CFA Institute Research ChallengePacific CFA Challenge – San Francisco       Santa Clara University                        ...
ALIGN TECHNOLOGY, INC. (ALGN-NASDAQ)Sector: Healthcare Industry: Medical Equipment and SuppliesCurrent price as of 2/1/13:...
COMPETITIVE POSITIONINGEarly Mover AdvantageWith 85% market share by cases in malocclusion treatment, Align enjoys distinc...
competitors in the braces and aligners space include 3M(incognito), Dentsply (mtm), Danaher (simpli5insignia), and Clear C...
Change of ManagementThere have been several organizational changes within the last few months including the heads of R&Dan...
Invisalign Teen: There is lot of growth potential in the Teen market, but recent results have indicated notso optimistic Y...
Discount Rate of Cash Flows (13-17)                                                     14% Discount Rate of Terminal Valu...
Valuation Summary:       We expect ALGN to report Revenue of $753M in FY2014.       Similarly, we expect ALGN to report ...
These products are in the growth phase of the Product Life Cycle with high potential for expansion in theadolescent market...
Increased competition could pressure ASPs and hurt marginsAlign has been operating in a niche space for a very long time. ...
APPENDIX ADENTAL PEER GROUP - COMPARATIVE VALUATION using EV/EBITDA                                                       ...
DISCLOSURES:Ownership and material conflicts of interest:The author(s), or a member of their household, of this report do ...
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Algn report santa clara university (1)

  1. 1. CFA Institute Research ChallengePacific CFA Challenge – San Francisco Santa Clara University TEAM MEMBERS Amarnath Pallampati ( Giordani Rivas ( Jaden Zhao ( Monalisa Chati ( Spencer Hsu (
  2. 2. ALIGN TECHNOLOGY, INC. (ALGN-NASDAQ)Sector: Healthcare Industry: Medical Equipment and SuppliesCurrent price as of 2/1/13: $31.90Estimated value currently well below current market price.Price Target: We are initiating coverage of Align Technologies with a SELL rating and a $23.70December 2013 price target.Considering ALGN relative to growth names in the market, the stock already presents an EV/EBITDApremium valuation to the sub-sector at 17x and 21.3x 2012E/2013E (vs. the group at 10x and 9.8x).(Reference: Appendix A) Recent macroeconomic headwinds across North America, Europe and Chinaaren’t likely to help valuations.The Leavey School of Business MBAs do not seek to do business with companies covered in its research report.Investors should not consider this report only as a single factor in making their investment decision.BUSINESS DESCRIPTIONAlign Technology, Inc. is a global company that develops technology-rich orthodontic products fortreatment of simple to complex malocclusion. Since the company’s inception in March 1997, Align hastraveled the path of true innovation and change. By introducing the Invisalign® system, a first-of-its-kindproduct and a game-changing approach to treatment, Align created the market we now call invisibleorthodontics or clear aligners. Invisalign® has evolved its niche products into an increasingly mainstreamtreatment option, using disruptive technology over the years. In 2011, Align acquired privately-heldCadent Holdings Inc, a leading provider of 3D digital scanning solutions for orthodontics in the hopes ofmore fully integrating Invisalign® with mainstream tools and procedures in doctors practices.MARKET SIZE & INDUSTRY OVERVIEWMalocclusion of teeth is known to be one of the worlds most prevalent clinical conditions. There are atotal of 10 million1 individuals that start orthodontic treatment each year worldwide, with about 26% casestarts having a mild to moderate malocclusion and are applicable for Invisalign® treatment. This impliesthat there are 2.6 million eligible case starts a year for Align. 2Align had about 363,000 case starts in the past year, which is about 14% of the worldwide addressableorthodontist market1. Based on the 2011 Annual Report by Align, its adult penetration is 24%, while teenis 4%. There is significant room for growth because teens represent 75% of all case starts for orthodontictreatment. By geographies, North America(NA) has 20% market share while International has 6% marketshare1.There is also significant room for growth here because international cases represent just over 50%of Aligns TAM.1 10K 2011 ALGN SEC Filing 2
