Align Technology, Inc.

By now, investors in Align Technology, Inc. (“ALGN” or “the Company”) are used to hearing that competitors are, for the first time, beginning to penetrate the clear aligner space. The bullish consensus: dental equipment competitors can coexist with Align, but cannot yet compete toe-to-toe with the 20-year incumbent.

The reality: the economics of clear aligners are on the precipice of a radical shift – and it has little to do with SmileDirectClub or other direct-to-consumer players. Once considered high-value-added “dental tech,” FDA-approved aligners of similar quality to Invisalign – Align’s clear aligner product – are now being printed at scale by commodity 3D printing labs, which price their aligners at less than half the cost of Align’s. Meanwhile, patent expirations have ushered in under-the-radar developments in aligner design software which are removing the final barriers to the widespread adoption of 3D printers by orthodontists – many of whom are infuriated with Align’s aggressive tactics, and who are actively exploring their options in a market which, for the first time, offers numerous (cheaper) alternatives to Align. On-the-ground diligence reveals that large dental players are already slashing aligner prices in response to these shifts, in some cases to as low as a third the price of Invisalign. We believe that it is only a matter of time – perhaps accelerated by industry cost pressures brought on by the pandemic – until Align is forced to follow suit.

Third-Party Labs Turning Aligners Into Commodities: For close to 20 years, Align operated as the lone major player in the clear aligner space, with other large dental equipment suppliers only recently entering the industry. Over just the past two years, however, patent expirations and developments in 3D printing have enabled dozens of third-party printing labs to begin to produce FDA-approved aligners of their own, threatening to transform the clear aligner from “high-tech” dental equipment into a low-value-added, easy-to-source commodity. What’s more, the former developer and provider of Align’s own polymer has developed a new plastic which can be used by third-party labs to produce aligners of comparable quality to Invisalign. Spruce Point has obtained term sheets from one such third-party lab which reveal that dental practitioners can save over 50% per case on average by sourcing from it rather than Align, and that a typical practice – depending on its volume – could increase its cash flow by close to 10% simply by switching from Align. We find evidence that large orthodontic organizations are considering switching from Align to third-party labs, and that other major dental players are already slashing prices to as low as 33% of Align’s in response to this competition. We believe that Align will inevitably be forced to follow suit – or else lose significant case volume – as third-party labs grow increasingly mainstream.

Under-The-Radar Improvements In Workflow Technology Make In-House 3D Printing A Threat: Until now, Align bulls have generally considered in-house 3D printing an inconvenient alternative to Align, as in-house printing forces orthodontists to bring entirely new workflows into their offices. Through a proprietary survey of high-volume orthodontists, together with conversations with industry experts, we find that interest towards in-house printing is in fact extremely high among doctors, who are attracted to the potential efficiencies and cost savings. We find that broader adoption of in-house printing has been constrained NOT by limited demand, but by the relatively limited supply of quality technological infrastructure to support this workflow – in particular, high-quality CAD/CAM aligner design software. However, with Align’s patents on this technology recently having expired, major innovations are coming to this space as we speak. Notably, uLab Technologies – a company founded by former Align executives and employees who were themselves behind the most successful attempt to compete with Align during the 2000s – is in the process of rolling out CAD/CAM software which experts believe to represent a step change over existing solutions. The full-scale launch is expected to occur this spring. With the final barriers to widespread in-house printing adoption set to fall in the near term, we expect interest in 3D printing – which offers even greater cost savings than third-party labs – to expand dramatically.

Emergent Competition Already Putting Pressure On Align: Though still relatively novel, Spruce Point observes that these competitive forces are already beginning to pressure industry pricing and threaten Align’s case volume. Our diligence reveals that a large dental service organization (DSO) representing up to 12% of Align’s US aligner volume is actively exploring opportunities to source aligners from third-party labs. Meanwhile, we are told that 3M is offering orthodontists lab fees as low as $500-$600 per case – less than one third the price of a comprehensive Invisalign case. We believe that this is just the beginning of a longer-term trend.

