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A major player in the malocclusion market, Align Technology’s (ALGN - Analyst Report) shares plunged 7.47% to close at $35.41 yesterday, following the release of its preliminary third quarter results that missed the Zacks Consensus Estimates on both fronts. The company also provided a poor fourth quarter guidance which is a matter of grave concern. 

The situation is turning critical as Align is currently conducting a goodwill impairment test of Cadent’s business that it acquired for $190 million last year. Disappointing performance of scanner and CAD/CAM services business and the termination of the distribution agreement with Straumann in Europe forced the company to go for this goodwill impairment test. Straumann used to market Cadent’s product iTero intra-oral scanners in Europe and North America. Final decision will be reflected in the fourth quarter result.

Prelim Results

Align’s preliminary third quarter 2012 net income was $24.3 million (29 cents per share), considerably higher than the year-ago level of $19.3 million (24 cents per share). However, after adjusting for certain one-time items from both the quarters, adjusted earnings came in at 28 cents (within the company’s guidance range of 27−29 cents), missing the Zacks Consensus Estimate by a penny but ahead of the year-ago quarter’s result by the same magnitude.

Total revenue increased 8.4% year over year to $136.5 million in the quarter but was way below the Zacks Consensus Estimate of $140 million. It also missed the company’s guidance band of $136.8−$140.8 million.

Align operates in two segments, Clear Aligner (product: Invisalign system) and Scanner and CAD/CAM Services (products include iTero and iOC intra-oral scanners and OrthoCAD services). Total Clear Aligner revenue came in at $126.7 million, up 10.8% year over year, driven by case shipments of 92.5 thousand (up 24.8% year over year) during the quarter. Invisalign teenager case shipments increased 21.5% year over year to 24.5 thousand. However, the company was disappointed with its soft Scanner and CAD/CAM services revenues which were $9.8 million in the reported quarter, down 15.5% year over year.

According to the company, more prominent summer seasonality for capital equipment purchases acted as a dampener for its third quarter performance as North American GP Dentists and International doctors were irregular in this period due to summer vacations. Align expects this softness to continue through October which will be reflected in the next quarter’s performance as well.

The company recorded 70.7% of the total Clear Aligner sales from North America orthodontists (up 15.1% year over year to $43.1 million), 34.0% from North American GP Dentists (up 10.1% to $46.5 million), 23.4% from international (up 4.8% to $29.7 million) and 5.9% from non-case revenues (up 19.2% to $7.5 million).

During the quarter, gross margin expanded 10 basis points (bps) year over year to 73.5%. The company witnessed 5.2% increase in sales and marketing expenses to $36.5 million; 10.6% rise in general and administrative expenses to $23.9 million and 11.5% increase in research and development expenses to $9.9 million. Operating margin of 22.0% was up 40 bps year over year.

Align reported international average selling price (ASP) of $1,355 versus $1,560 in the year-ago quarter. The lower ASP resulted from advantage rebate, promotional activity, product mix combined with unfavorable foreign exchange rates. Blended pricing slipped 4.9% to $1,320.

Align exited the quarter with $328.0 million in cash, cash equivalents and marketable securities compared with $248.0 million at the end of fiscal 2011.

Guidance

Align provided its outlook for the fourth quarter of fiscal 2012 with net revenue of $134.2−$137.8 million, much lower than the current Zacks Consensus Estimate of $148 million. For the quarter, Align expects Invisalign clear aligner case shipments to be in the range of 90.0−93.0 thousand cases (year-over-year increase of 9.0% to 12.6%).

Also, the company expects adjusted EPS in the range of 21−23 cents. The Zacks Consensus Estimate of 31 cents remains far ahead of the guided range.

Our Take

We are disappointed with both the preliminary third quarter result as well as lower-than-expected fourth quarter guidance of Align. The termination of the European distribution contract also added to our concern. We remain worried about the current economic uncertainty which continues to cast a negative impact on dental procedures because of its elective nature. Moreover, the company faces significant competition from players such as 3M (MMM - Analyst Report), Danaher Corporation (DHR - Analyst Report) and Dentsply International (XRAY - Analyst Report).

However, we believe that based on its several strategic initiatives, Align will successfully overcome these headwinds. Banking on its core product, Invisalign, the company witnessed balanced sales growth across all its channels. In a recent development, the company introduced its next generation of Invisalign clear aligner material SmartTrack. The company expects SmartTrack to become the standard Invisalign aligner material in the first quarter of 2013 for Invisalign products worldwide. Over the long term we have an ‘outperform’ recommendation on the company.

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