movement and that increased treatment time for certain cases.

Features in G3 are expected to add some additional passive Aligners to each case which will increase cost of good sold in the near-term. However, over time we have set G3 features to drive revenue growth in the business by improving predictability of treatment outcomes and reduce the need for case refinements, warranty and midcourse corrections.

We expect Q4 GAAP operating expenses to be in the range of $51.5 million to $52.5 million. The sequential increase in Q4 operating expense reflects spending – increased spending in international sales and marketing including headcount additions delayed from quarter three. Commercialization activities associated with the launch of Invisalign G3 and pre-commercialization activities in China as we set up and staff our new office in Shanghai.

In quarter four, we expect operating margins to be in the range of 19.1 to 20% and earnings per share to be in a range of $0.15 to $0.17. In quarter four, we expect the effective tax rate to be approximately 28%.

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 shares outstanding for quarter four to be approximately 78.5 million shares. From a balance sheet perspective, cash on hand at the end of quarter four is expected to be approximately $195 to – $295 to $300 million.

Now, before I turn the call back to Tom, I’d like to briefly comment on our long-term financial model targets which were communicated at our last analyst meeting in November 2008 and were intended to provide a framework for the business over a three to five-year period.

Over the past two years, we have made significant progress toward these goals and have consistently delivered financial results at the high end or slightly above our long-term model ranges. As part of our annual strategic planning process, we evaluate the model and determine whether it has been appropriate in terms of expected top line growth, strategic investments and return to shareholders.

With our recent performance and long-term strategy in hand, we remain confident about our future and I’d like to update you on our new three to five-year review of the business. Starting with revenue growth, (inaudible) the old range was 10% to 20%. The new range is 15% to 25%.

The gross margin range remains unchanged at 73% to 78%. Our operating expenses, the old range was 55% to 60%, the new range is 45% to 50%. And for operating margins, the old range was 15%to 20% and the new range is now 25% to 30%.

The new motto reflects our commitment to continue top line growth or driving leverage into the business. Again, I’d like to stress that this is our new three to five-year deal of the business and not guidance for 2011. I will provide more detail on our new long-term model at our analyst meeting in New York next week.

Now, I will turn the call back to Tom for some closing comments.

Tom Prescott

Thanks, Ken. Our updated financial model reflects a more bullish mid and long-term view of our business. That view is based on our strategic plan and confidence in the Align team's ability to execute on key strategic initiatives. At the same time, we are going to actively manage the business carefully through what looks to be a softer near-term period in dental industry.

Through these challenging times, we have seen our orthodontist and GP customers react differently to the environment and therefore our approach to each needs to reflect those differences. Our ortho customers react to tougher times by working harder among the referral sources like GP marketing in their communities and taking revenue growth opportunities in products like Invisalign.

We are well positioned to continue our positive trends with teen segment promotions, Invisalign Teen product in the G3 launch that will make it easier for orthodontists to use Invisalign in more complex cases. The GP scenario is a bit more complicated.

We know that during similar periods, our GP customers have tend to be more passive rather than finding ways to grow revenue or recruit new patients. We also know that some of the reduced activity and effort in lower volume GP practices has filed the elimination of the case requirements in Q2.

Specific plans are in place to drive activity in the field within the resumption of growth among the lower volume of GP customers. We know there are still tens of millions of consumers that want treatment even in these uncertain times. Our job is to better engage these GP practices to show them how Invisalign can contribute through a healthier growing practice and satisfy patients.

We are committed to strong execution of our strategic plan and know this leads to greater market penetration and increased shareholder value. We believe we will continue to grow revenue unit share at rates significantly above other orthodontic and dental peers and outperform the industry in general.

We’ve never felt better about our opportunities to build value in the business. I look forward to discussing this in more detail next week at our analyst meeting. With that, I will turn it back over to the operator for some questions. Operator.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will conduct be conducting a question-and-answer session. (Operator Instructions) Our first question is coming from the line of Mr. Matt Dolan with Roth Capital Partners. Your line is now open. You may proceed with your questions.

Matt Dolan – Roth Capital Partners

Hi, guys. Good afternoon.

Tom Prescott

Good afternoon, Matt. Hi, Matt.

Matt Dolan – Roth Capital Partners

Maybe, we can just walk through the quarter. Sounds like there were two variables at work, we would like to get little more detail on being the one being the proficiency case requirement having a lingering affect and the slow down on the dental visits. Tom, can you help us, maybe expand on those two variables as it relates to volumes intra quarter and specifically what does your guidance assume happens with those two issues as we progress to the fourth quarter?

