Align Technology Inc (ALGN) — Q3 2022 Earnings Call Transcript

Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued third quarter 2022 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available today by approximately 5:30 p.m. Eastern time through 5:30 p.m. Eastern time on November 9. To access the telephone replay, domestic callers should dial (866) 813-9403 with access code 119351. International callers should dial (929) 458-6194 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliations, if applicable, and our third quarter 2022 conference call slides on our website under quarterly results. Please refer to these files for more detailed information. And with that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?

Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our Q3 results and discuss the performance of our two operating segments, System and Services and Clear Aligners. John will provide more detail on our financial performance and our view for the remainder of the year. Following that, I'll come back, summarize a few key points and open the call to questions. Our third quarter results reflect the continued macroeconomic uncertainty and weaker consumer confidence as well as significant impact from unfavorable foreign exchange rates across currencies that affect our operations. On a constant currency basis, total Q3 revenues were reduced by $25 million or 2.7% sequentially and $57.4 million or 6.1% year-over-year, one of the largest quarterly foreign exchange impacts in our history. We remain confident in the execution of our strategic growth drivers despite the continuing economic headwinds. In Q3, we reached our 14 millionth Invisalign patient milestone during the quarter, which includes nearly 4 million teenagers and kids as young as six years old, who have been treated with Invisalign clear aligners. In Q3, teen case starts of 200,000 were up 13% sequentially and just off slightly compared to Q3 '21 a year ago when a record 206,000 teenagers started Invisalign treatment. We're also excited to be launching significantly new products and technologies that further enhance the Align Digital platform. Leading the digital transformation are the practice of dentistry. During the quarter, we also began to commercialize ClinCheck live update software, Invisalign Practice App, Invisalign Personal Plan, Invisalign Smile Architect, the Invisalign Outcome Simulator Pro with in-face visualization, Cone Beam Computed Tomography integration with ClinCheck software Invisalign, virtual AI software and iTero-exocad Connector. These technology advancements represent an important expansion of our digital platform that we believe will help our doctor customers increase treatment efficiency and deliver superior clinical outcomes and patient experiences, positioning us to drive growth when the market inevitably rebounds. We'll be showcasing these innovations next month at the Invisalign Ortho Summit Las Vegas, the premier education and networking experience for Invisalign practices with the most peer-to-peer presentations of any Invisalign education event. Through Q3, Systems and Services, interest in our iTero scanners was good with increased product demos across the regions. Doctors are increasingly recognizing the substantial benefits of intraoral scanning and end-to-end digital workflows with the iTero scanner and imaging systems. At the same time, increasing inflation, rising interest rates and less patient traffic and dental practices are lengthening sales cycles and conversion time. For Q3, System and Services revenues of $157.5 million were down sequentially year-over-year. On a constant currency basis, unfavorable foreign exchange reduced Q3 '22 systems and services revenues by approximately $4.1 million or 2.5% sequentially and approximately $9.9 million or 5.9% year-over-year. For Q3, scanner services year-over-year revenue growth was strong across all regions, particularly due to increased subscription revenue driven by growth of the installed base of iTero scanners. Year-over-year growth also reflects increased sales of iTero warranties lease and continued growth of our scanner leasing rental programs. We continue to work closely with our doctor customers to support their practice growth and digital transformation goals. This includes understanding different ways to enable them to navigate the more uncertain economic environment. Over the past year, we've had good success rolling out new leasing programs in Latin America and certified pre-owned or CPO, as we call it, options in India and North America. We're also looking at new opportunities on the capital equipment side for our DSO partners. This is a natural progression in an equipment business with a large and growing installed base. As we introduce new products, there are more opportunities for customers to upgrade, make trade-ins and provide refurbished scanners for emerging markets. We expect to continue to roll out programs that are especially helpful for customers in the current macroeconomic environment. It's selling the way doctors and customers want to do business and leveraging our balance sheet. We're still early. We're pleased with the contribution of margin accretion we're seeing. For our Clear Aligner segment, macroeconomic uncertainty and waiting consumer confidence continues to impact the dental market overall, making for a challenging operating environment across the board. For Q3, third-party reports indicate there are fewer new patient visits, less traffic flow and lower orthodontic case starts overall. Our Clear Aligner volumes further reflect the underlying orthodontic market trends and a shift away from adults toward teens in Q3. Q3 Clear Aligner revenues were down 8.2% sequentially and down 12.5% year-over-year compared to Q3 '21 year-over-year revenue growth rates of plus 35%. On a constant currency basis, Q3 '22 Clear Aligner revenues were reduced by unfavorable foreign exchange of approximately $21 million or approximately 2.8% sequentially and approximately $47.4 million or approximately 6.1% year-over-year. For the quarter, Q3 Aligner volumes reflect a sequential increase in Invisalign shipments from Asia-Pacific and Latin America as well as North America Invisalign teen cases offset by lower volume in EMEA and North America, primarily Invisalign adult cases. For Q3, Invisalign First for kids as young as 6 grew year-over-year and was strong across all regions. On a trailing 12-month basis, as of Q3, Invisalign Clear Aligner shipments for teens and young kids using Invisalign First are up year-over-year to over 734,000 cases. For Q3, the total number of new Invisalign trained doctors increased sequentially 8.5% driven by North America and Asia-Pacific. In terms of Invisalign submitters, the total number of doctors shipped to for Q3 increased sequentially to 84,400 doctors, the second highest number this year, driven by Asia-Pacific and the Americas. From a channel perspective, ortho submitters were slightly year-over-year up, especially from doctors submitting teen cases, offset by a few GP dentists year-over-year, especially in EMEA. For other non-case revenues, which include retention products such as Vivera retainers, clinical training and education, accessories, e-commerce, and our new subscription programs such as our DSP, Q3 revenues were up both sequentially and year-over-year. This reflects strong growth in retainers sequentially and year-over-year growth across all regions, driven by more submitters. In the U.S., revenues for our doctor subscription program increased sequentially and year-over-year. I'm very pleased to see continued momentum in non-case revenues driven by subscription-based programs that we expect to continue to expand across the business. Now let's turn to the specifics around the third quarter results, starting with the Americas. The Q3 Invisalign case volumes for Americas were down sequentially single-digit percentages and primarily due to lower Invisalign bulk shipments. The environment remains challenging and feedback from our customers indicates consumer financing and patient no-shows affecting their practices in Q3, especially with adult patients. Q3 Invisalign volume also reflects increased case submissions from the orthodontic channel and sequential growth in the teen segment. For Q3, teen patients were most resilient, reflecting continued momentum in younger patients with Invisalign First as well as the new Invisalign Teen Case Pack. During Q3, Invisalign Teen Case Packs grew both sequentially