Align Technology, Inc. (ALGN) Q2 2016 Earnings Report, Transcript and Summary

Greetings, and welcome to Align Technology Inc. Q2 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder this conference is being recorded. I would now like to turn the conference over to your host, Shirley Stacy, VP Corporate & Investor Communications. Please go ahead.

Good afternoon and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications & Investor Relations. Joining me for today's call is Joe Hogan, President & CEO; and David White, CFO. We issued second quarter 2016 financial results today via Marketwired, which is available on our Web site at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our Web site for approximately 12 months. A telephone replay will be available today by approximately 5:30 PM Eastern Time through 5:30 PM Eastern Time on August 11th. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13640324 followed by #. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information that the presenters discuss today will include forward-looking statements, including statements about Align's future events, product outlook and the expected financial results for the third quarter of 2016. These forward-looking statements are only predictions and involve risks and uncertainties that are set forth in more detail in our recent periodic reports filed with the Securities and Exchange Commission. Actual results may vary significantly and Align expresses no obligation to update any forward-looking statements. We have posted a set of GAAP and non-GAAP historical financial statements, including the corresponding reconciliations and our second quarter conference call slides on our webcast under Quarterly Results. Please refer to these files for more detailed information. With that, I'll turn the call over to Align Technology's President & CEO, Joe Hogan. Joe?