Widespread Dissatisfaction With Align Could Accelerate Customer Losses: Align bulls are quick to argue that the Company’s brand and practitioner network protect it from new competition. We find that orthodontists are, almost universally, anywhere from dissatisfied to infuriated with Align, which continues to raise prices aggressively on orthodontic practices even as costs fall across the rest of the space, and which has threatened orthodontists’ control over the teeth alignment industry by selling to dentists and backing direct-to-consumer players. With competitive options proliferating across the space for the first time in ~20 years, Spruce Point observes that even Align’s highest-volume orthodontists are actively pursuing alternatives – and doubly so as they pause normal operations in response to the COVID-19 pandemic, which has given them a unique opportunity to explore cost-saving measures.

Growth Into The Purported TAM Will Be More Difficult Than Expected: Management claims that Align captures just 1.5M of over 8M annual worldwide malocclusion cases which Invisalign can be used to treat, and that there are more than 300M additional candidates who would benefit from more minor treatments with clear aligners. However, we estimate that Align is already close to 80% penetrated among US orthodontists, making further growth into the domestic orthodontic channel difficult – particularly as increasing competition induces churn and causes utilization to fall. Meanwhile, cheaper competitors and DTC players like SmileDirectClub will make it difficult for Align to capture meaningful share of lower-complexity cases without reducing prices materially.

Management Reducing Transparency While Showing Little Confidence In The Business: After reducing disclosures which would have made it easier for investors to see the impact of competitive pressures on Company results, management expanded a number of risk factors in its most recent 10-K in ways that suggest that more aggressive competition is on the way. At the same time – just as sales growth decelerates and margins compress – insiders are selling their holdings of ALGN shares in size, while simultaneously increasing the Company buyback by 4x. With the Company experiencing declining growth as it is pinched by a more crowded competitive landscape, pivoting to M&A to support future growth, and buying back shares just as insiders sell out, Spruce Point feels that Align exhibits many of the classic characteristics of a business under pressure.

COVID-19 Pandemic Poses Unique Short-Term Risk, While Competitive Threats Could Inhibit Rebound: Shares in ALGN have largely traded in-line with the market as investors bet on when restrictions on normal economic activity will be lifted. However, with clear aligner therapy – an elective, cosmetic treatment – falling among the least critical of medical procedures, Align bears outsized risk to the potential lingering effects of the disease, which may not only depress discretionary spending for an extended period, but also prevent orthodontic offices from reopening entirely for up to a number of months, and discourage patients from entering what may be a high-risk, aerosol-laden environment thereafter. Meanwhile, our diligence indicates that orthodontists are using their time off to evaluate their practices’ cost structures and identify areas of potential cost savings – a trend which could result in accelerated switching away from Invisalign as the competitive landscape becomes increasingly crowded with low-priced providers. We estimate that case volume could fall by anywhere from 30% to 90% worldwide YoY in Q2, with the lingering effects continuing to drive declines of 20-30% for the rest of the year. We believe that near-term earnings revisions in the face of the ongoing crisis will serve as catalysts for downward moves in the stock, as revisions have before.

Not A Post-Pandemic Bounce Back Candidate, Even As Shares Trade Down: As ALGN shares trade lower with the market as the pandemic grows increasingly drawn-out, bulls with faith in the long-term growth story likely see the stock as a strong “buy low” opportunity. Spruce Point strongly disagrees: not only does Align bear outsized risk to the continued prevalence of COVID-19 beyond 2020, but the proliferation of competitors and alternative aligner printing technologies will, in our opinion, prevent the Company from bouncing back with the same force as the rest of the dental/orthodontic space. Spruce Point sees 40%-55% downside in ALGN to $80-$115 per share on disappointing case volume growth in FY21 and ongoing ASP pressure amidst an expanded competitive landscape. ALGN’s ~24x FY21 earnings multiple could also compress as investors increasingly understand the competitive forces facing the Company going forward, bringing the potential for even greater downside to ALGN shares.