Tom Prescott

Thanks, Matt. Those are the two primary factors as our other main channels. International and North American also are far more or less on track. Let me back up for a second. In the North American GP it was a reasonably normal summer, until we got into the later summer towards Labor Day and we just didn't get the normal bounce back in case starts and looking deeper into that, there were a couple different factors. One was that some of the practices that perhaps a year before were stretching and working harder to make the minimum case requirements, weren't stretching as much.

And then the second fact is they are reporting and saw a lot of this at the ADA. Attendance was down pretty significantly that the relative traffic flow for dentist in much of the country is down a bit and the demand for premium procedures is down a bit. So we can't quantitatively tell you whether these two factors play out in numbers, but they are captured in our guidance for Q4 because we exited Q3 with a lower case volume and entered Q4 with a lower case volume and therefore that's the track run.

Now, we expect to fix these. As I said, there are plans in place and there is a lot of positive things we are bringing to the GPs including improvements in the product, making it easier, including all kinds of promotion in the channel as well as the new advantage program which has been rolled out and it is a good reason to get to 10 cases or more for the year. That said, it’s going to take a little bit of time to move that and all of that is captured in a complete way in our guidance.

Matt Dolan – Roth Capital Partners

So are you saying from what you saw at the end of Q3 you're assuming those variables remain relatively stable in Q4, is that another way to put it?

Tom Prescott

We expect to get back to growth, but we believe it takes some time. And all of those run rates are factored into our total view of guidance. GP North America is the significant area that is creating this guidance change, this downward look.

Matt Dolan – Roth Capital Partners

Okay. And then Tom on the long-term guidance, maybe just looking at the margin opportunity, you pushed that up almost, not quite, but almost doubling it into the high 20s, again you’ve got to hit that number on an adjusted basis here in Q3. Should we be watching out for big infrastructure spent in the near-term as opposed to the long-term models that may bring you down off the levels we have seen in the last three quarters, 23, 24 and 26%?

Tom Prescott

No, we are not trying to telegraph any kind of nearer term implications. We have been running well above a two-year-old financial model virtually every quarter. And every time we are out with investors they ask if are going to update that. We were planning on doing that next week, so we thought we would preview that for this call. But we will run as best we ran toward that model and in that model and over perform if we are able to. But again, within a given quarter based on timing of spending and volumes in the business, will move around within that window a bit. But the short virtually answer was there’s no telegraphing of any nearer term activities in that range.

Matt Dolan – Roth Capital Partners

Okay. And then maybe lastly on the China initiative, can you give us any color on the magnitude of the investment you are going to be putting in as you go to launch late next year, maybe giving us a little bit on what the actual strategy is direct or distribution

Tom Prescott

I’m going to stop short of giving you a view strategy, because Richard Twomey, he was a very season hand and this part of the world is going to be previewing that for at a reasonable level of detail for the audience during our Analyst Day a week from today, actually, in New York. I will tell you that it is an investment. We are in investment mode, but we have been in investment mode. And we are metering these along with the rest of the business as we have been even through the very serious downturn. We continue to make the right investments in our highest priorities and China is a high priority for us. So you will hear a bit more about that next Thursday.

Matt Dolan – Roth Capital Partners

Fair enough. Thank you for the time.

Shirley Stacy

Thanks, Matt. Next question, please.

Operator

Thank you. Our next question is coming from the line of Mr. Spencer Nam with Madison Williams &Company. Your line is now open. You may proceed with your question.

Spencer Nam – Madison Williams &Company

Thanks for taking my questions. Just a couple questions on the outlook and also new product launch. First of all, it seemed like the Q4 outlook was somewhat predicted, somewhat unpredicted and I was just curious how you guys have a handle on the long-term growth when the near-term outlook seems somewhat of a unpredictable situation?

Tom Prescott

Spencer, I guess there is two pieces that tie together. I will answer the second part of it first and then come back to how we think more broadly about the business. We are out surveying our customers frequently. We do bottoms up and top down forecasting across our customer base and our field organizations around the world several times a quarter. And one fact that keeps – and we go in and do the same thing with consumers.

One thing that comes back to us again and again is that our customer base typically doesn't think about business forecasting. That's especially the case for a GP practice. They are – and I don't mean this in a bad way. They are more so up to treat those who come in the door for the conditions, their primary complaint. And they think less about how do I drive the business forward and how I think about initiatives I’m taking now to create growth in my practice.