Thanks, Shirley. Good afternoon and thanks for joining us. On our call today, I'll provide some financial highlights and then briefly discuss the performance of our two operating segments, Invisalign Clear Aligners and Scanners. David will provide more detail on our financials and discuss our outlook for the third quarter. Following that, I'll come back and summarize a few key points and open up the call to questions. Q2 was driven by a better than expected revenue due to continued strong year-over-year Invisalign volume across our customer base and record utilization. With International case volume up 38.3% and North America up 15.3%. We also had a continued strong demand for our iTero Element with record shipments this quarter, resulting in revenue growth of almost 200% year-over-year. For Q2 North America Clear Aligner volume was up 4% sequentially and 15% year-on-year on a sequential basis Q2 growth was driven by both our orthodontist and GP customers. Utilization among our orthodontist customers continued to increase and we reached record levels in both ortho and GP channels for a total of 10.7 cases per doc this quarter. On a year-over-year basis our Q2 volume growth rate continues to outpace our three year average driven by an increased ortho utilization, as well as expansion of our GP customer base. Q2 Invisalign volume for International doctors is up 17% sequentially and 38% year-over-year, continued strength reflects record International utilization driven by EMEA, as well as continued expansion of our customer base in APAC. We are also seeing increased use of Invisalign G5 for deep bite in EMEA as well as in our Invisalign G6 for extraction cases in APAC, both showing momentum in the quarter and nearly equaling the overall growth rate for each respective region. In EMEA Q2 volume was up 37% year-over-year led by Spain, France and the Netherland. Smaller country markets such as the Nordics and Eastern Europe also had strong year-over-year growth, although off a smaller base. Execution of our high touch TSM program is expanding our focused approach across all our markets in Europe and starting to deliver stronger growth. Our low state’s Lite denies seven products and continue to contribute incremental growth. In Asia Pacific record shipments in Q2 resulted in 42% growth year-over-year, growth is very strong again in China, Japan, South Asia and Taiwan. Q2 was a busy quarter for customer events that is more than 700 doctors and clinical staff attending our second annual Invisalign APAC Summit in Macao. In addition we had more than 500 orthodontists attend our country focused forum in China. We continue to ramp-up doctor’s training in APAC with particular focus on developing doctors in newer markets such as India, Korea and Taiwan. In fact more than 100 doctors in Taiwan were trained in June alone. In important teen segment the total number of Invisalign cases worldwide in Q2 increased 20% year-over-year reflecting continued adoption of Invisalign treatment for teenagers 11 and 19 years. We have definitely began to see an increase teen case starts in late Q2 as more teens go into treatment during the summer timeframe in North America. Teen volume grew 19% year-over-year among our North America orthodontists. In addition we continue to make progress internationally among teenagers where we had 35% year-over-year growth. In Q2 in APAC for example we held a teen’s forum for Australia and New Zealand markets where 200 doctors attended which was twice of what we expected. We also participated in a separate teen’s forum sponsored by the SWAN University on a 12 months basis 155,000 teens started orthodontic treatment with Invisalign with an average age of 15 years old. Our investments in the teen segment continue as discussed at our Investor Day last month. We are currently developing products that will stay in Invisalign applicability over the next two or three years enabling our doctors to treat more teen patients and address younger kids for the first time. Specifically we will preview a mandibular repositioning product for teen Class II corrections as well as our prototype parallel expansion used for Phase 1 treatment. With these additional offerings and features will give our doctors a complete set of clear and removeable appliances capable of any orthodontic treatment for patients of all ages. Our integrated consumer marketing campaigns in North America, EMEA and APAC leveraged traditional paid media, search digital, marketing, TR and social media to engage consumers at every point in the consumer purchase journey. Consumer interest and demand for Invisalign treatment continues to grow. North America, a key focus area for Q2 was sharing the stories of real patients that have used Invisalign treatment to improve their smile. These patient stories have driven high consumer engagement with 136,000 video views. New program launches included a partnership with Bravo TV on a network that reaches millions of woman who could benefit from Invisalign treatment. The Bravo integration via the Invisalign treatment into the story line of the hit show Odd Mom Out. In EMEA, we focused primarily on the real patient campaigning which continues to drive interest from Invisalign treatment online with Web visits growing 112% compared to the same period last year. In Asia Pacific, new consumer campaigns kicked off in China and Australia, New Zealand and programs continued in Hong Kong and Japan to drive consumer awareness and patient demand. In Q2, we are planning a big bang consumer campaign in China, which will leverage [Paris fashion week]. In Q2, our scanners business revenues were up 36% sequentially and up nearly 200% year-over-year, reflecting a record number of units shipped in the quarter. Demand of the iTero Elements scanner continues to expand fueled by primarily by North American customers. This past March we began shipping iTero Element to restore their workflows to customers who had pre-ordered and were awaiting the new iTero Element. In EMEA we received a record number of iTero contracts. And in APAC we received strong orders upon launching iTero Element at our Invisalign