and year-over-year. As a reminder, the Invisalign Teen Case Pack, a new subscription program that enables orthodontists to buy Clear Aligners and packs in advance. They also include exclusive practice development benefits with the Invisalign brand and require an incremental volume commitment from doctors. Teen case packs are currently available in the U.S., Canada, and France, and we expect to be expanded more in the EMEA region. Turning to our international business for Q3, Invisalign Clear Aligner volume was down very slightly sequentially, 1.4%, with strong sequential growth for APAC, offset by lower volume in EMEA. For EMEA, Q3 operating environment was challenging. Inflation in the Eurozone is more than 10% and global macroeconomic factors weighed on consumer sentiment and purchasing decisions, especially for adult patients, which compounded the impact of Q3 summer seasonality. Similar to the Americas, doctors in EMEA also reported increased appointment cancellations and the impact of fewer patients financing their purchases. EMEA teen patients also remained resilient in Q3, increasing sequentially in Iberia as well as France, where we introduced Teen case packs during the quarter. In APAC, Q3 sequential growth was led by China, Japan, and ANZ despite ongoing COVID restrictions and lockdowns in parts of China and Japan. On a year-over-year basis, Invisalign case volumes reflected increased shipments across almost all markets, led by Taiwan, Thailand, India, and Korea, driven by increased submitters. In Q3, APAC sequential growth also reflects strong demand from our expanded Invisalign Clear Aligner product portfolio in China. Recall in late April, Q2, we introduced two new products that better serve the expanding market in China. Invisalign Adult and Invisalign Standard Clear Aligners leverage our proven technology while broadening our appeal to more consumer segments. Q3 was the first full quarter offering these new products that provide doctors and patients in China with broader clinical and affordable options for moderate-to-complex adult cases. Finally, I'm pleased to share that the Invisalign system was recently awarded the Gold Design Award for 2022, making it the first orthodontic appliance to win the prestigious award in Japan. In the judge's assessment of the Invisalign system, they emphasized that the opportunity for teeth straightening is high in Japan and cited the barrier to adoption by Japanese consumers is resistance to metal braces and praised the Invisalign system as an orthodontic solution that can improve the quality of life during treatment. We certainly recognize the importance of the Japanese market for digital orthodontics and is one of the reasons we opened our first office in Tokyo nearly 15 years ago and established treatment planning operations in Yokohama a few years ago. Turning to new innovations. We continue to deliver on our technology road map. As I mentioned earlier, during the quarter, we began to commercialize several new products and services that we previously announced would come to market in the second half of 2022. These technology advancements illustrate our commitment to continuous innovation in digital orthodontics, and we remain excited about the transformational projects that we're working on as we continue to drive the evolution of our industry. No other dental company has the experience, including over 14 million patients treated to date, to lead the transformation of the practice of dentistry. Our consumer marketing focus on educating consumers about the Invisalign system and driving that demand to Invisalign doctor's offices ultimately capitalize on the massive market opportunity to transform 500 million smiles globally. In Q3, we built on our successful 'Invis Is' media campaign and continued our launch of the 'Invis Is trauma free' targeted at teens and 'Invis Is when everything clicks' targeted at adults. Our teen campaign, 'Invis is trauma free' highlights the benefits of Invisalign while humorously juxtaposing them with the significant trade-offs involved with using braces. Our 'Invis Is when everything clicks' campaign showcases Invisalign treatment transforming smiles and the resulting confidence it gifts young adults. During Q3, we had over 4.3 billion impressions delivered, resulting in 14 million visits to our website, a 1.6% year-over-year increase as a result of rightsizing our media investments. We're also rightsizing our consumer media investments across all core EMEA markets, impacting the impressions and unique visits. In the U.S., we continued our influencer and creator-centric campaigns, partnering with leading smile squad creators like Olympic Gold Medalist, Suni Lee, Michael Lee, Josh Richards, and Marsai Martin. Each of these creators shared their personal experience of Invisalign treatment and why they chose to transform their smile with Invisalign aligners. Most recently, Suni Lee shared her positive experience with Invisalign in major media programming including Good Morning America and people.com, resulting in over 93 million impressions. We continue to invest in consumer advertising across the APAC region, resulting in a 72% year-over-year increase in impressions and a 29% year-over-year increase in unique visitors. Our ongoing campaigns were omnipresent across the top social media platforms such as TikTok, Snapchat, Instagram, and YouTube to increase the awareness of the Invisalign brand with young adults and teens. In Q3, we launched a global plot on the Roblox platform within the popular game, Livetopia, creating a fun experience for players to learn about the benefits of Invisalign treatment. To date, we had over 5.9 million impressions delivered with over 2.6 million unique visitors on the game experience. Adoption of My Invisalign Consumer and Patient app continues to increase with 2.2 million downloads to date. Usage of our key digital tools also continued to increase. Live update was used by 41,000 doctors or more than 395,000 cases, reducing time spent modifying treatment by 18%, and the Invisalign Practice app has been downloaded 314,000 times to date. Further, we received more than 110,000 patient photos in our virtual care capability to date, providing rich global data to leverage our AI capabilities and improve our services for doctors and patients. The investments that we make to drive patient demand and conversion to support our doctor customers is unparalleled in our industry, leveraging the global recognition of the Invisalign system. No other dental company equals our brand strength today. For more details on our consumer marketing programs, please see our Q3 '22 earnings and conference slides. Turning to exocad. Overall, I'm very pleased with our progress with the exocad business and its leadership in restorative dentistry. In addition to the iTero-exocad Connector, I mentioned previously, during the quarter, we also introduced iTero NIRI, which is near infrared technology that allows intraoral camera images to be automatically imported into dental CAD when designing restorations, enabling technicians to visualize the internal and external tooth structure and optimize the process of margin line tracing. The new xSnap module is a model attachment for a printable 3D articulated system, featuring a spherical head, which allows a precisely executed movement. The Ivoclar's Ivotion Denture System, a complete workflow for digital production of high-quality removable dentures is now available on exocad. Together, the iTero and exocad product portfolios help accelerate the digital transformation of dental practices by facilitating the way doctors and labs collaborate to deliver better care for their patients. As part of the Align Digital platform, the integration of iTero's digital scanning and exocad's complete software solution delivers seamless end-to-end digital workflows from diagnosis to treatment planning and then fabrication. Customers are already utilizing the automated workflows, unlocking efficiencies and productivity, which are more important than ever in the current economic climate. With the recent integration of iTero NIRI and intraoral camera images unique to iTero Element 5D imaging systems and exocad Rijeka software release, Align is redefining restorative visualization and treatment planning for the doctors and labs. We are committed to continuing to innovate in the dental industry to drive efficiency and clinical excellence for the benefit of our customers and their patients. With that, I'll now turn it over to John.

