[ALGN – Align Technology] Process Advantages

“A lot of guys watch Bruce Lee movies. Doesn’t mean they can do karate.”

– Bobby Axelrod (Showtime series Billions)

If I were pitching this stock as a short 9 years ago, here’s what I would have said: Align’s main product, an expensive orthodontic appliance called Invisalign, is a joke.  Rendered in plastic, easily replicable, and incapable of treating complex cases, Invisalign is competing for a limited share of malocclusion cases.  Parents will not settle for an inferior, unproven remedy for their teenagers, who make up 75% of annual orthodontic case starts.  Moreover, the product offers inferior unit economics to orthodontists, who are, in any case, loyal to the wire and brackets they have been trained on.  Finally, the company is buffeted by intensifying competition from aligners manufactured by distribution giant Danaher and standing on the edge of several patent cliffs.  All these factors, when combined with a lofty valuation atop 25% EBITDA margins, sets the stock up for calamity.  But I suspect that behind all the well-reasoned objections to the stock was a visceral disbelief that a moat could possibly be found around these:

The first thing to understand is that Invisalign serves two constituents: consumers who need their teeth aligned and the doctors who treat them.  Just as Allergan relies on plastic surgeons to push Botox, so too does Align depend on orthodontists (who specialize in malocclusion cases), and dentists (jacks of all trades who focus more on restorative work), to recommend Invisalign to their patients.  But doctors are resistant to change what’s already working and won’t adopt a novel treatment solution unless it delivers comparable patient outcomes and makes them more money.

This was a problem for Align in its early days. 

The notion that you could effectively move teeth using a series of plastic trays seemed, on the surface, ridiculous and maybe even insulting to orthodontists who devoted years to honing the craft of manipulating wires and brackets.  Invisalign was widely perceived as a gimmicky aesthetic tool of dubious merit, not a serious orthodontic appliance.  And with clear aligners relegated to simple Class 1 malocclusion cases, that opinion was partly justified.  Meanwhile, the lab fees that doctors paid for an Invisalign case were 4x-5x more than what they spent on wires and brackets (~$1,000-$1,500 depending on volume vs. $300-$400), a cost difference that doctors were unsure could be passed on to patients.

But doubters be damned, Align poured substantial sums into developing the category and creating awareness.  As consumers became aware of the Invisalign brand, the product got better at treating more complex cases.  Mounting demonstrations of successful outcomes and growing volumes of patients asking for Invisalign by name could no longer be ignored.

Once efficacy was established, the benefits of clear aligners over braces were glaringly obvious: aligners didn’t erode enamel or leave white lesions as wire and brackets did, and could be easily removed for meals, social events, and selfies¹.  And as caseloads grew, Invisalign’s merits also became clear to doctors, who realized that Invisalign could be more lucrative than braces since it required fewer patient visits and shorter treatment times².  Relative to traditional braces, which consumed mostly doctor time valued at ~several hundred dollars / hour (to bend this and tighten that), Invisalign cases leaned more heavily on assistants, whose time was valued at ~$20/hour, though this claim is a matter of minor dispute.  In any case, at sufficient volumes – volumes begot through better product efficacy and growing brand awareness – Invisalign cases are far more lucrative per hour of chair time than braces³.

As more patients have asked their orthodontists for Invisalign, orthodontists, satisfied that Invisalign works, have bet on Align’s systems and treatment protocols and in turn, started recommending Invisalign for their patients.  Today, Invisalign is synonymous with clear aligners the same way Kleenex is with tissues, Xerox is with photocopies, and Google is with search.   

But even as Invisalign was gaining traction, there were festering questions about how easily a competitor could replicate Align’s intellectual property.  For most of its life, Align has been entangled in one serious IP imbroglio or another.  OrthoClear, co-founded by an Align founder in 2005, was sued by Align for IP theft and patent infringement before the two finally settled in 2006, with OrthoClear receiving $20mn in return for shutting down operations, transferring all its IP to Align, and having its senior officers sign 5-year non-competes.  A few years later, Align would be in the hot seat, settling patent infringement claims lobbed at it by Danaher, paying $13mn in cash and shares representing nearly 11% of the company.  And since 2011, when Align first sued ClearCorrect for infringing on its patents and (allegedly) pricing beneath its costs, the two have been engaged in ongoing, back-and-forth litigation, each side celebrating sundry wins along the way⁴.  The notion that Align’s patent/IP edifice would crumble, ushering in a deluge of competition, has long lurked in the shadows of just about every ALGN short thesis.  That possibility seemed inevitable starting in 2017, when a slew of seemingly significant CAD/CAM design patents came off patent, enabling competitors to 3D print computer-drafted models⁵.

And yet, the patent expirations have so far had no discernable impact on ASPs, margins, and case volume growth.  Align’s patent portfolio is important, even critical, but it’s not some static, slowly depleting asset.  It is the continuous expression of learning curve advantages that expands through iterative improvements in manufacturing and engineering.  Expiring patents will be more than replaced by new, more relevant ones. 

Focusing on patents also overlooks Align’s enormous process advantages.  Leveraging data from 6mn treated patients, Align has gotten progressively better at predicting how to move each tooth and at what speed; how movements in each tooth impact neighboring teeth; how those movements vary between teenagers and adults⁶, Asians and Europeans; which design features and physical materials to use to capture both crown and root movements.  Each scanned tooth is rendered into a 3D image and decomposed into thousands of points to enable the 10mn measurements that go into every treatment plan.  Accurately simulating how just two adjacent teeth move together involves hundreds of thousands of measurements.  Data from Align’s vast treatment database informs orthodontic nuances like teeth movement and angulation and arch symmetry, allowing the company to translate patient scans into ever more complete treatment plans that a doctor can approve with minor modifications through Align’s ClinCheck treatment planning software (inferences from case histories allow Align to offer multiple alternatives – “good, better, best” – to each patient). 

Treatment plans are digitally shot over to one of Align’s fabrication lines.  Now, these plants aren’t just monotonously fabricating the same appliance.  The 350k trays manufactured each day may look identical from afar (translucent plastic mouthguards that weigh less than an ounce), but each tray is obviously as different as the dentition it will cover, and each must be properly sequenced and packaged.