2023-12-11 07:56:35 ET
Summary
- Align Technology is a leading manufacturer of the Invisalign system, a popular alternative to traditional braces that has allowed it to become synonymous with the term 'clear aligner'.
- A leadership position in a very profitable business entails the incursion of numerous competitors seeking to steal market share, and Align shows signs of being affected by this.
- In my opinion, this is an industry where staying a leader is complicated and expensive, so Align currently has little to gain and a lot to lose.
- Although it could end up being a good investment, I think it's better to stay on the sidelines, which is why it's a 'hold' for me.
Investment Thesis
Align Technology (ALGN), over the past two decades, has delivered exceptional value to its shareholders, significantly outperforming the S&P500 during the same period.
However, the company is currently facing challenging times , experiencing a nearly 70% decline from its all-time highs. Recent years have shown a downward trend in both margins and returns on invested capital. In this article, we will delve into the advantages of the business model and attempt to uncover why the company appears to be grappling with structural complications amid increased competition in an industry that demands substantial research and development (R&D). In this sector, differentiation is primarily rooted in possessing the best technology, which, in my opinion, represents a somewhat weak barrier to entry .
Business Overview
Align Technology designs, manufactures, and markets the Invisalign system, a clear aligner system used for orthodontic treatment . Invisalign is an alternative to traditional braces and is popular for its nearly invisible appearance and removable nature. In addition to the Invisalign system, Align Technology also produces other products, such as the iTero intraoral scanners, which are used by dental professionals to create digital impressions of a patient's teeth.
Align has adopted a subscription-based business model for its Invisalign product. This model often involves a series of aligners provided to the patient over the course of their treatment, and fees are charged on a periodic basis.
Revenue Distribution
Currently, 82% of the revenue is derived from the Clear Aligner segment, which has experienced annual compounded growth rates of 20% since 2014, boasting EBITDA margins of approximately 39%. However, a noteworthy concern is the consistent decline in margins each year. This decline is likely attributed to the increasing number of competitors entering this segment. Despite Align holding nearly 1,700 active patents , sustaining margins and profitability becomes challenging in a competitive landscape with players competing for market share. We will delve into this issue in more detail later.
On a different note, in the Systems and Services segment, the company offers Exocad, a software aiding in computer-aided design and computer-aided manufacturing. When combined with iTero, a mouth scanner, Exocad enables dentists to swiftly, efficiently, accurately, and comfortably create a 3D image of a patient's teeth. This particular segment has exhibited impressive annual growth of 38% since 2014. The EBITDA margins, which had been steadily approaching 40%, experienced a decline to 31% last year. This dip can be attributed, in part, to dentists scaling back on their capital expenditures. This trend is notable as it reflects a broader pattern observed in various business models dependent on the capital expenditures of their clients, particularly in response to concerns about a potential recession and increasing interest rates.
This product replaces the traditional method of creating molds by applying plaster to the patient's teeth, offering a more advanced solution for obtaining dental details and designing brace treatments. Speaking from personal experience with conventional orthodontics, I can attest that Align's solutions effectively address a genuine problem, significantly enhancing the overall comfort of the process for both patients and dentists. This spans from the initial measurements and dental shape assessments to the treatment of aligning the teeth.
Competition
Align Technology has gained significant recognition and market share in the orthodontic industry, and its products are used by orthodontic professionals worldwide. The company has played a key role in advancing technology in the field of orthodontics and has become synonymous with clear aligner treatment.
A quick method to observe this trend is through Google Trends . The green line represents the total searches related to 'Clear Aligners' over the last decade, while the yellow line corresponds to the specific term 'Invisalign.' A noticeable disparity exists between these figures and those of competitors such as Smile Direct Club or Dr. Smile, indicating that Align's brand influence is robust and nearly synonymous with 'clear aligners'.
However, each year witnesses the emergence of new competitors striving to establish a presence in this lucrative market. Despite providing Align with returns on invested capital exceeding 20% and maintaining profit margins averaging almost 20%, the landscape is evolving. This evolution is evident in the percentage of searches attributed to Invisalign concerning the term 'Clear Aligners.' In 2013, this figure stood at 80%, but it has since diminished to 60%, suggesting a decline in interest , particularly in the context of Google searches, for Align products. It is crucial to monitor this situation in the future to determine whether it is a temporary phenomenon, perhaps triggered by consumer concerns about an impending recession leading them to defer costly treatments. If, however, it is indicative of a loss in competitive standing, it could potentially damage profit margins and the return on invested capital as it has already done in past years.