  3. 3. COMPETITIVE POSITIONINGEarly Mover AdvantageWith 85% market share by cases in malocclusion treatment, Align enjoys distinct advantages such asbrand recognition, product innovation, automation in production and patent protection. Clear Aligners aremedical grade custom designed plastics unique to each patient. It provides benefits such as excellentaesthetics, comfort, improved oral hygiene, reduced incidence of emergencies, and are easy to maintain.But, due to its limited movement, clear aligner treatments typically require a number of alignment units asteeth structure changes. Some of the notable product advancements by Align are3:Year Product Name Brief Description2005-NA Invisalign® Express(NA) Lower-priced solution for minor crowding/ spacing cases2008-EU Invisalign® Lite(EU) Post-treatment retention product for Invisalign® and non-Invisalign®2007 ViveraTM Retainers patients Features designed to treat teenage patients. Compliance indicators help2008 Invisalign® Teen parents and practitioners gauge aligners wear. Invisalign®ClinAssist or Designed as an instructive product for newly trained, less-experienced2009 Assist Invisalign® doctors SmartForce features provide root and rotation force systems to achieve2009 Invisalign® 1.5 predictable tooth movements. Precision Cuts designed for use with elastics for anchorage control to help2010 Invisalign® G3 treat Class II and Class III patients. Next generation of SmartForce for greater root tip control, improved2011 Invisalign® G4 predictability, and better clinical outcomes.PatentsBased on the presentation and conversations with Aligns team, we are encouraged with the portfolio of490 patents issued worldwide so far. Align continues to spend a significant percent of revenue on R&Dand new patents to protect future products. However, it will be interesting to find challenges incurred withsome of their patents expiring in 2017. Align also proactively defends its patented technology andproducts to sustain its leadership. An example is the case won against OrthoClear in 2006.Scope for Clear Aligner MarketThe clear aligner segment is currently at about 15%4 share of the TAM evidencing a significantopportunity to grow in the clear aligner space, but its adoption relies heavily on dentist acceptance.Conventionally, dentists are slow to accept changes to traditional treatments, but with continuousinnovation in the clear aligner product line, a paradigm shift can pave the path for increased adoption ofthis proven solution.Key competitors &Alternate options for malocclusionThere are several traditional or alternate solutions that consumers can choose from for malocclusiontreatment such as Metal Braces, Ceramic Braces, Lingual Braces, and Smart Brackets. Some of the3 10K 2011 ALGN SEC Filing4 3
  4. 4. competitors in the braces and aligners space include 3M(incognito), Dentsply (mtm), Danaher (simpli5insignia), and Clear Correct (clear correct). With the increasing list of competitors in the clear alignerspace and improving alternative treatment, Align should also focus on growing or maintaining currentmarket share. As a result, Align must continue innovating Invisalign® products and technology whileexpanding in emerging markets to remain successful.INVESTMENT SUMMARYPortfolio Manager Summary: Short term concerns overshadow promising long term growth storyWe model a 16% case CAGR from 2013 to 2015. While the fiscal cliff was averted, middle classAmericans are burdened by a 200bp higher tax for the first $113,000 earned by households. In addition,there are several macro uncertainties as GDP growth slows around the world and Europe continues to facemacro pressures. With the recent decline in consumer confidence, it has posed a challenge in short-termrevenue growth of Align. Nevertheless, there are still signs of optimism as nonfarm payroll continues toincrease. Thus, we forecast a moderate improvement in North America, 1% market growth in Europe, anda substantial growth ahead in the Emerging markets, especially in China.We recommend a SELL due to weakened consumer confidence level. Taking a look at the chart below,Align’s revenue has a modest correlation of 0.66 when compared to the consumer confidence rate for thepast 3 years5. In the latest report of consumer confidence on January 29, consumer confidence rate hasdropped for the second month in a row indicating concerns over the near-term. With macro uncertaintiesand a rise in taxes, consumers will be hesitant to make optional dental procedures. 