Shirley Stacy - Align Technology, Inc. Joseph M. Hogan - Align Technology, Inc. John F. Morici - Align Technology, Inc..

Jonathan David Block - Stifel, Nicolaus & Co., Inc. Robert Patrick Jones - Goldman Sachs & Co. LLC Suzie Yoon - Evercore Group LLC Glen Santangelo - Deutsche Bank Securities, Inc. Steve Beuchaw - Morgan Stanley & Co.

LLC Brandon Couillard - Jefferies LLC Erin Wilson Wright - Credit Suisse Securities (USA) LLC Richard Newitter - Leerink Partners LLC Steven Valiquette - Barclays Capital, Inc. Michael Ryskin - Bank of America Merrill Lynch Jeff D. Johnson - Robert W. Baird & Co., Inc. John C. Kreger - William Blair & Co. LLC.

Greetings and welcome to the Align Technology, Inc. Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded.

I would now liker to turn the conference over to your host, Shirley Stacy, VP, Corporate and Investor Relations. Thank you. Please begin..

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 second quarter 2018 financial results today via GLOBE NEWSWIRE 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 12 months. A telephone replay will be available today by approximately 5:30 PM Eastern Time through 5:30 PM Eastern Time on August 8.

To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13681104 followed by pound. International callers should dial 201-612-7415 with the same conference number.

As a reminder, the information that the presenters discuss today will include forward-looking statements, including statements about Align's future events, product outlook and the expected financial results for the third quarter of 2018.

These forward-looking statements are only predictions and involve risks and uncertainties that are set forth in more detail in our most recent periodic reports filed with the Securities and Exchange Commission. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement.

We've posted historical financial statements, including the corresponding reconciliations and our second quarter conference call web slides, on our website under Quarterly Results. Please refer to these files for more detailed information.

And with that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan, Joe?.

clear aligners and scanners. John will provide more detail on our financial results and discuss our outlook for the third quarter. Following that, I'll come back and summarize a few key points and open up the call to questions. I'm pleased to report another better than expected quarter for Align.

Our second quarter results reflect strong growth across our customer channels with record volume in all regions and almost every country market. Year-over-year revenue growth of 37.5% was driven by continued momentum from Invisalign doctors and increased adoption of Invisalign treatment for teenage patients which grew 42.1%.

Q2 Invisalign volume growth of 30.5% year-over-year reflects increased utilization and expansion of our customer base which was over 50,000 for the first time and included more than 5,000 new Invisalign trained doctors.

We also saw momentum from the iTero scanner and services business which includes the continued rollout of iTero scanners across Heartland Dental's supported offices as well as the first iTero scanner shipments to China. Turning to specifics around our second quarter results, let's start with results of our Americas region.

For the Americas, Q2 was a good quarter with Invisalign case volume up 8.9% sequentially and 22.2% year-over-year reflecting growth in both our orthodontic and also GP dentist channels.

In Q2, we trained 1,795 new Invisalign doctors in the Americas region, of which 640 were in Latin America alone, where we trained more doctors in the first half of this year than we did all of last year.

For the Americas region, year-over-year growth was led by orthodontist customers with another record quarter for North American ortho utilization at 16.4 cases per doctor.

Q2 Invisalign utilization for North American GP dentist were also up year-over-year at 3.6 cases per doctor reflecting continued expansion of the GP customer base which represented over 20,000 GPs for the first time in a quarter.

For international doctors, Q2 was another strong growth with Invisalign case volume up 14.9% sequentially and 45.4% year-over-year, reflecting strong Invisalign volume across the board driven by both increased adoption as well as expansion of our customer base.

For Q2, we're continuing to help expand the market for clear aligner treatment with approximately 1,650 newly trained doctors in EMEA. Year-over-year growth of Invisalign volume in EMEA was up 38% with a record quarter in all geographies as well as the teenage segment which was up 72% year-over-year.

We also saw growth across our key expansion markets, led by Central and Eastern Europe. In May, we announced a grand opening of our first Invisalign treatment planning facility in Europe located in Cologne, Germany. Until recently, Invisalign treatment planning for EMEA doctors was conducted in Align's treatment planning facility in Costa Rica.

The Cologne facility will also serve as a training facility for Invisalign doctors with a German speaking market providing clinical education and support in local language. In September, we'll host a grand opening of our new treatment planning facility in Madrid, Spain which will serve the Iberia market.

In APAC, Q2 Invisalign volumes were up 58.7% year-over-year led by China, Japan, Australia, New Zealand. Our Q2 results reflect continued strong growth overall and especially from teen cases which were up 74.3% year-over-year.

China continues to drive the majority of growth in the Asia-Pacific region and we are increasingly leveraging digital and social media marketing programs. Japan also had a strong year-over-year Invisalign growth, driven primarily by orthodontists as well as continued uplift from iTero scanners.