APAC Summit in May. We continue to work through the backlog of iTero Element Scanners, which remain at roughly six months lead time, as demand for our industry leading Intraoral scanners continue. Use of iTero Scanners for Invisalign cased emissions in place of [TDS] impressions continue to expand. For Q2, total Invisalign cases submitted with the digital scanner worldwide increased 37.4%, which reflects a record 46.4% from North America and 20.5% from international doctors. While these scans are predominantly from our iTero Scanner, we are also seeing some uptake from 3M’s True Def and Sirona's Omnicam, the other two third parties of digital scanners that are qualified for Invisalign case submission. Before I turn the call over to David for our financial review, I want to talk to you about a supplier agreement we announced today with SmileDirectClub for their doctor directed at home Aligner program for minor tooth movement. It feels that orthodontics and dentistry has changed tremendously in a few decades since Align Technology was founded. Many of the greatest changes we have been and continue to be driven mass customized Clear Aligners, 3D treatment planning and restorations, digital photography, XRAYS, scanning, laser therapy, practice management, software, mobile devices and this can go on-and-on. Technology has changed the demands of potential patients as well. The Internet, ecommerce and social media, if consumers access the more information and more options for every type of treatment and procedure including where and when they want it and that cost much lower than traditional options. We have been watching the intersection of these technology advances and changes in consumer behavior and particularly we have tracked the different approaches to at home teeth straightening with Clear Aligners. I am talking specifically about doctor directed treatment, shipped directly to consumers. Not consumers trying to treat themselves in a do it yourself fashion. The at-home model follows an established trend of direct to consumer ship to home option for eye glasses, contact lenses, hearing aids and more. Logically this type of at-home treatment in orthodontics is only possible with Clear Aligner. And as the leader in Clear Aligner technology we believe Align has to participate in and help shape this evolving market. The emerging leader in this market is now SmileDirectClub. It’s a privately owned business based in Nashville, Tennessee, they were found in 2013 and are doing business in 49 out of 50 states so far. Potential patients can either visit a smile shop to get scanned, schedule an in-home scanning appointment or send them photos and impressions online to begin the evaluation process. SmileDirectClub offers a device first class Medi many treatments that includes up to 20 stages with no attachments and no iTR in their proximal reduction. Primarily full adults it is permanent injunctions they have a network remote licensed orthodontists and general practitioner dentist to evaluate review and approve the patient treatment and monitor progress of the case throughout treatment. In a separate release today we announced the supplier agreement with SmileDirectClub specifically Align will provide a digital case set up which is made available on SmileDirectClub smile check portal. A SmileDirectClub licensed orthodontist or a general dentist will review and approve the treatment and Align will then manufacture aligners and ship them directly to SmileDirectClub. These aligners will be manufactured per SmileDirectClub specifications which does not include attachments and iTR. To be clear this is not Invisalign, Invisalign brand and system of Clear Aligners will not be used for this kind of direct to consumer market. The Invisalign system requires in office doctor involvement throughout the course of treatment, while only be made available from an Invisalign provider. At Align we are investing nearly $100 million in R&D and marketing to further advance the science and technology for Invisalign brand. The most advanced Clear Aligners in the world. So our doctors could continue to achieve great outcomes for their patients. We will continue to path the innovation we have delivered over the last 20 years as per advance of science and technology through our Invisalign doctors with new products such as class III, teen class II morph and Phase 1 pilot expander that we indicated again recently in 20-F, that will be available in 2017. These types of Invisalign advancement will significantly increase the applicability of Invisalign Clear Aligners to our in office doctors. With the goal of our agreement with SmileDirectClub is to help expand the market and opportunity for Invisalign doctors while supporting SmileDirectClub’s protocol as described. Which means we expect there to be little cannibalization of existing markets. In addition we are creating a new Invisalign doctor referral program similar to our Invisalign doc locater that will ensure that the 30% of SmileDirectClub potential patients that do not fit these protocols and who are interested in strengthening their teeth will be channeled back to existing Invisalign and office docs. The process will work like this, beginning in October we will create a new Invisalign doctor referral program much our like doc locator works today, consumers will request the smile check case assessment from SmileDirectClub, but whose case is outside of their treatment scope will be systematically referred to an Invisalign provider in the area. We believe this will provide incremental growth opportunities for Invisalign doctors by connecting them with new potential patients that would not have sought otherwise. The at-home direct to consumer market is growing rapidly and while still very small today we believe the incremental growth potential that this huge market represents is compelling, providing consumers who had very simple mild inclusions with access to more affordable treatment from the convenience of their own home is accelerating and will only expand the overall market for orthodontic treatment. With that, I'll now turn the call over to David.