160 80 140 70 120 60 Align Revenue in Millions 100 50 Consumer Index 80 40 60 30 Align Revenue(Millions) 40 20 Consumer Index 20 10 0 0 Align Revenue and Consumer Index CorrelationAverage Selling Price PressureAlign is seeing increased competition in Invisalign® Express and Teen market segments with averageselling price(ASP) drop by 9% from the previous year. We predict moderate pricing pressures in ASP asmore competitors enter the market and take away market share.5 4
  5. 5. Change of ManagementThere have been several organizational changes within the last few months including the heads of R&Dand North American Invisalign® Sales departing. According to the 8-K on Oct 17th, 2012, Dana Cambria,Vice President of Research and Development department, left the Company. Interim, Align’s Presidentand CEO Thomas M. Prescott will oversee R&D and Information Technology. In addition, CFO KennethB. Arola has stepped down after 6 years in the company. He has been replaced with the previous VP ofcorporate and legal affairs and general counselor for the time being. We agree and re-affirm that Align isknown for its technology, creative idea and vision towards future dental industry. Though we cannotquantify the impact of recent departures of C-level executives at Align, it could very well pose achallenge to strategic growth plans of the company.Strategy Adjustment for International market of Scanner and CAD/CAM ServicesOn October 17th, 2012, Align terminated the agreement with Straumann Group, the company’s exclusivedistributor of Scanner segment in Europe. At the same time, Align also had execution issues with Scannerand CAD/CAM services in Europe region leading to near-term growth concerns in this market space. Inthe future, Align plans to promote international scanner sales in a more opportunity based strategy.VALUATIONBased on reasonable and conservative estimates for Align’s Intrinsic Valuation, the share price is $23.17.Further, Comparables Valuation indicated the share price is $25.42.Our Final Valuation involves 75%weightage to Intrinsic Valuation and 25% to Comparables Valuation, resulting in Align’s stock pricevaluation of $23.7. This is 26% below the current market price of $31.90 (as on 02/01/2013). Our modeluses following assumptions as stated:Basic Model Assumptions  Risk Free Rate: closer to 30-year US govt. Treasury yield of 3%  Equity Risk Premium: 5.5% as per Duff & Phelps  Tax Rate: 27% (lower than statutory 35%due to efficient tax structure of the company)  Working Capital Growth rate: 3%  Terminal Growth Rate: 4%, as a result of ALGN’s presence in international regions where growth is typically higher.  WACC: 14.5%; Discount rate (WACC) considers only cost of equity (using CAPM) since company debt is almost negligible and equity beta of 2.09Revenue BuildInvisalign® Full: We expect a slight drop YoY in number of cases sold in 2013 due to managementchanges, and near term macroeconomic uncertainties. Near-term slowdown is also due to higher tax ratesin the US. But things can improve as management stabilizes and near term macro environment gets better.Invisalign Express/Lite: We expect the growth pattern to continue, but at a slower pace, due to increasedcompetition at the lower end. This will expand the total available market, but will affect the ASP. 5
  6. 6. Invisalign Teen: There is lot of growth potential in the Teen market, but recent results have indicated notso optimistic YoY growth. Based on the recent performance, we expect to see stable growth in the near tolong term of 27% YoY although there is huge potential in this market space.Invisalign Assist: Due to the product’s uniqueness in the market, the ASP should not take a hit and saleswill continue to grow steadily as new doctors use this product to start out with. We see a growth ininternational sales initiated] by Assist due to its easier learning curve.Scanner and CAD/CAM services: For the international market, we expect a drop in YoY revenue growthdue to Align’s strategy adjustment towards Europe market. For the NA market, we expect slight growthYoY in revenue due to more focus moved from international market. However, we do not