In addition, GP dentist channel in APAC was up 77.9% compared to last year. Q2 was all-time high for Invisalign volume in our smaller expansion markets in Thailand and India which are still very early in their development and adoption cycle.

Now turning to the teen market, in Q2, 78,400 teenagers started treatment with Invisalign clear aligners, an increase of 13.6% sequentially and 42.1% year-over-year, driven by continued strong adoption across all major regions, led by North American orthodontists.

Q2 was a seventh consecutive quarter that Invisalign teenage patient volumes grew faster than adults reflecting a shift toward younger teens and tweens. For Q2, year-over-year Invisalign teen patient growth for North American Orthos increased 30% and international doctors were up 73%.

One of the key drivers behind our strong growth is continued product innovation.

On July 1, we launched a new Invisalign Go product with a more user-friendly iTero digital chairside experience and greater flexibility to treat a wider range of mild to moderate cases such as crowded or gap teeth that require teeth straightening prior to restorative treatments.

Invisalign Go also incorporates new data-driven clinical protocols for predictable tooth movement and automated case assessments which will make it easier for dentists to tailor the treatments and plans to the individual needs of each patient.

We're very excited about the potential for Invisalign Go to help accelerate adoption among GP dentists worldwide.

As we aim to create even greater preference for Invisalign treatment from doctors and consumers alike, especially in the teen market, a key factor is expanding clinically applicability of the Invisalign system in order to treat more complex cases.

The launch of Mandibular Advancement feature last year has continued to ramp up and help drive adoption of Invisalign treatment among teenage patients in EMEA and APAC. Mandibular Advancement feature is pending FDA approval in the U.S. and we continue to expect approval in the second half of this year.

On July 1, we began offering Invisalign First, designed specifically to address a broad range of younger patients' malocclusions, including shorter clinical crowns, management of eruption dentition and predictable dental arch expansion.

While it's only been a few weeks, the initial response to Invisalign First has been very positive and excitement among top Invisalign doctors is rising and we're on a path to reach 1,000 Invisalign First cases across all regions in the first month alone.

The $100 million investment we make each year in consumer marketing programs include TV, digital, social media, PR, event marketing and more recently, our Concierge service and Invisalign store pilot. Our goals are to make the Invisalign brand a household name worldwide and to motivate consumers to seek Invisalign treatment through a doctor's office.

In Q2, we continue to successfully leverage the Made to Move campaign we kicked off last year, which is our first fully integrated global consumer marketing campaign launched across all major markets.

We also continued to build on regional programs like Teen and Mom campaign in North America and launched an entirely new initiative in APAC called Asian Smile in May. We have included the key indicators from our consumer marketing programs in the Q2 earnings slides posted on our website, so I won't go through them on this call.

Needless to say, all metrics for tracking consumer interest are up with strong growth in Invisalign website visitors across APAC and opt-ins in the Americas region, which captures consumers who take an action on our website and give us permission to contact them directly.

Our Smile Concierge program that we launched over a year ago is continuing to help more consumers start Invisalign treatment by shortening their research cycle and connecting them with an active Invisalign doctor. Year-to-date we scheduled over 30,000 Invisalign consultations in the U.S.

which equates to connecting hundreds of consumers to Invisalign doctors every day. Concierge service is also equipping us with valuable consumer insights that help our doctors better engage with consumers in their practices and online.

It's been very exciting to see how Invisalign doctors are working to reflect these insights and connect more effectively with the consumers that we send them every day. The Smile Concierge service is also expanding outside the U.S. with teams in Singapore, Brazil, Australia, and most recently the UK.

And while it's still early, each of these countries are seeing great initial traction and helping more consumers become Invisalign patients.

Sole purpose of the Invisalign store is to connect new potential patients with Invisalign doctors in their offices by raising awareness of Invisalign treatment and removing some common barriers for consumers to get started.

Our experience with the stores continues to evolve and grow and we are learning a lot from our consumers and participating doctors. To-date, the Invisalign stores have contributed to a significant influx of consumer interest in the San Jose and San Francisco orthodontic marketplace.

Over 8,000 consumers have visited our Align (sic) [Invisalign] stores. The average participating doctor in the store network has received dozens of scanned consumers, with the top providers easily receiving over 150 consumers. Many doctors have said the Invisalign stores have far surpassed their top referral sources.

Earlier this month, we opened two new Invisalign stores in Bethesda, Maryland and King of Prussia, Pennsylvania. And we're excited to see the impact these pilots will have on the participating Invisalign practices in the area.

We look forward to continuing to learn more from these pilot locations and we'll update you on our progress throughout the remainder of the year. In Q2, iTero revenues were up 10.9% sequentially as we saw benefit from the launch of iTero Element 2 and Element Flex, as well as the first commercial shipments of Element scanners in China.