Thanks, Joe. Now for our Q3 financial results. Total revenues for the third quarter were $890.3 million, down 8.2% from the prior quarter and down 12.4% from the corresponding quarter a year ago. On a constant currency basis, Q3 2022 unfavorable foreign exchange reduced Q3 revenues by approximately $25.1 million sequentially and approximately $57.4 million year-over-year. For Clear Aligners, Q3 revenues up $732.8 million were down 8.2% sequentially primarily due to lower volumes, unfavorable foreign exchange, higher promotions and discounts, and product mix shift, partially offset by higher additional aligners. On a year-over-year basis, Q3 Clear Aligner revenue was down 12.5%, primarily reflecting the aforementioned items, offset somewhat by per order processing fees and higher non-case revenues. On a constant currency basis, Q3 '22 unfavorable foreign exchange reduced Q3 Clear Aligner revenues by approximately $21 million or approximately 2.8% sequentially and approximately $47.4 million or approximately 6.1% year-over-year. For Q3, Invisalign ASPs for both comprehensive and non-comprehensive treatment decreased sequentially and year-over-year. On a sequential basis, the decline in ASPs reflects unfavorable impacts from foreign exchange as Joe described earlier as well as higher discounts and product mix shift, partially offset by higher additional aligners. On a year-over-year basis, the decline in ASPs reflects the significant impact of unfavorable foreign exchange, product mix shift and higher discounts, partially offset by higher additional aligners and per order processing fees. As our revenues from subscription, retainers and other ancillary products continue to grow and expand globally, some of the historical metrics that focus only on case shipments do not account for our overall growth. In our earnings release and financial slides, you will see that we have added our total Clear Aligner revenue per case shipment which is more indicative of our overall growth strategy. Clear Aligner deferred revenues on the balance sheet increased by $37 million or 3.3% sequentially and $184 million or up 18.6% year-over-year and will be recognized as the additional aligners are shipped. During the three months ended September 30, 2022, we recognized $137.2 million that was included in the Clear Aligner deferred revenue balance at December 31, 2021. The Q3 Systems and Services revenue of $157.5 million was down 8% sequentially, primarily due to lower scanner volume, partially offset by higher services revenues from our larger installed base and down 11.7% year-over-year, primarily due to lower scanner volume and lower ASP, partially offset by higher services revenue from our larger installed base. Q3 '22, Systems and Services revenue was unfavorably impacted by foreign exchange of approximately $4.1 million or approximately 2.5% sequentially. On a year-over-year basis, System and Services revenues were unfavorably impacted by foreign exchange of approximately $9.9 million or approximately 5.9%. Systems and Services deferred revenues on the balance sheet was up $4.1 million or 1.6% sequentially and up $76.5 million or 40.9% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenues included with the scanner purchase, which will be recognized ratably over the service period. During the three months ended September 30, 2022, we recognized $13.3 million that was included in the Systems and Services deferred revenues balance as of December 31, 2021. Moving on to gross margin. Third quarter overall gross margin was 69.5%, down 1.4 points sequentially and down 4.8 points year-over-year. Overall gross margin was unfavorably impacted by approximately 0.8 points sequentially and 1.8 points on a year-over-year basis due to the impact of foreign exchange on our revenues. Clear Aligner gross margin for the third quarter was 70.9%, down 2.4 points sequentially due to lower ASPs and increased manufacturing spend as we continue to ramp up operations at our new manufacturing facility in Poland. Clear Aligner gross margin for the third quarter was down 5.3 points year-over-year due to increased manufacturing spend for the reasons stated previously, higher freight, and a higher mix of additional aligner volume and lower ASPs. Systems and Services gross margin for the third quarter was 63.3%, up 3.6 points sequentially due to improved manufacturing absorption and lower freight costs. Systems and Services gross margin for the third quarter was down 2.3 points year-over-year due to higher inventory costs and manufacturing inefficiencies coupled with lower ASPs, partially offset by higher service revenues. Q3 operating expenses were $475.5 million, down sequentially 4.8% and down 3.7% year-over-year. On a sequential basis, operating expenses were down $23.9 million, mainly due to controlled spend on advertising and marketing as part of our efforts to proactively manage costs. Year-over-year, operating expenses decreased by $18.5 million for the same reasons as sequential as well as