expect the totalrevenue of scanner and CAD/CAM to be greater than 10% of the total revenue, as scanner andCAD/CAM is just a segment which helps integrate Invisalign® with mainstream tools and procedures indoctors practices.Opex BuildSales and Marketing: Assuming 30% fixed percentage of salesGeneral and Administrative: Gradual decrease from 17% in 2012 to 12% in 2017 as the companyachieves efficiency in terms of scaleR&D: Assuming 8% fixed percentage of salesEBITDA Margin: Steady growth of ~1% each yearDISCOUNTED CASH FLOW METHOD using Free Cash Flow  Midpoint Terminal growth rate of 4% (Valuation done using 3%, 4% & 5%) (USD Mil) 2009 2010 2011 2012 2013 2014 2015 2016 2017 Revenue $313.5 $387.9 $480.1 $560.0 $650.5 $753.3 $869.0 $1,010.6 $1,173.8 % YoY 24% 24% 17% 16% 16% 15% 16% 16% EBITDA 66.1 129.5 129.6 129.3 176.2 211.6 252.8 304.1 364.9 % Margin 21% 33% 27% 23% 27% 28% 29% 30% 31% Operating Income 38.0 99.3 92.9 89.0 133.2 161.8 195.4 237.3 287.4 Add: Amortization PF Operating Income 133.2 161.8 195.4 237.3 287.4 Less: Cash Taxes (36.0) (43.7) (52.7) (64.1) (77.6) Unlevered Net Income 97.3 118.1 142.6 173.2 209.8 Add: Depreciation 13.0 14.2 17.5 17.8 17.0 19.6 22.6 26.3 30.6 Add: SBC 15.1 16.1 19.2 22.4 26.0 30.1 34.8 40.4 47.0 Less: Capital Expenditures 7.0 18.0 30.0 41.0 (39.0) (45.2) (52.1) (60.6) (70.4) Less: Change in Net Working Capital (2.7) (3.1) (3.5) (4.2) (4.9) Unlevered Free Cash Flow 98.5 119.6 144.4 175.1 212.0 % Growth 21% 21% 21% 21% 6
  7. 7. Discount Rate of Cash Flows (13-17) 14% Discount Rate of Terminal Value 14% Perpetuity Growth of FCFF 3% 4% 5% PV of Cash Flows $483 $483 $483 % of Enterprise Value 33% 31% 29% PV of Terminal Value $966 $1,068 $1,192 % of Enterprise Value 67% 69% 71% Enterprise Value $1,449 $1,551 $1,675 Plus: Net Cash / (Debt) $335 $335 $335 Equity Value $1,784 $1,886 $2,010 Price Per Share $21.92 $23.17 $24.69 No. of Shares outstanding (M) 81.38Sensitivity Analysis  WACC & Terminal Growth Rate Terminal Value WACC $23.17 15.0% 14.5% 14.0% 13.0% 12.0% 11.0% 2% $20.13 $20.85 $21.63 $23.41 $25.55 $28.18 TVG 3% $21.09 $21.91 $22.80 $24.87 $27.39 $30.57 4% $22.22 $23.16 $24.20 $26.64 $29.69 $33.63 5% $23.57 $24.68 $25.92 $28.86 $32.65 $37.72 Equity Value Per Share  EBITDA Margin & Revenue CAGR Rate Long term EBITDA Margin 25% 28% 31% 31.1% 33% 34% 10% $15.57 $17.46 $19.34 $19.34 $20.60 $21.23 12% $16.46 $18.50 $20.54 $20.54 $21.90 $22.584 year 14% $17.41 $19.61 $21.82 $21.82 $23.28 $24.02Revenue 16% $18.43 $20.80 $23.17 $23.17 $24.76 $25.55CAGR 18% $19.51 $22.06 $24.62 $24.62 $26.33 $27.1813-17 20% $20.65 $23.41 $26.16 $26.16 $27.99 $28.91 22% $21.87 $24.83 $27.79 $27.79 $29.77 $30.76 24% $23.17 $26.35 $29.53 $29.53 $31.65 $32.71 26% $24.54 $27.95 $31.37 $31.37 $33.65 $34.79 Equity Value Per Share 7
  8. 8. Valuation Summary:  We expect ALGN to report Revenue of $753M in FY2014.  Similarly, we expect ALGN to report an EBITDA of $212M in FY2014.FINANCIAL ANALYSISFY 2012:2012 EPS of $0.80 (representing 4% bottom-line decline) is driven by 17% top-line growth offset by 22%operating expense increase fueled by the Cadent acquisition impairment. By segment, our revenuebreakdown stems from Invisalign® Teen +23%, partly offset by slower growth in Invisalign®Express/Lite +21%, Invisalign® Full +12%, and Invisalign® Assist +5%.We expect gross margins to decline 1 bp to 74.3%, as the company continues with the Cadent integrationand the search for a distributor and distribution model in Europe and North America. However, we expect2bps decline to the expense leverage ratio, due to impairment of goodwill associated with the acquisition.Operating margins are expected to increase 18bps to 16%.Invisalign® case submissions continue to slow down (+17% compared to +19% in 2011). This is partlydue to lower North American case revenue, which has declined 8 percentage points since 2007and not sosuccessful efforts to expand international sales in Europe, Latin America and Asia. Comparing therevenue mix of North America (NA) vs. International, we find that the share of revenue from NorthAmerica has increased by only 6% and International share of revenues increased by only 8%, which isclearly less than the previous YoY growth rates of 29% and 28% respectively. 