Thanks, Joe. Let's review our second quarter financial results. Revenue for the second quarter was $269.4 million, up 12.8% from the prior quarter, and up 28.6% from the corresponding quarter a year-ago. Second quarter Clear Aligner revenue of $243.4 million was up 10.8% sequentially, and up 21.2% year-over-year. The sequential revenue increase was primarily related to increased Clear Aligner volumes and to a lesser extent our price increase in North America. On a year-over-year comparative basis, the growth rate for both total revenue and Clear Aligner revenue was lower by approximately four points, related to the Additional Aligner policy change we implemented in July last year. Q2 ASPs were up sequentially from Q1, about $30, reflecting a price increase in the U.S. as well as favorable foreign exchange rates. Our year-over-year revenue growth reflected Invisalign case volume growth across all customer channels and geographies, as well as our price increase in North America and International. These increases were partially offset by lower ASPs, primarily related to the Additional Aligner policy change made last year. For the second quarter, total Invisalign shipments of 177,000 cases were up 8.1% sequentially, reflecting growth from both our international and North America customers. Year-over-year case volume growth was 22.4%, driven by growth across all regions. For North American orthodontist, Q2 Invisalign case volume was up 4.7% sequentially, reflecting higher adoption and utilization rates across the channel, and up 20% year-over-year. For North American GP dentist, case volume was up 3% sequentially and up roughly 10% year-over-year, reflecting continued solid performance from mid high volume GPs offset somewhat by our large base of oral volume GPs. For international doctors, Invisalign case volume was up 16.8% sequentially and up 38.3% year-over-year, reflecting increased adaptors and utilization. Worldwide Invisalign utilization in Q2 was 5.1 cases per doctor, up from 4.6 in Q2 last year. North America ortho utilization was a record 10.7, up from 9.5 in the prior year. North America GP utilization was 3.1, up from 3.0 in the prior year. And international utilization was 5.0 also a record, up from 4.6 cases per doctor in Q2 last year, driven primarily by increased utilization in EMEA, which was a record 5.5 cases per doctor in Q2 compared to 4.8 cases a year ago. In Q2, we added 2,885 new Invisalign doctors worldwide, 1,125 of which were new North American doctors, and 1,760 of which were new international doctors. This compares to 2,470 in Q1 and 2,455 in the same quarter last year. Our Scanner & Services revenues for the second quarter were $26 million, up 36.3% sequentially and up almost 200% year-over-year. As Joe mentioned we began shipping the iTero Element for restore the workflow in Q2 and as a result almost half of the scanners shipped were for our GP customers who have been patiently waiting for their new iTero Element. We are pleased that demand for scanners continues to be strong as we continue keeping pace with shipments. Moving on to gross margin, second quarter overall gross margin was 76.2%, slightly better-than-expected, up 0.5 points sequentially and year-over-year. Clear Aligner gross margin for the second quarter was 78.6%, up 0.3 points both sequentially and year-over-year. The sequential increase was primarily driven by higher ASPs partially offset by seasonally higher training activity. The year-over-year gross margin increase primarily reflects the benefit from leverage of our fixed cost over higher case volumes, partially offset by lower ASPs as a result of the additional Aligner policy. Q2 gross margin for our Scanner segment was a record 53.6%, up 8.6 points sequentially and 38.6 points year-over-year. Both the sequential and year-over-year increases in gross margin were primarily a result of higher ASPs and the lower manufacturing cost of our iTero Element scanner. Q2 operating expenses were $140.1 million, up sequentially by $12.8 million or 10%, primarily due to a full quarter of employee compensation related cost such as annual wage increases, stock based compensation awards and new hires as well as go to market investments. Q2 operating expenses were lower however than our outlook due primarily to slower hiring and investments in sales territory coverage, same go-to-market activities that were delayed on the second half of the year and more ERP cost being capitalized and anticipated during the quarter. On a year-over-year basis, Q2 operating expenses were up $23.8 million or 20.4% reflecting increased headcount and continued investment in our go-to-market activities incidental to the growth of our business as well as our ERP implementation project. Our second quarter operating margin was 24.2% up 1.9 points sequentially and up 4 points year-over-year. The sequential increase in operating margin relates primarily to higher Clear Aligner volumes and higher gross margins overall. On a year-over-year basis, Q2 operating margin was impacted by 2.3 points from the Additional Aligner policy change. With regards to our second quarter tax provision, our tax rate was 23.2% compared to 23.4% in Q1 2016. Second quarter diluted earnings per share was $0.62 compared to $0.50 reported in Q1 and $0.39 reported in the same quarter last year. Moving on to the balance sheet, capital expenditures for the first quarter were $18.8 million, primarily relating to equipment purchases to expand our manufacturing capacity in Juarez, Mexico, and our ERP implementation. Cash flow from operations for the second quarter was $76.2 million and free cash flow for the second quarter, defined as cash flow from operations less capital expenditures, amounted to $57.3 million. During the quarter, as a part of our $300 million April 2014 stock repurchase program, we entered into an accelerated stock repurchase agreement, to purchase $50 million of our common stock. Under which we paid $50 million and received the initial delivery of approximately 0.5 million shares based on current market prices. The final delivery of shares is scheduled for October and the number of shares will be based on our volume weighted average stock price during the term of the ASR less on agreed upon discount. Upon completion of the ASR, we will commence the repurchase of $50 million of our common stock on the open market. These two options together will complete our April 2014 stock re-purchase program. Cash, cash equivalents and marketable securities, included both short and long-term investments were $685 million, this compared to $678.7 million at the end of 2015, an increase of approximately $6.3 million. Lastly I wanted to comment on our ERP implementation, which went live the first week of July. Over the past year plus our team has worked very hard to ensure successful data migration and integration of new systems and processes. Overall our implementation went very smoothly. Given the magnitude of this process, and project we are continuing to monitor and trouble shoot potential issues but at this time believe we are past any potential for significant business disruption. We are pleased to have a foundation that enables new capabilities, improves our speed of execution and will be used to improve our customers’ experience. As part of this implementation, we also implemented a legal restructuring of our subsidiary relationships, which will return in access of $100 million of cash to the U.S. tax free in Q3. As Joe mentioned earlier, in October we will begin supplying aligners to SmileDirectClub’s aligner program for minor tooth movements. As part of this transaction Align acquired a 17% stake in SmileDirectClub for $46.7 million and gained a seat on SmileDirectClub’s Board of Directors. As a result of our equity holding in SmileDirectClub Align is required to account for this investment under the equity method of accounting. Thus Align will include a proportional share of SmileDirectClub’s earnings or losses in its financial statements beginning July 25, 2016. Our financial results will reflect two components, commencing in October when we begin to supply aligners the sale of aligners to SmileDirectClub and the income there from under the supply agreement which will be reported in our Clear Aligner business segment. And in Q3 and going forward our portion of SmileDirectClub’s reported profits and/or losses will be included in our operating expenses. We are excited about this incremental new market opportunity and the potential our Invisalign doctors to benefit from an untapped segment of consumers with minor malocclusion who want a better smile. We anticipate this relationship would be incremental to our top-line revenue and earnings in 2017. With that let's now turn to our business outlook and the factors that inform our view. Starting with the demand outlook, as we head into the summer months and busy teen season we expect to an increase of teen case starts, among our North America Orthos. Our North American GPs typically have a seasonally slower quarter in Q3. Overall we are expecting North America volumes to be seasonally down quarter-over-quarter. In our International markets our European doctors typically spend fewer days in the office due to summer vacations and extended holidays. Our Asia Pacific region continues to grow and is beginning to offset some of the seasonality we typically experience in our European countries. We therefore anticipate international Invisalign patients to be flat to sequentially up from Q2. For our scanner business we expect scanner shipments to be up sequentially as the iTero Element continues to penetrate the market. We estimate the Q3 impact of the SmileDirectClub transaction will reduce diluted EPS by less than $0.01 per share. With this as a backdrop, we expect the third quarter to shape up as follows, Invisalign case volume is anticipated to be in the range of 174,200 to 176,900 cases, up approximately 18.1% to 19.9% over the same period a year ago. We expect Q3 net revenues to be in the range of $267.2 million to $273.5 million. We expect Q3 gross margin to be in the range of 74.4% to 74.8%, down sequentially, primarily due to increased mix of scanner business and continuous investment in international manufacturing expansion. We expect Q3 operating expenses to be in the range of $147.1 million to $148.1 million, up quarter-over-quarter primarily due to hiring. The late marketing investments as previously mentioned and higher ERP expenses as the cost of the last implementation phase called stabilization are not capitalized. Our Q3 operating margin should be in the range of 19.3% to 20.6%. Our effective tax rate should be approximately 24.5% and diluted shares outstanding should be approximately 81.4 million, exclusive of any share repurchases. Taken together, we expect our Q3 diluted EPS to be in the range of $0.49 to $0.52. With that, I'll turn the time back over to Joe for final comments. Joe?