lower incentive compensation. On a non-GAAP basis, excluding stock-based compensation and amortization of acquired intangibles related to certain acquisitions, operating expenses were $443.4 million, down sequentially 4.8% and down 4.9% year-over-year. Our third quarter operating income of $143.7 million resulted in an operating margin of 16.1%, down 3.3 points sequentially and down 9.6 points year-over-year. Operating margin was unfavorably impacted by approximately 1.6 points sequentially due to foreign exchange and lower gross margin. The year-over-year decrease in operating margin is primarily attributed to lower gross margin, investments in our go-to-market teams and technology as well as unfavorable impacts from foreign exchange by approximately 3.5 points. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles related to certain acquisitions, the operating margin for the third quarter was 20.2%, down 3 points sequentially and down 8.6 points year-over-year. Interest and other income and expense net for the third quarter was a loss of $21 million compared to a loss of $14.6 million in Q2 and an income of $0.8 million in Q3 of '21, primarily due to larger net foreign exchange losses from the weakening of certain foreign currencies against the U.S. dollar. The GAAP effective tax rate for the third quarter was 40.7% compared to 35% in the second quarter and 30.9% in the third quarter of the prior year. The third quarter GAAP effective tax rate was higher than the second quarter effective tax rate primarily due to the decrease in profits and changes in jurisdictional mix of income, resulting in lower tax benefits from foreign income tax at different rates and higher than in the U.S. On a non-GAAP, our non-GAAP effective tax rate was 33.1% in the third quarter compared to 25.6% in the second quarter and 22.2% in the third quarter of the prior year. Third quarter net income per diluted share was $0.93, down sequentially $0.51 and down $1.35 compared to the prior year. Our EPS was unfavorably impacted by $0.30 on a sequential basis and $0.48 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $1.36 for the third quarter, down $0.64 sequentially and down $1.51 year-over-year. Moving on to the balance sheet. As of September 30, 2022, cash, cash equivalents and short-term and long-term marketable securities were $1.1 billion, up sequentially $163.8 million and down $96.8 million year-over-year. Of the $1.1 billion balance, $471 million was held in the U.S. and $670 million was held by our international entities. Q3 accounts receivable balance was $859.6 million, down approximately 7.8% sequentially. Our overall days sales outstanding was 86 days, flat sequentially and up approximately 11 days as compared to Q3 last year. Cash flow from operations for the third quarter was $266.5 million. Capital expenditures for the third quarter were $75.3 million, primarily related to our continued investments to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures amounted to $191.1 million. We are well capitalized to continue to invest for growth while managing through these challenging market conditions, exiting the quarter with over $1 billion in cash on the balance sheet and no debt. Now turning to the full year 2022 and the factors that influence our views on our business outlook. Underlying market dynamics as well as the reactions to macroeconomic headwinds by central banks, governments and consumers remain uncertain. We will continue to focus on those matters that have been central to our historically successful business strategies by managing those things within our control. This includes maintaining fiscal controls and focused delivery on our business model so that we are positioned for success once the difficult operating environment ultimately abates. We remain confident in the huge underpenetrated market for digital orthodontics and restorative dentistry, our technology and industry leadership and our ability to execute and make progress toward our long-term model of 20% to 30% revenue growth. We expect to be below our fiscal 2022 GAAP operating margin target of 20%, which includes the impact from the current unfavorable foreign exchange of approximately 2 to 3 points that was not factored into our operating margin guidance for the fiscal year 2022 when we gave an update on the Q1 '22 earnings call in April. For 2022, we expect our investments in capital expenditures to exceed $300 million. Capital expenditures primarily relate to building construction and improvements as well as additional manufacturing capacity to support our international expansion. This includes our investment in the aligner fabrication facility in Wroclaw, Poland, which began servicing doctors in the second quarter of 2022. In addition, during Q4 2022, we expect to repurchase up to $200 million of our common stock through either or a combination of open market repurchases or an accelerated stock repurchase agreement. With that, I'll turn it back over to Joe for final comments.