So even when we survey our customers and they project growth or expansion, that doesn't mean they tie that out to a business plan and action and deliver on that. Secondly, for a customer that is doing two or three a quarter perhaps or even less, for them if they do two instead of three, that doesn't seem like a big deal to them. But at 4,000 or 5,000 customers do, one fewer case, suddenly we have 4 to 5,000 to 6,000 cases that we were expecting based on what our discussions with them were to show up. And that's what you are looking at here. A broad base of fairly low volume customers that it just not going to come out of summer with the effort and activities leading to case starts. That's the second part of your question about visibility. We work really hard, but yet we can't know when our customers don't look up stream and we are working on figuring out a way around that.

Again, we have greater visibility into orthodontist efforts because they are bit more pragmatic in market. Back to your – the first part of your question, the long-term strategy, we put a lot of effort into building blocks of our strategy and have been successful over the last three, four years at executing on those and delivering growth and progress in a business from the top line all the way down to the bottom line. And so we have good visibility, good execution and high confidence in that and we do have a more bullish view of the mid and long-term even if the face of a more challenging drift in the GP in North America. But we believe we are going to get that fixed. That's maybe the second part of your question.

Spencer Nam – Madison Williams &Company

Yeah, appreciate that. On the new product side with the Invisalign G3 and also expansion to China, I mean, what are some of the strategies you guys are looking at how to push G3 into this somewhat of a choppy environment and what kind of – the processes or precautions, if you will, are you taking moving it to China while the established business may be going through some changes as well as some of these – only somewhat of an unexpected fluctuations in business?

Tom Prescott

Well, those are two pretty – we look at them as related in some level. But if we take a look at – there are three pieces there, I guess if I unpack it. The first is what we are doing in China. The second is what is G3's impact? Does it help or hurt? And the third is does GP, does GP specifically if I heard you correctly, help maybe as specially as low volume customers. So I will set China aside for a moment. G3 actually helps and we put a great deal of effort into a pre announcing and pre training and ask the expert calls. We have had great attendance by Orthos and GPs on those calls and not just original call but they can do it on demand later.

We had an enormous poll upgrading of the new ClinCheck software, the new doctor site which replaced VIP and so we saw a very rapid transition by high and low volume customers to new technology platform. And understand, these are clinicians that don't change easily. So we were very pleased to see how quickly they pulled this technology. We had – Orthos, within the first day setting up very complex cases to try the new precision cuts feature as I mentioned a moment ago on the call. And to us that's a homerun because they are out testing and trying on a much more complicated class two or class three case. These new features that would have been more of a hassle before.

On the G3 side, we are hearing while it is a little daunting for the very first look, it is far easier to use for the doctor and the staff. They can see the whole account at a glance.

So we believe – we went into this huge G3 evolution with our eyes wide open. The feedback across the board after we have gotten through the first week is, it looks like it really will help. Now, getting back to how we get activity and effort in the GPs offices is just good, be blocking and tackling as we head through Q4 and reestablish growth going into next year. China, we are going to take this great product evolution and that will be our starting point for our Chinese customers. They are going to get the benefit of all the other progress we have made. So we are starting them at a different evolution of wherein advice where Invisalign is versus our North American and European customers that we’ve had to bring along. So we think that’s just going to be net benefit.

Shirley Stacy

Thanks, Spencer. Next question, please.

Operator

Thank you. Our next question is coming from the line of Mr. Jonathan Block with SunTrust Banks Inc. Your line is now open. You may proceed with your question.

Jonathan Block – SunTrust Banks Inc.

First question, Tom. I believe this one’s for you and it might be somewhat similar to some of the past questions, asked a different way. He mentioned some of the disappointment coming from largely the GP channel. What I am trying to flush out here is was it disappointing across the GP channel where utilization which is below, where you guys were expecting or was there any subset that essentially went to 0 because they turned off and Invisalign and may be trying a competitor? The others hung in there and pulled down the entire mean, or was it just across the board, like I said patient volumes weakened to dental offices and the mean all across sort of stepped down, if you would?

Ken Arola

So, Jonathan, it is actually the latter. We look at this – first of all, we can't speak for the whole dental industry. We are seeing a slice of it. So we are certainly looking at the dental industry in a keenly and watching what the real benchmark companies do. For us it was across the board in every segment of our North American GP customer base. Volumes were down as we expected through the summer. They just didn't come back Labor Day and beyond and that was the surprise to us.