Thanks, David. Exciting time for Align Technology demand and adoption of our Invisalign system continues to expand across all of our regions and with each new Invisalign innovation, doctors are doing more and more with Clear Aligners and growing their practices. Today we announced a supply agreement with SmileDirectClub, who will provide access to Clear Aligner treatment to more consumers than before while providing Align with an incremental revenue opportunity and helping us to connect Invisalign providers with a new base of potential patients. Thanks for your time today. I'll now open the call for your questions, operator?

Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Your first question today comes from Robert Jones of Goldman Sachs. Please go ahead.

Most of the metrics in the quarter were ahead of your own guidance and then ahead of our expectations. I guess one exception relative to us at least was North American cases and in particular case growth with GPs so I guess I was just curious how does the 10% growth case in North American GP is compared with your own internal expectations, and then just related to that any view of what you can do or what you are doing that could reaccelerate growth in that group in the back half?

Yes, Bob, David. So, if you look at our business in North America and you compare that growth relative to the last few years. If we feel like our North America business has really taken a nice uptick this year and starting last year with many of the investments we made, we think it's still strong on both the ortho and the GP side where we're continuing to see at record or near record utilization amongst those classes of doctors. We still are challenged when it comes to low stage doctors particularly the most emitting GPs who engage with us one quarter and then maybe don’t engage in the next quarter, and so we struggle at times trying to reach those doctors and we continue to invest in various to go market strategies that will build engage them more fully with us but it does represent a challenge for us in terms of how we forecast those doctors in any particular quarter. The other thing I would just mention is that when you look at our comps particularly in second quarter year-over-year you will remember that Q2 a year ago we had, we were running an E5 and E10 promotion at that point in time, which we’re not running this year. And so when you look at last year, Q2, we had a very strong quarter from a case launch standpoint because of those promotions on those low stage products, as well as the fact that we had additional aligner program that was -- you might say an easier qualification mark for the doctors to qualify for. And when you look at those two, they have a bigger impact on our year-over-year volume, but certainly a lesser impact on a year-over-year revenue basis.

Okay, that will make sense. And I guess just one on the SmileDirectClub agreement. And it sounds like you are saying it could be incremental to the P&L and in particular top-line next year. Anyway we could put a little bit more numbers around that, maybe how many members that they have today, how many do you anticipate will show up at Invisalign dentist offices, anything just directionally to help us as we think about layering that in, would be really helpful?

Hi Bob, it's Joe Hogan. You can tell by the announcement that that will start in October, we’ll start shipping then. It’s hard for us to really triangulate around what that might mean as we go into next year. But we’ll give you as much transparency as possible when we come back for the third quarter earnings announcement.

Fair enough, thanks so much.

Okay.

The next question comes from the line of Robert Willoughby from Credit Suisse. Please go ahead.

Same line of questioning, I guess. Can you give us any sense of how much you think the SmileClub deal expands your total addressable market here? This looks previously untapped. Do you have a size of the overall opportunity?

Yes it's really hard for us to call the market. I mean when you look at the run rate right now of SmileDirectClub it's in the $50 million range. It has really been accelerating significantly over the last six months. So it's really difficult to quantify this market. You can also see by the statistics that we threw out, Rob did -- this is the market that we really haven't serviced. It's less than 2% overlap with our current business. It's something we’re learning a lot from Doug and David, the two key leaders in the business who know exactly how this works. So we’re excited about it. We think we can help. We’ll make a good partnership. We’re also excited about how we feel it can help our business too in the sense of referrals back, they’re going through this protocol back to our Invisalign in-doc office business, so.

But again this is brand new. It's hard for us to call it. And we’ll give you more data as it becomes more apparent and as we move into the supply agreements in October.

Maybe another factorial question around it though. If they’re kind of tracking along at a $50 million rate, I assume they’re losing a little bit of money on that. Is that a safe bet?

Yes right now, I think they’ll be cash flow positive next year sometime. So, this year they’ll still burn again.

And just how worse -- is there a liability if the treatment goes bad, that goes back to an orthodontist somewhere, correct? That does not come to you. And just the last one on SmileClub is there a bad debt number associated with the business?

I’ll take the later part. As it relates to the bad debt part, they have a very small cancellation rate amongst the people that are qualified. So, they go through a process where person identifies himself in having an interest in being treated. They are screened in multiple levels from both a photographer -- both from a photo standpoint as well as from a scan or an impression. And assuming the person passes their protocols and is capable of being treated, they have a very small cancellation at that point in time.

And Rob on the question as you had about, from a liability standpoint. Remember we’re the supplier of these aligners. We are -- FCC will sell them to the customer base. We do as per their specifications. Our job is to make the cleanest best aligners we can based on those specifications. FCC obviously makes the transfer, and something like that. We have liability. And we think we’re all doing a lot too there we have the deepest pockets they are going to have some issues too, but I think from a liability standpoint, I think it's shared in that sense that I'll ask Roger to make a comment on this.

Hi, it is Roger George, General Counsel. The doctor is writing the prescription and then treating the patient, so that is where they start. That's our common model.

The next question comes from Brandon Couillard of Jefferies. Please go ahead.