Thanks, John. As we continue to navigate macroeconomic uncertainty, weaker consumer confidence and the lingering impacts of COVID-19 shutdowns primarily in China and Japan, we remain focused on our strategic initiatives as well as the incredible market opportunity for digital dentistry and our products. We believe our unwavering drive to transform smiles and change lives for millions of people around the world is unmatched by any other clear aligner company and positions us to better address this market opportunity. Regardless of the operating environment, we are committed to balancing investments to drive growth and long-term strategic priorities that will transform the practice of dentistry and strengthen our business. These are uncertain times. Every business is being impacted by macroeconomic environmental uncertainty. In addition, as a multinational company based in the United States with roughly half of our sales outside the country, the negative impact from unfavorable foreign exchange has been like anything I've ever seen in my career. We will continue to invest in digital solutions and demand creation to help doctors and their patients. We are committed to doctor-directed care and transforming the industry together while working through these global macroeconomic challenges. Thank you for your time today. We look forward to updating you on our next earnings call. Now I'll turn the call over to the operator for questions.

Joe, from what we've seen and heard in the market, I think it goes without saying that monthly demand has just been quite choppy here in the U.S. I think July and September were pretty soft, August maybe not as weak, but still not great. I guess, did you see a similar level of uneven demand when we look outside the U.S., and I guess is there anything you'd call out geographically or in any of your channels that was maybe less bad than what you were prepared for three months ago?

We started with low expectations initially. However, the U.S. market performed as we expected overall, with slightly more strength in Latin America, showing some momentum despite the elections and economic factors there. Europe didn’t meet our expectations; the uncertainty in Europe and the situation in Ukraine have contributed negatively. In Asia, we are facing COVID impacts again. We experienced growth in China, which was respectable, and also in Japan, but the market was affected in those regions as well. I felt positive about the smaller parts of our business in Korea, Taiwan, Thailand, and others that showed significant growth, but our main markets—Australia, China, and Japan—were still impacted by COVID issues. Overall, we anticipated our current position and hoped for a better year. What's particularly notable is the strong teen demand worldwide, including in the U.S. The teen packs performed well, and we plan to expand that to other regions. The impact on the adult segment, however, was surprising, which is evident in the orthodontic and general practice communities, not only in the U.S. but across the globe.

Joe or John, regarding the margin topic, it seems you're moving away from the 20% margin floor commentary you previously mentioned. I understand that part of this is related to foreign exchange. Could you discuss how much of this is influenced by the decremental effect of lower volumes? I know it's a challenging macro environment to predict, but many investors are trying to understand how stable margins and profitability might be as we approach 2023. I hope it won't be the case, but it could be another difficult year for the business given the current global macro conditions. Are you able to provide any guidance on what to expect for 2023 margins? Or perhaps you could elaborate on how much flexibility you have in the profit and loss statement to mitigate pressures from lower volumes?

Jason, it's a fair question. First of all, I'll turn it over to John, but I'm going to give that 20% operating margin piece. I had no idea. You'd see international currency swings, and the way we've seen it. I've been in these jobs for a long time and you don't expect 25% decreases year-over-year in currency. And so obviously, we had to back up on that piece. I feel good about the way we manage our cost; I feel good about where we're investing and where we continue to right-size. John will give you more specifics.

On a constant currency basis, we expect to achieve 20% or more. As Joe mentioned, the changes in foreign exchange have been significant. We previously noted that this will impact the year by 2 to 3 percentage points. We remain committed to that margin and are investing based on the volume we anticipate, as well as our priorities in research and development and go-to-market strategies. However, the foreign exchange aspect is something we want to emphasize. Still, on a constant currency basis, we believe the 20% target remains achievable.

I wanted to go back for a moment to the monthly progression, as it might help us understand the underlying market dynamics, particularly comparing the Americas to international markets. What were you observing throughout the quarter, and as we exited the quarter and moved into Q4, were things stabilizing, improving, or getting worse? Any insights you can provide about the situation as we move forward from Q3 would be appreciated.

Brandon, similar to our previous call, I believe things unfolded as we expected. We discussed the performance of the teen segment in the third quarter, which is typically a strong period for them. The results were in line with our expectations. As we mentioned earlier, we feel that teens are somewhat insulated from the economic climate, thanks to the support they receive from their parents during this phase. On the other hand, the adult segment experienced the most fluctuations, particularly in the United States, Europe, and Asia. It's challenging to indicate any significant changes from month to month or quarter to quarter; the patterns have remained relatively consistent. John, do you have anything to add?

I mean that's how we saw it. Okay. And then internationally, you guys sound pretty excited about kind of the new product launches within China, specifically offering that new maybe lower-tier product. Can you just talk a little bit about what you're seeing there? How strong has the recovery been in China? How much of that recovery has come from really opening up the product portfolio there? And how should that kind of continue going forward?

That's a great question. China is a very significant market for us. As we have mentioned in previous calls, targeting Tier 3 and Tier 4 cities has been crucial. For about two years, we've recognized a gap in our product offerings in those areas. We have a comprehensive product and a more moderate one in between. We introduced Invisalign standard and Invisalign adult to help us better segment the market. These products are designed for moderate cases, focusing on areas where public hospitals have had a strong presence. We observed positive results from the uptake over the last quarter and will maintain this strategy. We are optimistic about it.

And it's about market expansion there. We're selling to more doctors than we've sold to in the past with these products. So we are really trying to capture more of that market, as Joe said, into Tier 3, Tier 4 cities, and we saw good uptake from that. It's something that we know to go to the market and be able to reach these potential customers. These are the types of products that we need.