In April, we received China FDA approval to sell iTero Element in China. And, today, we announced that we have received regulatory approval to manufacture iTero Element in our new manufacturing facility in Ziyang, China.

Year-over-year Q2 scanner revenues were up 60.9%, reflecting very strong growth across all regions and reflects the continued trend toward an end-to-end digital workflow starting with an iTero scanner on the front-end.

Not only do Invisalign doctors with an iTero scanner have notably higher utilization rates than non-iTero doctors, but it also enables greater efficiency between precision dentistry and higher overall customer experience and satisfaction.

Our dental service organizations or DSO partners have recognized the strategic fit of the iTero scanners and are adopting the platform across their business. In Q2, Heartland Dental continued to rollout iTero scanners across their U.S. supported locations and plan to have scanners in 90% of supported offices by the end of the year.

Similarly, Aspen Dental will begin to rollout iTero scanners to their customer base over the next two quarters beginning in Q3. Use of iTero scanners for Invisalign case submissions in place of PVS impression continues to grow and remains a positive catalyst for Invisalign utilization.

For Q2, total Invisalign cases submitted with a digital scanner in the Americas increased to a record 69.3%, up from 67.3% in Q1. International scans increased 47.3%, up from 43.2% in Q1. Finally, in the Doctor-Directed at Home Channel, Align is a third-party supplier to SmileDirectClub or SDC.

We manufacture a portion of SDC aligners which are non-Invisalign clear aligners. For Q2, shipments to SDC were up sequentially and higher than expected.

In April, SDC filed a complaint alleging that the launch and operation of Align's Invisalign Store Pilot program constitutes a breach of non-compete provisions applicable to the members of SDC Financial LLC, including Align.

On June 29, 2018, the Chancery Court for Davidson County, Tennessee, denied SDC's Entities' request for temporary injunction to prevent us from opening additional Invisalign stores.

As you heard earlier, we will continue to open additional Invisalign stores as part of our pilot program designed to connect consumers interested in Invisalign treatment with Invisalign-trained doctors in their offices.

We continue to dispute the allegations that we have breached our obligations to the SDC Entities under applicable law and will oppose any with a vigorous defend ourselves in the arbitration proceedings currently scheduled for December 2018.

As it relates the SDC, we believe working with them was a way to influence and shape the evolving consumer market for clear aligners. Our objective was and still is to reach consumers who would not otherwise consider orthodontic treatment and connect them with Invisalign doctors in their offices.

Our relationship with SDC has not worked out as expected. We have not been able to impact the decision-making process at SDC we had hoped and transfer the out-of-scope patients to an Invisalign doctor's office has not scaled as we had hoped. We do not anticipate renewing our supply agreement with SDC when it expires in 2019.

With that, I'll now turn the call over to John..

Thanks, Joe. Now for our Q2 financial results. Total company revenue for the second quarter was a record $490.3 million, up 12.2% from the prior quarter and up 37.5% from the corresponding quarter a year ago. Year-over-year revenue growth was favorable in all regions.

Clear Aligner revenue of $433.2 (sic) [$433.3] (16:21) million was up 12.4% sequentially on higher than expected volume. Year-over-year Clear Aligner revenue growth of 35% reflected strong Invisalign shipment growth across all customer channels and geographies and increased Invisalign ASPs.

Q2 Invisalign ASPs were up sequentially approximately $5 from Q1 to $1,315, reflecting increased secondary revenue and favorable price (sic) [product] (16:50) mix, partially offset by unfavorable FX and sales promotions.

On a year-over-year basis, Q2 Invisalign ASPs were up approximately $30, reflecting favorable FX, price increases, and product mix, partially offset by sales promotions and deferrals related to additional aligners.

For the second quarter, total Invisalign shipments of 302.7 thousand cases were up 11.2% sequentially and up 30.5% year-over-year, driven by growth across all regions. For Americas orthodontists, Q2 Invisalign case volume was up 9% sequentially and up 25% year-over-year.

For Americas GP dentists, Invisalign case volume was up 8.6% sequentially and up 18.2% year-over-year. For international doctors, Invisalign case volume was up 14.9% sequentially and up 45.4% year-over-year.

Our Scanner & Services revenue for the second quarter was $57 million, up 10.9% sequentially due to increased ASP benefiting from Element 2 and Element Flex product launches and the first Elements shipped into China. Year-over-year revenue was up 60.9%, primarily due to higher volume, product mix, and higher scanner ASPs.

Moving onto gross margin, second quarter overall gross margin was 74.6%, down 0.3 points sequentially and down 1.4 points year-over-year. Clear Aligner gross margin for the second quarter was 76.5%, down 0.5 points sequentially, primarily due to costs from the regional expansion of our manufacturing operation and increased aligners per case.