Hi, it is Sachin in for Brandon. David if we look back four years ago, 3Q12 was on the very few periods historically that Aligner has come short of its revenue guidance. And at that time, you pointed to noise around Olympics as well as the pullback in advertising activity because of the event, so I am curious did you apply an extra dose of conservatism or not with respect to your initial 3Q guidance with upcoming Olympic and for which extent did you consider that factor if at all?

Well, I wasn’t here four years ago, but I think that’s an interesting cause well I haven’t heard that one before since I have been here. I can tell you as it relates to our Q3 guidance that we have given today that didn’t enter into our thinking at all. And we basically approach our guidance the way we typically approach it, looking at the strength of the prior quarter, the doctor engagements, et cetera. And that particular factor wasn’t considered.

And also could you walk us through impact of the anniversarying of the aligner policy change in the second half on both the revenues and the P&L?

So, it continues to be a drag on earnings and it will be drag on earnings for as we said a year ago, for at least a couple of years as we work off those grandfathered cases. But starting in Q3, however, it won't be a drag on a year-over-year compare because Q3 2015 was the first quarter in which we actually implemented that policy. So, I think those -- we won't talk about it necessarily so much on a year-over-year basis, but it still will be a drag to some extent.

The next question comes from Steve Beuchaw of Morgan Stanley. Please go ahead.

Just a two couple of little household housekeeping items, the ERP, I mean once we get to fourth quarter, can you give us a sense for what the swing is on OpEx between say 3Q and 4Q just for underlying purposes once we get past that ramp?

Yes. So, Steve, it’s going to be a little bit up in Q2, about a little bit less than a couple of million dollars, primarily as I indicated in my comments that, the stabilization phase is not capitalizable. So, that’s an uptick in Q3 and when we get to Q4, we would expect that principally to reverse itself almost dollar for dollar as those costs begin to drop off.

And then just one Joe sort of reflecting back on your prepared remarks, probably the most positive I have heard you in your tone around third-party scanners and their contribution, I wonder if you could just expand upon that, I mean what is it you're saying there that is incremental here and could you give us a sense for where you think volumes are headed there? Thanks.

Steve, I think my enthusiasm is around just the scanners in general when you see the percent of scanner are getting right now, they come into organization approaching 50%. I mean it is a lot to us from a quality standpoint and how we can build our customer base, so I think I interpreted my enthusiasm more around just the scanning piece than it is third-party or whatever. Our scanning business obviously is having a really good year and we are expecting it to have a very strong this year too, and it's not just selling scanners, it's just what it does it reinforces from a customer base standpoint, both through GPs and Orthos, and just makes things easier for us. And it gives a wonderful platform in the sense to use that scanner for additional products, making things easier for our customer base. As far as the third party piece, as shown in 3M or whatever, we're just seeing continued growth of those. There is nothing I would say that that's entotic about it. But it's just good strong linear growth going forward. And so that's helpful also.

Thanks everyone.

Your next question comes from Jon Block of Stifel. Please go ahead.

I might have a two or three. And numbers look really good. So I'm actually going to focus on the FCC deal that you announced. The first one Joe, I'm still a little confused. You mentioned 1% or 2% cannibalized. But when I look at your cases and sort of lean on the Analyst Day, spread seems to be 15% plus. So can you sort of walk us through numbers, or rectify them. Why Express 15 plus, you are cannibalizing one and two. Is that just because of the lack of attachments in the ITR?

Hi Jon it is Joe. When you look at there is different protocols on this and so it's not just a number of aligners. It's what’s done. So just from an overall standpoint, remember there is no ITR as it's been on these, there is no attachments and obviously on E5 you wouldn’t have attachments, but E10 you do sometimes. Secondly is, it's not directly it doesn’t move lower. They are basically moving so-so swiftly, and they’re moving with different velocity and different rates. And when you add that all up, it really comes after to as a very small overlap on that piece. Now your question has to do with our Express line. I think those overlaps are like 4% on E10, 8% on E5. When you are running against our whole portfolio, that's where you get less than 2% to the whole thing. So, we have a track pretty well. We know this well. That's why we're confident about the minimum amount of cannibalization we would expect as we go into market.

Okay. And maybe, can you give any details on what you are going to ship aligners to FCC in terms of the cost that they don’t pay on the revenue that you will recognize on those aligners?

So we have not disclosed, Jon, the pricing of those aligners. What we have disclosed is that the pricing is dependent upon volume discounts. And as their business ramps, they will earn lower pricing. But when you look at it on an incremental basis, we priced it basically on a pro-liner basis. We believe it's going to be accretive to the Company, both from a revenue standpoint as well as from an operating margin standpoint.

So, I get that, and accretive to you guys. But is it going to be dilutive to your customers, and that’s maybe my final question, and then I have got more and I'll take them offline. But that's what I'm having a really hard time here with is. Joe you came in and you did such a great job, sort of walking off to the customers, shaking hands and eliminating the main point of friction with the additional aligner policy. And it seems like to me, is this a risk that you just sort of bring back in a main point of friction, because you are going to have a subset of docs who believe they are Express business in some other cases are now being pointed to that whole business? Thank you, guys.