As we dug into that, certainly what we and certainly we heard in spades at the ADA a few weeks ago, was that they were – traffic was slower. A good example is, 'gee I have a patient that would have gone for a full mouth restoration is doing individual tooth restoration.' People are pulling back a little bit and they are not doing premium procedures. Now, we can't quantify that today, but that's again when we went looking for what's going on.

The second thing is there were some lower volume customers that dropped out during Q2. So, if they would have done one or two in a prior quarter, maybe they disappeared completely in Q3, yet we expect to see them again. And that not gone forever and there is no evidence they went to competition, none. And so they just, again, we think this is right now and I try to say as clearly as I could, we believe the strong results in Q2 in the GP channel, even though we had removed during the Q1 call in April, we announced that we are removing the minimum case requirement. We believe we are a little further past of proficiency program. And we think really not reaching for the 10 cases a year probably was a factor in some of these practices. So with all of that rolled up together. That's what you see rolled up into our Q4 outlook.

Jonathan Block – SunTrust Banks Inc.

Okay. So then just the second part of the first question because I want to make sure I'm clear on this one. You believe your share, your market share within GP is absolutely unchanged. The problems are across the board where the weakest was felt across the board?

Tom Prescott

Absolutely.

Jonathan Block – SunTrust Banks Inc.

Just second question, Ken, this one might be for you. You speak to the long-term guidance. I realize that is not for four q10 in, but you speaking long-term guarantee that’s got two or three quarters with our Margins bouncing around 23% and 26% and you wish you got inch for 19% to 20% in the fourth quarter I believe non-GAAP. So what's going on there? I know you mentioned some one-time stuff, but is it really sort of start up costs in China that’s costing you 300 to 400 pips? Thank you.

Tom Prescott

You are talking about quarter to quarter, specifically. Here’s a couple things going on, one certainly with the volume drop off in quarter forth on the case perspective has impacts obviously on gross margins as well operating margins. As far as operating expenses are concerned on a quarter to quarter basis, we were actually behind in headcount additions in core Europe and we have people on board now or signed up to come on board during the fourth quarter, so we will see that expense come into play.

And the international arena was also a little slow in advertising during the summer because of the holidays. So they picked that up in the fourth quarter. And then – from China we have been spending in China. It has been a few head counts as far as expenses go, but as we look forward now we will be looking at getting an office space set up and those types of things. We are not talking large dollars, but it adds to the overall increase quarter over quarter.

Jonathan Block – SunTrust Banks Inc.

Okay. Fair enough. Thanks, guys.

Operator

Thank you. Our next question is coming from the line of Mr. Drew Jones with Stephens Inc. Your line is now open. You may proceed with your question.

Drew Jones – Stephens Inc.

Thanks guys, just a couple quick ones. First, just kind of shifting gears a little bit. As we look at the teen product, what percentage of the mix do GPs make up? And is that growing?

Ken Arola

Drew, GPs make up a very small percentage of that overall mix of teens product. Product has been targeted toward orthos and even since we’ve introduced the product it has been relatively flat on a quarter-over-quarter basis. The growth you see in the teen product is coming from the ortho space.

Drew Jones – Stephens Inc.

Okay. Okay. And then last one, obviously you guys have been pretty active on the promotional front. As we look at that awareness and marketing span and I don't think you guys will specifically break this out, but can you give us an idea how that is trending this year and your expectations going into 2011?

Ken Arola

Yeah. Now, this year I would say the way to think about the trending of spending is that we have been relatively consistent over the first three quarter of the year. Quarter four, we go down a little bit in our advertising spend. This year there has been a shift in advertising with the teen product. More specifically in the summer we came out with a new ad related to teens, specifically addressing moms and teenagers. We have shift in spending from adults towards teens.

And then things that Tom mentioned on the call like the Teen Choice Awards and some of the things we have done around that and various event kind of marketing activities has shifted some of that. But the overall spend has been – it typically falls off in quarter four and relatively consistent over the first three quarters of the year. And we’ll share more next – next year we start getting into Q1 guidance. But, we are going through our plan right now and we will be looking at how we want to look at our advertising spend next year. But we have been spending on a mixed basis, more toward digital and social media advertising as well as TV.

Drew Jones – Stephens Inc.

Right. And I guess on an absolute dollar basis versus 2009, it is up?

Ken Arola

We will probably be spending a little bit more next year in advertising, yeah.