Yes. So Brandon, I think honestly, I feel really good about our positioning there. China did perform well from a volume standpoint, and we'll continue to update you on our progress.

Maybe just first for me. The 3Q '22 ASP of 1150 versus 1220, so I'm calculating down 6% Q-over-Q. Some of that's FX, but I think if I look at your comments, it seems like half of that 6% headwind is FX. And John, I know you said mix, but I'm counting that teen was about 35% of your 3Q '22 cases versus 30% of your 2Q '22 cases and teen is a high acuity comprehensive ASP. I would think DSP is also helping pull out some of the lower ASP cases as DSP ramps quarter in, quarter out. So can you just help me with the ASP movement, what else was it outside of FX? And if it was mix, why mix based on my teen commentary?

Yes, I think you've hit the major pieces, John. When you look at it, the majority was FX. We saw the dollar strengthening, that obviously hits our numbers. And then you look at the other parts, we do have a higher proportion of teen in the third quarter, and that's a help. We also have things that we've done like we answered on the previous call about mix in China and expansion out, and there's offsets to that. But it's primarily FX and then you have some mix. But from a discounting standpoint, or other things, there was really no overall change to how we've done stuff. It's primarily the FX piece and the mix.

John, one other thing to add to that, too, on the DSP program, we look at that as incremental, not as replacing other business that we've had in the past. So like we feel good that's an expansion play for us. And I think you see that in the numbers too.

So maybe just quickly on that last point, Joe. Question B would be, you don't really think any cases are being pulled out of the case volume number into DSP that's actually having an incremental negative impact to '22? Do you think those are just truly largely incremental? That was 1B, just to be clear.

Yes, I think you learn a business, John, never be binary, either or. I'd say the majority of those cases, if you look at it, we're picking up from an ortho standpoint, a lot of retention we never had before. We see orthos doing touch-up cases, and all that might have been done in-house at times. So I'm not saying that there's absolutely nothing that would transpose from one to another, but I'd say primarily, we're looking at that as a growth opportunity for us.

And then the last question, which is where I have the most difficulty. I think it's a bit irrelevant, but my perspective on teens versus how you have positioned it, with all due respect. I understand that there was good sequential growth from the second quarter to the third quarter, but when looking at the first quarter to the third quarter, it was actually below trend on a four-year average, excluding 2020. Joe, if we could explore that a bit more, teen case volumes were still down 3% year-over-year. The whole narrative revolves around taking approximately 200 basis points of market share annually in this market. What do you estimate the overall global teen case volume was if you were down 3%? The key questions revolve around market share gains and whether you still feel you have momentum in that area or if it has slowed recently, and what could help re-accelerate it?

Yes, John, that's a good question. When comparing the first quarter to the second quarter, we need to remember the usual rhythms and seasonality we've experienced in this business, which have not been the same since 2019. We've seen muted signals regarding teens throughout 2020 and 2021. What I found encouraging in the third quarter was the return of teens in a pattern typical for teen season during Q3 and Q4. It's early for me to analyze the data and determine our market share against wires and brackets. We don't discuss specific products often, but I want to highlight the positive results we're seeing with the Invisalign First product line for young patients aged 6 to 9 years old, particularly in Phase I and Phase II treatments. The Phase II treatments are often less complex than the Phase I treatments that used wires and brackets, including our various expansion devices. We're seeing significant growth in that product line from a teen perspective, which we consider a penetration increase. We have also observed consistent growth in our share of teen cases globally. Additionally, we recently introduced curved wings for mandibular advancement, which has started off well in the market and addresses some cases that previous mandibular advancement methods could not handle. With our technology, advertising campaigns, and teen packs, I remain optimistic about our progress. We will provide more information as we analyze trends and share dynamics, but I feel confident about our position in the teen market.

Just a question on just OpEx and how you're managing headcount, whether you pulled back in any parts of the business globally? And maybe just talk about the levers that might be at your disposal if the environment continues to deteriorate and maybe if there are some areas that would be ring-fenced as far as potential cuts.

Ben, it's Joe. Look, first of all, what I protect with my life here are our direct salespeople and also our technology and our engineering team and what we focus on. And so we've made sure that we continue to reinforce those. There's just other parts of our business too that we right-sized. I mean, obviously, this business is used to growing 20%, 30%. And so we kind of came into the year with that mindset. We quickly realized it wasn't. And so we've taken actions in order to do that. But you see that throughout the business. Don't forget, we also have really strong productivity programs and manufacturing and all, that really help us during these times. Emory and his team do a terrific job; they help to drive that. John will give you another insight in a sense of how we're managing OpEx across the business.

We have good insight into our P&Ls across the world. So we're looking at country by country in certain regions and so on. And like Joe said, from an overall focus, we want to make sure that we're going to market and protecting the sales, make sure our R&D technology is putting out the best products and the best technology going forward. So we protect that. And then we look at what expenses make sense in the short and long term in various regions, various campaigns that we have to make sure that we're getting the return that's appropriate given the market conditions. So we're constantly iterating and changing things. It's no different on the other side of things. When a year ago, we were looking at the growth opportunities, we're looking at it the same type of way kind of on a country-by-country, market-by-market basis is just the other way as it is now. So we feel like we have a good understanding of our return on investment and a good understanding of the levers that we need to pull or not pull given these conditions.

