In the first half of the year, the pandemic stifled the top-line growth of Align Technology, Inc. (ALGN) as virus fears and social restrictions kept patients away from dental clinics. The heavy reliance on doctor visits to generate sales has forced the company to adopt a digitally-focused operating model, though its benefits will take time to accrue. The virus fears continue to hold back cash-strapped patients from visiting the dental offices to seek treatments, and thanks to their virtual model, Align’s low-cost rivals are at an advantage as the pandemic-driven recession hurts consumer spending.
Despite the ongoing disruptions, trading at a premium to the past three-year average, Align looks overbought in terms of NTM EV/EBITDA. However, as the digitalization takes shape, the company with a robust balance sheet and ultra-low gearing warrants a premium multiple, which, in combination with our 2022 EBITDA forecasts, emphasizes a ‘Hold’ strategy for the long-term shareholder.
Source: The Company Website
The Pandemic Disrupts Orthodontic Care
Last week’s GDP data mirrors the grim reality encountered by the consumer-facing businesses as the COVID-19 pandemic reached a peak in the past quarter keeping the U.S. public indoors amid widespread lockdown measures. In annualized terms, GDP shrank ~32.9%, while the consumer spending on services dropped ~43.5%. With dental offices closed or operating at reduced capacity to focus only on emergency care, the clear-aligner industry that treats teeth malocclusion or the misalignment was no exception to the pandemic’s economic consequences.
The dental practices are central to Align’s treatment plan. With intraoral scanning or PVS (polyvinyl-siloxane) impressions (images), the dental professional initiates the treatment plan that could take weeks during which additional aligners are dispensed to the patient at regular checkups. The pandemic-induced social restrictions and virus fears of patients have exposed the vulnerability of Align’s business model in the era of remote working. In contrast, the direct-to-consumer player, SmileDirectClub, Inc. (SDC), looks more resilient. Its treatment plan can be started either with an in-person doctor visit or an at-home creation of the impression using an online-ordered kit delivered to the customer.
However, the gloomy industry prospects have caused both companies to underperform the ~11.2% YTD (year-to-date) gain of the XHE (SPDR S&P Health Care Equipment ETF). Yet surprisingly, Align, with a gain of ~5.3% YTD, has outperformed SDC, whose disputes with regulators, professional dental groups, and even disgruntled customers have cost the share price to decline ~3.3% in the year so far. The reopening dental offices have turbocharged the gains in the past month with both Align and SDC rising ~10.3% and ~9.6%, respectively, matching the ~9.7% gain in the XHE. However, the raging pandemic tests the resilience of their business models as virus fears continue to threaten the doctor-patient interaction.
Doctor-driven Model Puts Align at a Disadvantage
With the U.S. dental offices operating with restrictions from March, the company recorded flat revenue growth in Q1 2020 (first quarter of 2020). Marketed as Invisalign, Align’s clear aligner volumes, making up ~84% of the top-line, have remained stagnant from the previous year with a decline of ~13.1% QoQ (quarter over quarter). In Q2 2020, the clear aligner volumes have seen even a sharper decline of ~41.4% YoY and ~38.3% QoQ dragging the top line ~41.3% YoY. Meanwhile, SDC, thanks to its virtual business model, managed a ~9.1% YoY growth in revenue in Q1 2020 driven by ~12.0% YoY and ~6.7% QoQ growth in aligner shipments. Though it hasn’t yet released its Q2 2020 financials yet, in the previous earnings call, the company’s CFO was confident of expanding the unique aligner orders from 10.5K in April to 11.0-15.0K in May.
In a competitive landscape dramatically changed by the pandemic, its cheerful forecast looks feasible as virus fears jeopardize the doctor-patient interactions in traditional aligner therapy, putting the direct-to-consumer players at an advantage. Unlike SDC’s treatment plan where the doctor visits are not a must, the Invisalign therapy requiring more frequent interactions with the dentist is unlikely to be the ideal option to avoid the infection. Meanwhile, the face masks and remote working will keep the cosmetic issues of teeth misalignment hidden from the outside world, giving the patients more reasons to defer the treatments. Despite an outsized market opportunity, the company’s volumes in the vastly underpenetrated and less discretionary teen-and kids’ segment are on the wane. The low-cost competitors are making entry to the promising demography with treatment plans specifically designed for the age group. Compared to ~40.5% YoY growth in 2018, the newly-started teen and kids’ cases at Align have slowed to ~34.2% YoY in 2019 before falling ~44.7% YoY in Q2 2020. Furthermore, the sluggish economic environment is not favorable for the premium pricing model of Align positioning the low-cost competitors such as SDC to take market share leveraging its virtually-driven treatment plans as virus fears take hold. Despite a 60% cut in the marketing expenditure, SDC’s at-home kits, which usually account for a tenth of its new case starts, were down by only 40% in the two-month period through last May.
Sources: The Author; Data from the company Earnings Call Presentations
The Digital Shift Gains Speed
However, Align is accelerating its digitalization efforts to counter the pandemic-driven disruption to the business model. As virus fears swept across the U.S. last March, the company snapped up Exocad Global Holdings GmbH. It expects the CAD/CAM dental software company from Germany to reinforce its digital footprint with end-to-end integration of dental workflows. Over the years, the scanner segment, which made up ~16% of the top line in 2019, underpinned Align’s digital push as highly accurate digital scans reduce the need for more frequent patient visits. The utilization rate of Invisalign products by North American orthodontists has risen from 56.7 cases per doctor in 2018 to 65.0 in 2019 as the quarterly average of cases submitted using digital scanners climbed from ~70.2% in 2018 to ~77.9% in 2019 in Americas before reaching ~85.8% in the previous quarter.
