2023-05-01 03:38:42 ET
Summary
- Align Technology has rallied nearly 90% since November.
- The company will likely face increasing headwinds due to emerging competition and a weakening economy.
- The latest earnings were extremely disappointing with both the top and the bottom line dropping.
- The current valuation is unjustifiably expensive and should present meaningful downside potential.
- I rate the company as a sell.
Investment Thesis
After performing poorly in early 2022, Align Technology ( ALGN ) has come alive in the past few months with its share price up nearly 90% since November. However, I do not believe the rally is sustainable and the company has multiple concerns. It is facing increasing competition and the weakening economy will also present meaningful headwinds. The latest earnings remain very disappointing, as both the top and the bottom line continues to decline. After the massive rally, its current valuation is also extremely expensive, especially when considering its financials. I believe the risk-to-reward ratio at the current price is very unattractive and I rate the company as a sell.
Increasing Headwinds
For those unfamiliar with the company, Align Technology is a US-based orthodontic technology company founded back in 1997. It provides Clear Aligners and other imaging-related services for customers and orthodontists across the globe. The company is known for its Invisalign products which had been used by over 15 million patients to date.
Align Technology has been growing rapidly in the past decade due to the increasing adoption of clear aligners, as they offer a more comfortable and better-looking alternative to traditional braces. While the company has been the leader in the industry for a long time, it is now facing tougher competition as the availability of scanning and manufacturing technology increases.
For instance, Zenyum, a 5-year-old Singapore-based company, is now able to provide similar teeth straightening services at a lower cost and shorter duration. At the moment, Zenyum's price averages around $2,650 to $3,990, while Invisalign's price can range from $2,888 up to $8,000. Its average treatment duration of 3 months to 15 months is also slightly shorter than Invisalign's 3 months to 18 months. Zenyum does have a more limited scope of treatment, but the emergence of these smaller competitors should continue to impact Align Technology's demand.
Besides increasing competition, the company is also pretty exposed to economic downturns due to its discretionary nature. Other than some serious cases, most orthodontic budgets are not prioritized by consumers, as the price tag is hefty and there are simply no near-term urgencies or need to do so. As the economy continues to weaken, I believe the company will face stronger headwinds as consumer spending power declines further.
Weak Q1 Earnings
Align Technology recently announced its first quarter earnings and the results are very weak, as both the top and the bottom line slumped. The company reported revenue of $943.1 million, down 3.1% YoY (year over year) compared to $973.2 million.
Revenue from Clear Aligner declined 2.5% from $809.7 million to $789.8 million, accounting for 83.7% of total revenue. The decline is mostly driven by lower demand, partially offset by an increase in pricing. Revenue from Imaging Systems and CAD/CAM (computer-aided design/manufacturing) Services declined 6.2% from $163.5 million to $153.5 million, or 16.3% of total revenue. The drop is attributed to the lower volume of scanners sold, partially offset by higher service revenue from existing customers.
The bottom line was even worse as costs and expenses remained elevated. Despite revenue being down, costs of sales grew 6.6% YoY from $263.9 million to $282.5 million, as manufacturing costs increased. This resulted in the gross profit margin dipping 280 basis points from 72.9% to 70.1%. Gross profit was down 6.9% YoY from $709.3 million to $660.7 million.
While SG&A (selling, general, and administrative) expenses were flat, R&D (research and development) expenses grew 21.7% from $71.8 million to $87.4 million, as the company continues to invest heavily. Due to the increase in costs and spending, net income plummeted 34.6% YoY from $134.3 million to $87.8 million. The net income margin also contracted 4,500 basis points from 13.8% to 9.3%. The diluted EPS was $1.14 compared to $1.70, down 32.9% YoY. The guidance for Q2'23 was also very underwhelming. The company expects revenue to be between $980 million and $1 billion, which translates to a growth of only 2% at the midpoint.
Unjustified Valuation
After the massive rally in the past few months, Align Technology's valuation looks extremely expensive in my opinion. The company is currently trading at a PE ratio of 80.5x, which is significantly elevated considering its historical average and growth rate. As shown in the chart below, the current multiple is near the high end of its historical range and represents a massive premium of 58.5% compared to its 5-year average PE ratio of 50.8x. The multiple is also unjustified, as the revenue decline of 3% recently reported is much worse compared to its 5-year average growth rate of 25.6%. Considering the lofty valuation and the deteriorating growth rates, I believe there should be meaningful downside potential moving forward.
Investors Takeaway
I believe Align Technology is currently priced to perfection. The company will likely face increasing headwinds moving forward as competition intensifies and the economy deteriorates. The weakness was already shown in the latest earnings as revenue dipped amid slowing demand, and the guidance indicates little improvement. Despite having such a dire backdrop, the company's valuation remains unreasonably high and should present meaningful downside potential if the multiple reverts back to the historical average. Therefore I rate Align Technology a sell.
For further details see:
Align Technology Q1 Earnings: Way Too Expensive