Jon, it's a fair question. And obviously it was something we strategically had to wrestle with inside the Company as we work with SmileDirectClub. But I think you can see that as we work through this, when you looked at, we keep the Invisalign product within SmartTrack, SmartStage, all the pieces of that, Invisalign brand name, all that stages at doctor's office. And also see this is EX30 it is basic dental materials that’s been out there for years. There is no ginger of a cut straight rail system it's going to a group where we feel demographics that are a lot more concerned with convenience and cost. And then when we ran those protocols that we just talked about and showed the less than 2% would be an issue for us from a cannibalization standpoint. And I make stat Jon honestly with when you look at what's going to on overall in the market place right now with direct to consumer, you just saw the thing with Dollar Shave Club and what Unilever had to pay for that company, because they were late to that game. I really felt that for a lot of reasons both from an offensive standpoint and a new market standpoint, that this would be balanced well with concerns from a customer base. And we will do our best to ensure our customer base if this isn’t intended that way. And we'll work as best to see to continue to target the demographic that they have been targeting and being successful with.

Alright. Thanks for your time guys.

Yes.

The next question comes from John Kreger of William Blair. Please go ahead.

Hi thanks very much, I had a CapEx question. I think at Analyst Day you talked about over the next few years moving both planning and our fabrication to Europe and Asia, can you just remind us the timing of that and if we should assume any sort of a step up in CapEx to do it and when you layer the volume of SmileDirect on, will that prompt any sort of retrofitting anywhere else?

So John, we have actually begun some of the activities incidental to expanding our pace of international operating activities. So as an example, we established in Europe a base where doctors who are submitting physical impressions, can send them to a European address to have them scanned. Those are sending them all the way to Juarez. So we have implemented that. And so you've seen, there has been some CapEx associated with that and there has been some operating expenses for starting that activity up. We have also begun looking at establishing some treat capacity in some of our regions and begun piloting some of that with small numbers of people and experimenting with how those work flows might work. As it relates to a bigger piece which would be doing Aligner Fabrication, that is still further add to the future, 2017 plus. And so, we will begin to see some of that now. And when you look at our gross margins actually for guidance in Q3, there is a little of an impact from that. As far as CapEx standpoint is concerned, STC won't really impact that very significantly. Their volume is relative to our, volumes are still very modest. And we wouldn’t expect the uptick to be meaningful. As it relates to the rest of our business, probably for the next two years or so, I think as that infrastructure begins getting placed geographically, we would probably see a little bit higher CapEx than what we normally experience. And that at which point as those operating are established and the brick and mortars up, we would probably expect CapEx return to kind of a nominal rate we saw historically.

Great thanks and just one more, Joe, stepping back if you think about your opportunity with that Clear Aligners, the bigger opportunity which seem to be teens, but that tends to have a little bit lower volume growth for you, what do you think you need to do to get teen growth equal to or outpacing your adult case lines?

Yes I think, at our Investors Meeting recently in New York, I think we laid that out pretty well. When you look at first of all from an R&D standpoint. China moved from a chronological standpoint backward to the pilot expansion and main digital expansion kind of devices that we announced that we'll have in the marketplace in 2017 is one part of that. Secondly is a sense of how we go to consumers and how we communicate Invisalign capability to the consumer base. Honestly, a lot of our approach to that marketplace over the years has been primarily through our results and that’s all demographic. And we feel pretty strongly as we move into next year, we’re going to have to - really there is two sides this equation. As you look at the three people involved normally in teens, you have a father, you have a mother, and then you’re going to have the teen and then you also have a doctor. We found that overtime you get to win two out of three. And I think often we win the one with teen we lose the mom, or we lose the doc. And so we’re working on both ends hard from an advertising standpoint to make sure we do better in working with our docs in the sense of our teen capability and expanding it coming forward. And then secondly is to get to the mom in a much better way, particularly around compliance, a lot of mothers or fathers have concerns of their teens really were aware of the amount of time that’s needed to properly move the teen. We found out through over the years that actually teens are more compliant than adults. And so we’re very confident. And frankly the dentition and teen are really helpful in the sense of how loose the dentition is and how fast we can actually move teen teeth. So, as we speak, we’re working hard in a sense of how we’re going to approach teens next year. It’s a great question, because it is obviously 75% of the marketplace, and it’s one that we have not obviously penetrated thoroughly. And I think we can make some really good progress in the next year.

Hi John just to add a little bit color to Joe’s comments there. If you look at our teen growth, our teen growth is still north of 20% year-over-year, which we think is really outstanding in a market that’s only growing 3% to 4%. You know that share that we’re taking away from large in brackets. And I think when you look at the 20% it made a lag our overall growth as a company by maybe a point or two. But I think some of that is largely attributable to the fact that our international business is growing faster than what we’re growing here in North America. And their business is more dominated by treatment of adults. So as our international business has been growing at those faster rates, it had somewhat of a dilutive impact on our overall teen growth, because our teen is more dominated here in the U.S. So we still feel like that the teen business is growing great and still feel like we’ve got plenty of opportunities still headed of us there.