Source: The Author; Data from Company SEC Filings
Meanwhile, the company offers a fee-based consultation service for dental practices to fast track their digital shift. Currently available in APAC (Asia-Pacific) and EMEA (Europe, the Middle East, and Africa), its U.S. rollout begins in H2 2020. As the company presentation details, within six months of the implementation, the program has been proven to improve the dental practice’s revenue and profitability by 20% and 15%, respectively. While supporting the struggling dental practices to switch to a virtual model to resist the pandemic’s impact, the program will also ensure the future demand for Align’s product portfolio as the company, with no reduction in the headcount, stands ready to ramp up production once normalcy returns. In China, one of the earliest countries to ease social restrictions, the order numbers in May had recovered to ~80-85% of the pre-pandemic level, making the APAC become the only region to expand case volumes for the company in Q2 2020.
Sanguine Revenue Forecasts by Analysts
Given the uncertain demand backdrop, Align has already withdrawn the 2020 revenue guidance, though, in a recent CNBC interview, the CEO envisioned an annual growth rate of 20-30%. Commanding only 17% of share in the global orthodontics market where 70% of 12 million annual cases are applicable for aligner therapy, the forecast looks convincing in the long term. However, the analyst estimates have already baked in the optimism with the 2020 consensus revenue estimate of ~$2.1 billion, indicating only ~7.2% YoY decline in the second half of the year (2H 2020). With six-month net revenue growth ranging from ~21.0-26.2% YoY in 2019, our forecast for 2020 projects ~13.4-9.4% YoY growth rate for Align for H2 2020 driving the full-year revenue to ~$1.99-2.04 billion with a decline of ~17.3-15.2% YoY. Rebounding to a 39.2-43.0% YoY growth next year, we further expect the top line could reach ~$2.8-2.9 billion in 2021 before normalizing to a ~18.8-22.8% YoY growth in 2022, to reach ~$3.3-3.6 billion in 2022.
Digital Efforts to Drive Margin Expansion
Declining from ~75.5% in 2016 to ~72.5% in 2019, Align’s gross margins have narrowed under the pricing pressure of low-cost rivals. With the company losing the advantage of economies of scale as the case volumes plummeted, the gross margin has slipped to ~63.7% in Q2 2020. The decision to keep the salaries and the headcount unchanged will pressure the margins even further until the case volumes recover meaningfully.
Sources: The Author; Data from Company SEC Filings and Earnings Call Presentations
Even though the LTM (last-twelve-month) EBITDA margin ranged from 24.6-26.8% in 2019, the consensus forecasts for 2020 imply ~27.8% of EBITDA margin for Align in H2 2020. Estimating only a 14.6-15.6% margin for the period, our EBITDA projections of ~$197.3-216.0 million for Align suggest ~9.9-10.6% of margin for Align for the full year of 2020. With the management targeting more than 25% of operating margin in the long term, up from ~22.5% in 2019, EBITDA margin could improve in the long term as the digitalization benefits kick in. Expecting the margins to reach ~21.5-22.6% and ~25.1-26.1%, our forecasts for 2021 and 2022 suggest the EBITDA could reach ~$597.2-659.4 million and $825.9-935.5 million, respectively.
Solid Balance Sheet and Digital Shift Warrant a Premium
Even though the Exocad acquisition cost ~$420.8 million in cash in Q2 2020 at the height of the epidemic, the company ended the quarter with positive free cash flow. The onerous operating conditions haven’t yet compelled the company to slash staff salaries or cut back the headcount. In contrast, it has added new employees in China, and the share buyback program is on track. With a net cash position, Align can afford to do so as its total debt remains extremely low with gearing, measured in terms of total debt to equity, falling to ~1.8% in Q2 2020 from ~4.4% in 2019. Meanwhile, the recently secured 2020 credit facility worth ~$300 million replacing the 2018 facility pushes back the debt maturity date from 2021 to 2023, further easing the debt commitments.
In terms of NTM (next-twelve-month) EV/EBITDA, Align currently trades at ~35.2x, with a premium of ~3.6% to ~34.0x, the average over the past three years. Even though the multiple peaked ~55.6x in mid-2018, assuming the average to reflect the existing operational challenges, our 2020 EBITDA forecasts imply an overvalued stock. With a 20% premium to reflect the future digitalization benefits, the average with our EBITDA forecasts for 2022 indicates a premium of ~22.8-38.9% for the stock, underscoring the gains ahead for the long-term focused investors.
Sources: The Author; Data from Seeking Alpha, Koyfin and The Author Estimates
Align is accelerating its digital shift as the pandemic discourages dental visits. With a virtual model, the low-cost direct-to-consumer peers are at an advantage as the consumer spending contracts, and pandemic fears persist. Thanks to a robust balance sheet, the company can comfortably withstand the slowdown until the digitalization benefits accrue. However, per our near-term EBITDA forecasts, the stock looks overbought with a trading multiple at a premium to the three-year average. With a 20% premium added to reflect the future benefits in digital focus, our 2022 forecasts imply an undervalued stock for long-term investors to ‘Hold’.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.