Drew Jones – Stephens Inc.

Okay. Thanks, guys. Thank you.

Operator

Our next question comes from the line of Mr. Robert Gold with Brigantine Advisors. Your line is now open. You may proceed with your question.

Robert Gold – Brigantine Advisors

Thank you. Hi, guys. Just a quick question getting back to the demand factors at play here. And I'm just trying to get a sense of are you really getting – are you seeing some of these patients just simply not being treated or do you get a sense they are may be converting to wire and brackets and I guess my concern there is going forward. Are these patients that are potential Invisalign patients now, no longer in the Invisalign pipeline, I guess so to speak?

Tom Prescott

Well, again, since – well, first of all the summary – if I go back three or four years, summertime is when we got crushed in the ortho channel. We continue to do well in the ortho channel and continue because the biggest chunk of starts for pediatric and teen cases occurs in the summer months when kids are not in school and mom and dad can get them there for their long series of appointments. So again, whatever the market gives us, we are willing to take share and we believe we again managed a gross share nicely this year. We believe it will continue to be up above the ortho manufacturers. They mostly reflect pure orthodontic business.

Our issue is on the GP side, fairly and so in the summer typically GP volumes go down anyways. A lot of the customers that GPs treat are adults and adults are not top of mind thinking of treatment in the middle of summer. GPs offices are closed more. Dental visits go down in general. Normally, it comes back after Labor Day. It didn't this year. A, we don't certainly on the clear liner side, if anything we gained share, even in a tougher market environment. B, certainly that was the case in ortho. We believe we took share from all the traditional brackets and wire manufacturers and we believe growth rates will bear that out if you look at the ortho numbers. Most of the orthodontic manufacturers to the extent they report news are only talking about ortho starts and we grew very nicely and our teen starts grew very nicely in Q3.

And then the last point would be on the GP side, there are very few GPs that do fixed appliances, so. When a patient doesn't start it is probably because the GP and the office isn't really geared up to work on selling it, so our view is and when we go calibrate with consumer demand and available patient populations, there are still tens of millions of patients out there who said they wanted a better smile and are still poking around about how to find the right doctor to do that. So patients are there. We have not lost share. And this is really a sideways drift in the North American GP channel for us that we are setting on fixing.

Robert Gold – Brigantine Advisors

Okay. Got it. Thank you. Just one housekeeping thing, the tax rate for Q3 was pretty well below what I was anticipating. Is there something behind that, the OUS shift or is there something there.

Tom Prescott

No, it is right in the range of what we communicated last quarter on our guidance.

Robert Gold – Brigantine Advisors

So 28% would be something in Q4 and then going forward?

Tom Prescott

Yeah, In fact I commented on the call that it was going to be 28%approximately for the quarter.

Robert Gold – Brigantine Advisors

Okay. I’m sorry. Sorry, I just missed that. And then just finally on the G3 product, can you just talk about how, what the impact is on the margins? I know you said there was a little depression there from G3.

Tom Prescott

Sure. So with G3 one of the things we are allowing doctors to do is slow down tooth movements. And with that it will do, is add a few extra Aligners per case. What we are going to be doing is offering up what are calling it passive Aligners. So for example if you have an upper that is using 20 stages of Aligners and a lower arch with 18 stages of Aligners. We are going to add passive Aligners to the lower arch so they have 20 stages for each arch, but two on the lower arch, this will not have any movement with them. They will just hold the teeth in place. But it gives doctors better predict ability on outcomes.

If I pile on for a second, that's actually an investment by us. And as we have tested it, we believe that overtime will lead to lower refinement rates, lower midcourse correction rates and ultimately higher net margins. It is slowing down slightly very marginally. Some cases with difficult movements, but ultimately lowering total cost of the treatment and increasing quality and predict ability. That's one of the bets embedded in G3.

Robert Gold – Brigantine Advisors

And better economics at the physician level, ultimately.

Tom Prescott

Absolutely. And less hassle factor for sure.

Robert Gold – Brigantine Advisors

Okay. Great. Thank you.

Tom Prescott

Thank you.

Shirley Stacy

Thank you. And thank you everybody for joining us. This concludes our conference call for today. We look forward to seeing you at our upcoming analyst meeting next week in New York on October 28th and other upcoming conferences such as the Credit Suisse Healthcare Conference on November 10th or the Lazard conference on November 16th and 17th. Thanks and have a great day.

Operator

Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you very much for your participation.

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