Very helpful. Thanks.

[Operator Instructions] Our next question is from Richard Newitter of Leerink Partners. Please go ahead.

Hi thanks for taking the question. Just going back to the CDC, I’m curious if you could characterize for us the type of customer or consumer that just the lead generation aspect to the type of customer or consumer that’s going to SmileDirect and how will that compares to who is learning or coming to Fair Aligners through your Web site. Did you do any research, or do you have any information there about kind of the types, who were just getting this type of products versus traditionally who goes through the doc locater and traditionally on your align channel?

You know I could day that we don’t have exhaustive data on that. I mean what SmileDirectClub has shared with us. the demographic end tend to be heavily weighted toward women versus men, which we see in our demographics too. But these are people that are really often millennials. The convenience is really important to them. If they have a certain want, from a freedom standpoint as such that visiting doctors' offices, there is obviously a price point here too that's something simple in the sense of what they want to move from inclusion standpoint. So it's not necessarily a gender difference from what we've done or an age difference, but it's a preference difference in the sense of how people want to engage from what we can see so far.

Okay and then maybe just turning one financial one, on gross margin, I think you said that you have some manufacturing start up cost for you APAC kind of initiatives there bringing manufacturing closer to that part of the world, that's going to impact the step down in gross margin in third quarter. Can you just give us a sense as to whether or not that is kind of finite nature or should we kind of think of that as kind of a go forward kind of gross margin rate for future quarters modeling or how should we think about that? Thanks.

Yes, I would say it's probably more of a go forward rate, but let me give you a little bit more color to that, because I was answering that question in the context of a CapEx discussion. When you actually look at the biggest impact on gross margins and the fact that they are declining just slightly quarter-over-quarter, the biggest impact is from our scanner business, which has a gross margin that is in the low 50s. And as that business is growing more than doubling on year-over-year basis, it's having a little bit more of a dilutive impact on overall gross margins. But I would say that the guidance we've given for Q3 is probably the best guidance we could give you on a more going forward basis as well.

Okay, thanks. And if I could squeeze one more in. I believe you said you had the G6 product launching in the U.S., so you had anticipated that, I was just wondering any initial feedback there and how that launch is going assuming it's already happened?

We've launched G6 in the U.S. G6 functions well. I mean we have good feedback on it, but honestly when you look at the demographics again of this, it moves to Asian, because extraction cases in Asia are way over board in a sense of number of cases they see. So It's being used in North America, it's been successful, it's growing in that sense, but predominantly it's been an APAC product.

Thank you.

Thanks Rich. Operator, we will take one last question, please.

Okay, the last question today comes from Chris Lewis of ROTH Capital Partners. Please go ahead.

Hey guys thanks for squeezing me in.

Hi Chris.

I guess first just on North American price increase, can you quantify what the increase was on the timing of that and the rest of just what you've seen since you have implemented that pricing strategy?

Yes, the price increase was effective April 1, so we saw just a partial impact of that in the second quarter. The magnitude of the price increase vary depending upon the products that are primarily applied to our full stage products and varied anywhere from $50 to I think $70 to $80.

Okay got it, so it's reasonable to assume that at least in North America ASP trend up in the third quarter from second quarter?

From a revenue standpoint, yes. There are other factors however though when you go into the third quarter, because typically we have more promotion activity going on in the third quarter particularly for teens, but holding that aside, you are right.

Understood, and then just turning to actuarial element, understands it's going to increase sequentially. Are you still working through the backlog there and if so when do you think that will be kind of more on a normalized basis. I guess I'm looking beyond the third quarter and just kind of trying to gauge where sales go post to 3Q? Thanks.

So, I think one of the things we've been very fortunate where this that, demand that we saw and post the announcement of the product in March of 2015 has continued to almost outpace our ability to deliver. And so we’ve had a very good first half of the year with orders maintain that backlog in spite of our increased efforts to get ahead of it. We would expect that more nominal way to backlog would probably be somewhere in the half the levels that we have today. And we think that would be somewhere maybe towards the end of the year by the time we would catch up.

Okay great and then just one more from me, as we think of that full list of new scanners being placed, it sounds like mostly in the GP channel. When do you think that will really start to translate into utilization? And do you think - is there an immediate pick up, uptick in utilization, once the GP receives that scanner or is a bit of a lag effect there? Thanks.

We still wrestle with that question. Honestly, Chris I think obviously there is an immediate pick up if they are a user today, from an Invisalign standpoint, they turn all the impressions over to iTero, and you see it immediately. But as far as, they actually keep doing more and more cases, we have more and more data say that’s true. We can't quantify exactly right now, exactly how true that is and to what degree it occurs.

Okay, thanks for the time.

Thank you everyone - sorry operator. I’ll go ahead and close. Thank you everyone for joining us today. We appreciate your time. If you have any follow-up questions, please contact Align Investor Relations.

This concludes today's conference. Thank you for your participation. You may disconnect your lines at this time.