2010 2011 2012 Revenue in YoY Revenue in YoY Revenue in YoY Millions Growth Millions Growth Millions GrowthNA Invisalign® Case 262.5 18% 339.3 29% 361 6%RevenueInternational Invisalign® 90.1 25% 115.6 28% 124.7 8%Case RevenueRecent results of Align’s performance indicate a lower YoY growth rate in the Invisalign product mix(24% in 2011 vs. 17% in 2012) arising growth questions. After the introduction of Invisalign® Teen inthe year 2008, YoY growth rate of revenue has steadily decreased to about 23% YOY in 2012. On asimilar note, Invisalign® Assist, introduced in the year 2009, performed well initially but has succumbedto a YoY growth rate of only 5%. 2009 2010 2011 2012 YoY Revenue YoY Revenue YoY Revenue YoY Revenue Growth Growth Growth Growth Invisalign® Teen 318% 249% 42% 23% Invisalign® Assist 817% 167% 86% 5% 8
  9. 9. These products are in the growth phase of the Product Life Cycle with high potential for expansion in theadolescent market but have not grown at the pace expected or observed in the recent past. An effectivestrategy to guarantee Align’s long-term growth lies the utilizing the foreseeable growth opportunity andsustainability of the Invisalign® Teen and Full aligners.In addition, Align faces a business dilemma between maintaining higher prices vs. offering attractiveprices to increase customer base, without sending the wrong signal to the markets (e.g. clients canperceive discounted products as lower quality products). In this regard, we project a lower ASP across theboard for Align to be able to face the competition from firms offering alternative products.(USD Mil) 2009 2010 2011 2012 2013 2014Revenue $313.5 $387.9 $480.1 $560.0 $650.5 $753.3 % YoY 24% 24% 17% 16% 16%EBITDA 66.1 129.5 129.6 129.3 176.2 211.6 % Margin 21% 33% 27% 23% 27% 28%PF Operating Income 38.0 99.3 92.9 89.0 133.2 161.8 Unlevered Net Income 27.7 72.5 67.8 65.0 97.3 118.1 % Growth 161% -6% -4% 50% 21%EPS 0.40 0.93 0.85 0.80 1.16 1.37 % Growth 131% -9% -5% 44% 19%Dilusted Shares 69 78 80 81 84 86FY 2013 EstimateOur 2013 EPS estimate of $1.16 (representing 50% bottom-line growth) is driven by 16% top-linegrowth. By segment, our revenue breakdown is generated by Invisalign® Teen +24% and Invisalign®Express/Lite +28%, partly offset by growth in Invisalign® Full +11%, and Invisalign® Assist +7%.We expect gross margin to be flat at 74% over mounting pressure from higher operating cost. As thecompany continues to re-evaluate its strategy to strengthen Invisalign® Teen, solidify the internationalsales and successfully complete the Cadent integration, Align may face mounting pressure from proventreats, thus making it more difficult to manage a 74% gross margin.Align may need to increase its sales and marketing from an average of 29% to at least 35% as apercentage of revenue to drive social awareness in special Teen events where aesthetics may influencetheir opinion and in events that draw big crowds. Align’s balance sheet continues to have excess capacityto finance projects even after the Cadent acquisition as working capital is financed all in cash. Betterbalance sheet management is required to expand and grow.INVESTMENT RISKSDownside Risks:Limited insurance reimbursements and macro environment factors affect demandMost insurance companies around the world offer little to no assistance when it comes to treatment. Onaverage, per Invisaligns website, insurance pays about $500 of treatment costs. With the treatmentranging from $3,500 to $8,000 in the US, this is a considerable amount for consumers to pay. Dips inconsumer confidence and nonfarm payrolls are potential headwinds. 9
  10. 10. Increased competition could pressure ASPs and hurt marginsAlign has been operating in a niche space for a very long time. Even though they currently dominate theclear aligner space, there are new competitors trying to take Align’s market share, especially at the lowerend of their products. Aggressive price competition could greatly affect Aligns ASP in turn affectingoverall profits.Success of marketing programs from quarter to quarterA large part of the consumer buying behavior relies on influential marketing campaigns. Brand awarenessis a huge factor for adoption of products by both dentists and patients. Align’s strategy to get a minimumnumber of orders placed from each dentist was an unsuccessful marketing campaign. Many dentists,especially at the smaller clinics, did not want to have to deal with a minimum requirement so theyswitched to a competing