And then John, just one follow-up. Can you help me just kind of understand what's going on with the inventory line and why that continues to grow year-over-year and sequentially? Is there something tied to the new European fab facility that may be driving that? And what we should expect on that line in the next few quarters?

Yes, I think we're reaching a point where some of the inventory increase is due to the addition of a third manufacturing site, which comes with its own raw materials and in-process inventory. Additionally, on the iTero side, where we are manufacturing and securing supply, we have a solid plan in place for our components. We've acquired several components to ensure we have enough supply to meet our forecasts. Overall, there's nothing unusual aside from the expansion related to new manufacturing and our efforts to secure our supply lines, which is reflected in our numbers.

So Joe, I want to pin you down a little bit on a couple of things, if I could here that questions that have been asked. And on the teen packs especially, I mean, look, we know there were so many adult cases last year with the assume a factor, whatever we want to call it and stimulus spending and all that. But the teen number is obviously the important number. I think we're all trying to focus on here. The down 3% I think is what you said year-over-year, up sequentially. That's down 3% year-over-year on teen cases globally. I mean, how do you feel like that compares to the overall ortho market? Were you better or worse than other teen cases done with brackets and wires when you throw in other clear aligners from the competitors, things like that? Just how are you competing in that teen market right now?

It's a valid question, Jeff. To start, I'll address Europe. Our performance there declined significantly, and we haven't received a clear signal from the economic conditions. Overall, we performed reasonably well in Europe, but typically, the third quarter is not strong for us there. Looking at the United States, Gaidge Data shows that while aligners were down, Invisalign outperformed the generic aligners, indicating that we are still performing well with our teen portfolio. Additionally, there’s an increase in wires and brackets cases. This suggests that orthodontists are focusing less on adults, creating a mix phenomenon that makes it seem like they are doing more with wires and brackets. Moving on to Asia, I have always considered Asia to be diverse by country. The COVID situation in Japan and China has affected things, but I believe the teen case volume remains reasonable. However, it’s still challenging to extract clear signals amid the noise from COVID shutdowns in those regions. Just like I mentioned in response to John's question, I am optimistic about our product portfolio and our strategy. I believe the teen packs align well with how doctors wish to approach this market, and I expect to see continued strength in that area. The future for teen cases undoubtedly lies in digital innovations, and our challenge is how we approach this, the products we introduce, and demonstrating to doctors that teens will adopt these solutions while showcasing the results we're achieving worldwide.

Well, on the doctor shipped to, what we've done is consolidate them together to a total. And what we saw, if you looked at international versus domestic, they're both up. And the numbers that we had. This is actually our second-highest ever from a shipped-to standpoint. But we decided to consolidate those together without giving too much more details on that. But they're both up.

Sequentially, John, just to be clear?

Yes, yes, correct.

Yes, on a sequential basis. Regarding volume-based purchasing in China, we are closely monitoring the situation, Jeff, as you can imagine. This segment accounts for approximately 15% to 18% of our operations there. The framework they are establishing primarily targets areas outside of our core markets in China. I believe we are well-positioned to navigate this. Having experience in other medical device companies, I understand the impact this could have on products like stents and hip transplants. The setup indicates that 70% of this procurement will be volume-based in those specific areas, while 30% will remain at the discretion of doctors regarding their preferences and usage. It is crucial for us to leverage our product portfolio and capabilities in that market to achieve a strategic advantage. I do not anticipate any significant changes as we move into 2023, and we will have to monitor developments into 2024 and 2025 to see how government actions unfold.

I guess my first question is just on equipment line. I noticed you sort of talking more about leased equipment in the quarter. Can you sort of talk about how that's been growing and sort of what contribution that made to the equipment revenues in the quarter?

Yes, I can start with that. It's obviously a strategy that we have. We've got great equipment, great products, and we want to be able to get those to our customers in a way that they want to buy. Sometimes those doctors of ours don't necessarily want to purchase it outright. They want to try other things. And so we've tested in certain markets just alternatives, kind of the rental model and so on. And we see good uptake. We see them these doctors now wanting to get a scanner to be able to digitize their practice. So it's really at an early stage right now, Elizabeth, but it is something that when we think about how we want to go to market, we want to offer alternatives such as leasing or expanding rental or other parts of our business are going to see the certified pre-owned where you have upgrades and other things that happen as we have a larger and larger installed base, we're going to get some of that equipment back. We want to be able to have a mechanism to use that equipment, use it in other places, and give our customers alternatives, both in terms of the equipment that they can purchase from us and then how they purchase and use that equipment from a financing or maybe leasing or rental options. And we think that they'll end up using our equipment more and more. And then we know that helps from a digital standpoint when they use their equipment and then they'll end up using more Invisalign. So it all kind of works from an ecosystem standpoint.

And then just in terms of on the P&L, like one of the things that obviously saw the change in SG&A spend in the quarter and how you pulled back on spending there. What about on the R&D line? Do you sort of see an opportunity to pull back on R&D as well going forward? Or is that something you're sort of keener to defend going forward?

Elizabeth, it's Joe. We want to defend R&D. It's a very important part of the business. You can see the programs are rolling out. The programs we're rolling out, we didn't do them this year, right? Some of these are 3-year-old programs that we've been working on. And so I don't want to stop the momentum on those. I mean obviously, we'll take any steps here to preserve the cash flow and integrity of this business that we have to do. But our front lines are our sales organization and technology. And before we go anywhere near those, we want to make sure we do everything we can, the right size of business in other areas.

