Align Technology: Oversold

Summary

• Fears of competition in the clear aligner market are overblown, specifically in the teen and international segments.
• Current valuation implies 0% revenue growth over the next 5 years.
• Using a P/Sales and DCF valuation, I arrived at a $220 price target representing 20% upside.

Align Technology (ALGN) has declined 30%+ since releasing their Q2 earnings report, mainly due to fears of intensifying competition and slowing international growth. This article will outline why this is a overreaction and how the growth story is still alive.

Still Fundamentally Solid

• Management insisted that their 20-30% long-term revenue growth target is still intact. 
• Hogan stated that the short-term and medium-term ASPs should remain flat on a currency adjusted basis 
• Management stated that they saw improving orthodontist case shipments in China and North America during July. Hogan stated that China revenue growth should resume back to the 30-40% range in Q3
• Joe Hogan purchased $1MM worth in shares, backing his statements

Competition

• Align has distanced itself from the competition through innovative products such as MAF, Invisalign First, and Invisalign SmileView. In addition, Align uses superior materials (ie. SmartTrack) and has the manufacturing/supply chain expertise to maintain their leadership position. 
• Invisalign has already established its brand image among orthos, doctors, and customers. 
• International revenues should be stickier due to Align's globalized supply chain and sales experience internationally. While, competitors are mainly focusing in the North American market
• My model assumes ASPs to continue to decline Internationally and in North America, as DTC players such as Smile Direct gain presence, offering lower cost solutions
• Invisalign revenues can be broken down into non-comprehensive products(<15 cases) and comprehensive products (>15 cases). Align broke down their revenues into these categories in 2016, as seen below. Align no longer reports this segmented data, but we can clearly see that comprehensive products dominate their portfolio.

Comprehensive Market (High Complexity)

• Essentially all teen case volume falls into this segment, since their cases are the most complex
• Large scale competitors (Dentsply Sirona and 3M) are not targeting the teen market, which is a key segment for Align where revenues have been growing in the 30-40% range. Align should continue to have the upper-hand in the teen market due to the higher complexity of the cases, while competitors are focusing on the non-comprehsive (express adult) market.
• According to a survey conducted by Stifel in late 2018, Align held 94% market share of the 16-30 aligner cases and 96% of the highly complex cases with 30+ aligners. This further proves Align's massive head-start over its competitors for the more complex products.
• In another survey, Stifel asked doctors/orthos to evaluate competitor product offering compared to Invisalign. The findings are seen below, where the bulk of the data lies in the 3-4 range (3.38 average), showing that Align's product set is superior in the comprehensive market, where Align thrives. Dentsply Sirona's SureSmile achieved the highest rankings at 3.47, yet still not even close to being equivalent to Invisalign. 

Non-Comprehensive Market (Low Complexity)

• Competitors have made inroads almost exclusively in the non-comprehensive market, specifically customers in the young adult segment (20-29 years old). These cases are the most vulnerable for Align, since Align's core competency is with the more complex cases. However, this segment is not crucial for Align since it represents only 15% of Align's adult revenue. 
• The young adult market should keep growing due to the very low clear-aligner market share (<10%), so Align's non-comprehsive revenues growth will continue to provide some growth
• Align plans to ramp their non-comprehsive DTC presence this year, with their new storefront initiative. This model was proven by Smile Direct Club, giving me increased confidence with its potential. Align offers their specialized product, Invisalign Go for these mild/moderate cases.
• ASP compression will mainly take place in this segment due to the increased competition and stronger presence by DTC players like SDC. As Align attempts to foster growth with a DTC approach, we can also see further ASP compression as these mild cases have a much lower ASP than the complex cases.
• Referring back to the Stifel survey, Align had an 83% market share in 2018 for non-comprehsive cases. I expect this to be even lower now, most likely in the 60-70% range.
• Stifel conducted the same survey comparing competitor products with Invisalign for the non-comprehsive cases, and again Invisalign came out on top. Competitors had an average score of 3.14. Surprisingly, the average is actually lower than the comprehensive score, but nevertheless supports the ideal that Invisalign is the top product in both segments. Again, Dentsply Sirona was the top performer at 3.39, showing that their product has been making the most advancements.