To counteract the impact of competition , Align has strategically focused on cultivating a preference directly among orthodontists. As patients often receive orthodontic treatment prescriptions during their office visits, it becomes crucial to incentivize dentists to choose Align's products over those of competitors, who function as external agents. To achieve this goal, Align has implemented an innovative points and discounts program strategy. Orthodontists earn points and discounts based on the volume of orders placed, providing a consistent incentive to choose Align products. As orthodontists accumulate more orders, they enjoy increasingly favorable points and discounts. This dual approach not only boosts Align's sales volume but also establishes a loyal and recurring customer base .
The strategy creates a substantial barrier for competitors, as convincing orthodontists to forgo the benefits of the points and discounts program in favor of alternative aligner brands proves to be a significant challenge. The more discounts and benefits orthodontists accumulate, the more appealing their profit margins become for each product sold. This dynamic further solidifies Align's position in the market, making it challenging for competitors to sway orthodontists away from the established program
Key Ratios
Examining the overall figures underscores the consistent decline in margins year after year. Despite being in a period of economic slowdown, there is no indication that this trend will reverse in the near future. This predicament exemplifies one of the primary challenges faced by technology companies. In a profitable sector where dominance is established, competitors swiftly enter the market, impacting margins and exerting constant pressure to maintain leadership. When this mission is unsuccessful, a fate akin to Intel's may arise—a semiconductor manufacturer that, once a near-monopoly, currently navigates a profound downturn triggered by the ascent of its competitors.
To confront the challenges posed by competition and sustain dominance, the company must make substantial investments in operating expenses (OpEx), including Research and Development (R&D), representing around 7% of revenue over the last decade, as well as Capital Expenditure (CapEx), which has accounted for another 7% of revenue. Marketing expenditures are also essential to uphold the company's preeminent position in the minds of consumers. Notably, the company has executed robust influencer marketing campaigns to connect with teenagers and young adults, a demographic more inclined to embrace new orthodontic technologies.
Simultaneously, the return on invested capital provides insights into the company's diminishing returns , evident when plotting a trend line. This decline serves as yet another indicator of intensifying competition.
A notably positive aspect is the company's debt-free status, with a current net debt of -$1.17 billion. In other words, the cash on its balance sheet is sufficient to cover its total debt. This financial resilience is crucial because, in the face of competitive pressures, the last concern would be shouldering interest payments on debt. Such a scenario could force a diversion of resources away from crucial areas like R&D and marketing, jeopardizing the company's position in the market—a perilous outcome to avoid.
Valuation
Valuing a high-growth company based on multiples and growth estimates is a complex task. To estimate the potential return on an investment in Align at the current price, I plan to conduct a Reverse Discounted Cash Flow . This involves reverse engineering known variables to estimate the necessary Free Cash Flow growth to achieve the desired return. These variables that we already know are the following:
- LTM Free Cash Flow: $686 million.
- Cash & Cash Equivalents: $1.24 billion
- Debt: $126.8 million.
- Shares Outstanding: 77.1 million.
And my assumptions are the following:
- Share Reduction: -1%
- Terminal Growth Rate: 3%
- Expected Return: 15%
Given that my standard hurdle rate for a satisfactory return is 15% annually over the next decade, the Free Cash Flow would need to grow at an annual rate of 19%. However, this appears somewhat unrealistic to me. I estimate that a more plausible growth rate for Free Cash Flow would be around 15% per year. Therefore, based on the current price, the expected return could be around 13% compounded annually .
While this return is reasonable and could justify a 'buy' rating, I personally prefer a bit more margin of safety, especially considering the existing uncertainty regarding competition, as thoroughly analyzed throughout the article.
Final Thoughts
My conclusion is that Align Technology presents a mixed picture . While it continues to be a leader in the orthodontic industry and has implemented strategic measures to counter competition, there are concerns about declining margins and the ongoing competitive landscape. The potential return may be compelling, but one should exercise caution and consider a margin of safety given the current uncertainties in a business model that was once very profitable but now seems to depend heavily on innovation and brand awareness to overcome competitive pressure.
Currently, it seems to me that Align has much more to lose than to gain . Although I would not venture to give a 'sell' rating to a business with such good margins, growth, and profitability, I do think that it is best to stay on the sidelines. Hence, a ' hold ' rating seems to be the fairest.
For further details see:
Align Technology: Competitive Pressures Provide A Mixed Picture