product. Eventually Align had to relax this norm to ensure Brand loyalty.Product changesOver the past few years, Align has released a new Invisalign® product on a regular basis, leading to anincrease in the number of cases sold each year. However, there are no clear differentiating productinnovations lined up in the near future, except for a change in clear aligner material, which poses achallenge for Align’s growth. Also there is no guarantee that future versions of Invisalign® products willbe accepted by consumers and will satisfy the needs of the dentists. It is also important to continue toeffectively scale manufacturing when it comes to new products and to properly market these products asthey come.Costs and expenditures due to litigationAlign has an extensive patent library and it is imperative for them to financially defend proprietarytechnology internationally. If they are unable to enforce intellectual property rights successfully, theirmarket share and profits will take significant hit due to substantial increase in competition.Management changesSeveral top-level executives have left the company in the last year, including the CFO and VP of Finance.There is a possibility that additional leaders of the company will soon follow, leading to potentialchallenges in managing and growing Align’s business. This can also impact their brand value and strategyto develop new products, leading to potential loss to shareholders and the bottom line.There are other investment risks such as unanticipated delays in production caused by insufficientcapacity, foreign operational and political risks and changing government regulation of the healthcareindustry.Upside Potential:Accelerated adoption in the Teen segmentWord of mouth is the best form of marketing, especially in the Teen segment. As this segment is veryunderpenetrated, proper brand awareness of Invisalign® can create a preference over competing products,offering a huge potential for a large revenue stream.Potential for huge growth in emerging marketsThe middle class of emerging markets continues to expand at a very quick rate. As disposable incomeincreases in those markets, there would be a large pool of potential case starts for malocclusiontreatments. This is a very large untapped stream of future revenue, if partnerships are establishedeffectively in these regions. 10
  11. 11. APPENDIX ADENTAL PEER GROUP - COMPARATIVE VALUATION using EV/EBITDA EV/EBITDACompany Ticker CY12E CY13E CY14EDentsply International Inc XRAY 11.9 10.8 9.6Nobel Biocare Holding AG NOBN-CH 7.7 8.7 7.6Sirona Dental Systems Inc. SIRO 11.3 9.7 8Straumann Holding AG STMN-CH 12.5 10.6 8.8Patterson Cos. Inc. PDCO 10.2 9.4 8.8Group Average 10.7 9.8 8.6Implied Valuation ($M except per share)EBITDA 129.3 176.2 211.6Multiple 10.7 9.8 8.6Align Tech EV/Share $17.0 $21.3 $22.3Align Tech Cash/Share $4.11 $4.11 $4.11Align Tech Equity Value/Share $21.1 $25.4 $26.4 11
  12. 12. DISCLOSURES:Ownership and material conflicts of interest:The author(s), or a member of their household, of this report do not hold a financial interest in thesecurities of this company.The author(s), or a member of their household, of this report do not know of the existence of anyconflicts of interest that might bias the content or publication of this report.Receipt of compensation:Compensation of the author(s) of this report is not based on investment banking revenue.Position as a officer or director:The author(s), or a member of their household, does not serve as an officer, director or advisory boardmember of the subject company.Market making:The author(s) does not act as a market maker in the subject company’s securities.Disclaimer:The information set forth herein has been obtained or derived from sources generally available to thepublic and believed by the author(s) to bereliable, but the author(s) does not make any representationor warranty, express or implied, as to its accuracy or completeness. The information is not intended tobe used as the basis of any investment decisions by any person or entity. This information does notconstitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security.This report should not be considered to be a recommendation by any individual affiliated with CFAInstitute of San Francisco, CFA Institute or the CFA Institute Research Challenge with regard to thiscompany’s stock. 12