China

• China is a key market where Align has been generating growth due to the more image focused society. Align grew China case volume at a 102% CAGR over the last 4 years. 
• Competitors have yet to target this market, since there are more barriers to entry such as regulation around clinically pursuing teenagers. This area is not being attacked by competition, but general macro changes have impacted recent growth in Q2
• Management assured that the 30-40% growth rate in China will be sustained in Q3, where the headwinds in Q2 were due to backlash on American goods and consumer spending cutbacks, not competition.
• Align recently opened a training facility in Shanghai, and trained 1100 doctors in Q2 in APAC (40% were in China).
• Align is opening a manufacturing facility in Ziyang, China and plans to transfer case production to Ziyang from their Mexico facility. This should cut costs moderately, supporting possible gross margin expansion. 

Clear Aligner Market is Still Massively Under-penetrated 

• The non-comprehensive market is trending towards DTC, where SDC leads the market. 3D printing in ortho practices can be another catalyst for clear aligner penetration.
• TAM for the ortho market is 12mm cases out of the 15mm total malocclusion cases, showing that clear aligners can take ~80% of the malocclusion market. The TAM has potential to increase since 300mm people with malocclusion are untreated, and DTC products provide easier access for potential customers.
• Only 14mm cases are started annually, where 10% of which are being treated using clear aligners (15% in the US). 
• Teens represent a whopping 75% of the TAM. The teen market is slightly less penetrated at 9-10%, where Align's revenues should be the most sticky.
• The TAM is still massive, and regardless if Align loses market share in the short-term, they will almost certainly be the dominant player as the industry shifts towards clear aligners.

Other Thoughts

• iTero revenue growth is still growing rapidly (82% in Q2) and offers a recurring revenue base.
• iTero diversifies Align's product portfolio away from Invisalign, supporting top line growth if clear aligner competition threats get worse than expected.
• SDC S1 shows gross margins at 68% compared to Align's 74% in 2018, indicating that Align's business model is likely more profitable. SDC has still not generated a operating profit yet reaching large scale, raising questions about the profitability of the DTC strategy.

Risks

• More-than-expected pressure on ASPs due to competition
• Low visibility in international markets
• Slowing international economic growth

Valuation

• The comps set is weak since there are no pure-play clear aligner producers in the public markets yet (SDC incoming), so I will resort to DCF and historical multiples valuation.
• As seen by the table below, ALGN is trading at a discount to all of its 10 year historical valuation averages. We even see a slight discount for PEG ratio, implying that Align's current valuation remains fair/slightly cheap despite their "slowing growth". 

Metric	Current	Historical Avg (10 yr)	Discount
P/Sales LTM	6.74	7.34	-8%
P/Sales NTM	5.41	5.78	-6%
EV/EBITDA LTM	24.74	26.66	-7%
EV/EBITDA NTM	19.47	21.23	-8%
Trailing P/E	35.49	60.64	-41%
Forward P/E	30.56	33.62	-9%
PEG NTM	1.42	1.47	-3%

• Applying the average historical NTM P/Sales multiple to my projected 2020 sales, we obtain a share price of $212 (16% upside)
• The base case of my DCF model assumes North American case volume to grow at 18-20% and international case volume to grow at 25-30%, for the next 5 years. ASPs are projected to decline at a -2% CAGR in North America and -1% CAGR internationally over the next 5 years. This results in Invisalign revenues growing 15-22%. iTero revenues are projected to grow at a 40% rate annually.
• This leaves EBITDA margin in the high 20s or around 30% after adjusted for stock based compensation

• My DCF model uses a 12% WACC and 2% terminal growth rate, however I do not believe the clear aligner market will be exhausted in 5 years (a 10 year DCF may be appropriate). This valuation method obtains a share price of $235 under the base case (28% upside).
• If we plug in the current share price of $180 into my model and solve for the revenue growth rate, we get close to a 0% annual revenue growth rate for the next 5 years (keeping my assumptions about ASPs constant). This means the market is currently pricing in no top line growth for Align over the next 5 years, which certainly will not be the case.

Key Takeaways

• Competition fears are overblown, especially in the more complex cases, such as the teen segment
• Management insists revenue growth is not slowing
• Current share price implies no top line growth for the next 5 years
• Taking the average of the historical NTM P/Sales valuation and DCF valuation, I obtain a price target of approximately $220 representing a 20% upside. 
• The next few earnings reports should fully confirm if competition is making successful strides.