And then just in terms of my 2B question, in terms of what you're seeing through the month of October so far, if we're sort of thinking about how the cadence of 4Q is shaping up, which is to expect like the cases to be sort of flat sequentially at this point based on what you're seeing? Or how do we think about sort of where we are now?

Kind of anticipating that question is, we're not seeing any major change, I'd say, from the momentum that we saw in the second quarter.

If I could return to the topic of margins for a moment. You indicated that the target for this year remains unchanged on a constant currency basis. If I could rephrase my question, if there are no further changes in foreign exchange rates or the overall demand environment, do you believe the 16% margin observed this quarter on a GAAP basis is a reliable indicator for what we should expect moving forward, assuming the underlying conditions remain consistent?

I wouldn't take that. I think when we're talking about for the full year, we're kind of looking at that on a constant currency basis, that 20%. And I think you have impacts with the Poland startup and some other things in the quarter that are impacting that. But when we look at the 20% and what we were calling earlier in the year, we were thinking about that less about the quarters, but more on a total year basis on a constant currency basis.

Okay. And the FX headwind for the year on margins is that 2% to 3%?

That's the way to look at it, Nate. We're currently using the latest FX rates available, but it's difficult to predict what will happen in the next two months. However, based on our current situation and our performance throughout the year, we estimate a 2- to 3-point impact from these rates. Without considering the FX rates, our GAAP numbers would have been around 20%, as we previously mentioned.

If I could just ask a quick follow-up. Joe, I think you had noted less willingness of consumers to finance treatments in both the U.S. and Europe. How big is that as a percent of case volumes in terms of what's typically financed? And how much in particular kind of might have this weight on demand? And I guess, bigger picture, are there ways kind of in this environment that you kind of see as maybe being best able to stimulate demand just in terms of how you might either help customers or doctors in this environment?

Yes, Nathan, I think what we gave you is basically data that we receive from the marketplace. It's what we're hearing from orthodontists and dentists in general in treatment. We don't have any quantification to say so many patients were seeking funding, they didn't get it or there's so many losses in that sense. That's pretty much listed as the reasons why patients have refused treatment or thinking about treatment in the financial considerations of it. John, would you?

No, I think there will always be a mix. Some patients will pay for everything upfront, while others may seek financing either through their doctors or external groups. This will likely continue. We are working with our doctors to provide them with some financial flexibility so that when they have payment options available for us, they can potentially pass some of that support on to their patients to help them manage their cash flow. We recognize this situation and do what we can. However, it's an ongoing issue. As Joe mentioned, we cannot quantify it, but we understand that in tougher economic times, patients will look for different alternatives.

And the other part of your question, Nick, about how do we help accounts. We watch payments. We try to help in that sense at times. We try to drive direct Invisalign docs to do a lot of Invisalign. And obviously, our advertising is extremely important to them. So we have our whole lead program to help them drive those things. We just want to be as close to our customers as possible because they're feeling what we feel. And we have strong relationships with many of them, and they're part of the family here. We work it country by country, doctor by doctor, region by region to see how we can help.

Operator, we'll take one more question, please.

So may have found a little bit on the comment around October, saying that the momentum continued. If we think about that, that was sort of down 12%, right, year-over-year. I think what we're all looking for is we saw cases flat Q1 to Q2. And then we saw a step down in Q3 despite a stronger teen season. So I think what we're all trying to figure out here is adjusting for the third quarter strength, seasonality in teen, when do you actually expect to see stabilization globally in cases, meaning either sequentially or year-over-year flatness? Like when do you actually expect that, that could happen?

Kevin, it's Joe. Look, I think we can sit here and tell you, I think we're in pretty volatile economic times. I can't tell you what the dollar is going to be in three months. I don't know what's going to happen in Europe. I don't know how bad COVID hits China. I don't know what it does in Japan. So I know exactly what you're asking for and every investor is asking for. And we'd give you that data if we thought we had it, but we are in such a volatile time right now. We're just working this thing from month to month. As I mentioned, as we go into the fourth quarter, obviously, there's a rhythm between teens and adults from the third quarter to the fourth quarter. What I mentioned from a continuation standpoint is we haven't seen much of a change between the third and the fourth right now as we move into it. That's about as well as I can tell you of what we're seeing and what we're experiencing; trying to forecast what's going to happen toward the end of the quarter, next quarter, I can't do that. I don't think anybody here can.

If I could just ask a follow-up. There's been a lot of discussion around spending and margins in the 20% range and more. Historically, you have always invested to grow. Given the current uncertainty, are you now focused on managing to a margin or aiming for the 20% margin excluding foreign exchange? Is that your strategy, or are you still aiming to achieve the growth targets you normally have?

It's a growth business, Kevin. If we were experiencing better economic conditions, our conversation would be very different. The challenge we face is managing costs responsibly in a difficult demand environment, which has positioned this company strongly, as historically, markets rebound sharply. We need to ensure we are well-prepared to capitalize on that rebound when it happens. Therefore, you'll see us being fiscally responsible while still investing and making necessary adjustments in various operational areas to safeguard crucial aspects like customer interactions, technology development, and operational capacity when demand returns. This approach applies not only to manufacturing aligners but also to servicing customers across the board. We'll find a good balance in our leadership strategy.

Well, thank you, everyone, for joining us today. We appreciate your time and look forward to speaking with you at upcoming financial conferences and industry meetings, including the Ortho Summit in Las Vegas next month. If you have any further questions or follow-up, please contact our Investor Relations team. Have a great day.