Clear Aligner gross margin was down 1.6 points year-over-year, primarily due to regional expansion of our manufacturing activities and increased aligners per case, partially offset by higher worldwide ASPs.

Scanner gross margin for the second quarter was 59.6%, up 0.4 points sequentially due to higher scanner ASPs, partially offset by higher production variances and freight cost. Scanner gross margins were up 2.9 points year-over-year primarily due to higher scanner ASPs along with increased manufacturing efficiencies.

Q2 operating expenses were $242.9 million, up sequentially 6% and up 29.6% year-over-year. The increase in operating expenses reflects continued investment in our go-to-market activities, including higher advertising spending, geographic expansion, as well as increased compensation related to expenses due to higher head count.

Our second quarter operating income was $122.7 million, up 25% sequentially and up 46.8% year-over-year. Our second quarter operating margin was 25%, up 2.5 points sequentially and up 1.6 points year-over-year. The sequential increase in operating margin is primarily due to volume leverage and operating expense efficiencies.

On a year-over-year basis, the increase in operating margin primarily reflects leveraged operating expenses on higher revenues from both Clear Aligner and Scanner & Services, as well as favorable foreign exchange rates.

With regards to the second quarter tax provision, our tax rate was 6.6%, which includes the impact of $16.6 million in excess tax benefits related to stock-based compensation. Second quarter diluted earnings per share was $1.30, up $0.13 sequentially and up $0.45 compared to the prior year. Moving onto the balance sheet.

As of the second quarter, cash, cash equivalents and marketable securities, including both short and long-term investments, were $720.7 million. This compared to $673 million at the end of Q1, an increase of approximately $47.7 million, primarily due to increased collections and working capital improvements.

Of our $720.7 million of cash, cash equivalents, and marketable securities, $338.1 million was held in the U.S. and $382.6 million was held by our international entities. Q2 accounts receivable balance was $374.4 million, up approximately 3.6% sequentially.

Our overall days sales outstanding, or DSOs, was 68 days, down 6 days sequentially and down 6 days from 74 days in Q2 last year. Our Q2 DSO is down sequentially as a result of improvements in both collections and AR aging. Capital expenditures for the second quarter were $57.7 million, primarily related to increased aligner capacity and facilities.

Cash flow from operations for the second quarter was $139.8 million, up $29.3 million compared to the prior year. Free cash flow for the second quarter, defined as cash flow from operations less capital expenditures, amounted to $82.1 million. During the second quarter, we also announced a new $600 million stock buyback authorization.

As of June 30, 2018, we have $100 million remaining under the April 2016 repurchase program that we expect to utilize during the remainder of 2018. With that, let's turn to our Q3 outlook and the factors that inform our view, starting with the demand outlook.

We expect our international business to grow on a sequential basis as the APAC market is going into their strong teen season, offset somewhat by EMEA market going into their summer seasonality. For Americas, we expect North America to grow on strong teen demand, offset somewhat by seasonally slower adult season.

LATAM will be flat on a sequential basis due to their summer holiday. We started selling iTero Element in China in Q2 of 2018. Additionally, Align has been effectively growing its iTero business in the North America DSO market. We expect a sequential increase in iTero units recognized as a result of these go-to-market activities.

We continue to expect SmileDirectClub volume to be minimal in the third quarter. With this as a backdrop, we expect the third quarter to shape up as follows. Invisalign case volume is expected to be in the range of 302,000 to 307,000 cases, up approximately 28% to 30% over the same period a year ago.

We expect Q3 revenues to be in the range of $493 million to $503 million, an increase of approximately 28% to 31% year-over-year. We expect Q3 gross margin to be in the range of 74% to 74.4%, reflecting higher expenses as we regionalize our treatment planning and manufacturing operations, partially offset by higher ASPs.

We expect Q3 operating expenses to be in the range of $245 million to $249 million, up on a sequential basis to reflect our continued investment in go-to-market activities. Q3 operating margins should be in the range of 24.2% to 24.9%. Our effective tax rate should be approximately 21%.

We expect approximately $1.5 million equity loss related to our share of SmileDirectClub. And diluted shares outstanding should be approximately 81.6 million, exclusive of any share repurchases. Taken together, we expect our Q3 diluted earnings per share to be in the range of $1.13 to $1.18.

In addition, as we continue our operational expansion efforts, we expect CapEx for Q3 to be approximately $60 million to $65 million, and we expect depreciation and amortization to be $10 million to $11 million. Now let me turn to our view of 2018.

Based on the momentum in our business to-date and our planned investments for the remainder of the year, we now anticipate 2018 total revenue growth rate to be above our long-term model and in the low to mid-30s. We expect Invisalign revenue and volume to be in the low 30s.

Notwithstanding continued investments in our strategic growth drivers, we expect operating margin for the full year to be slightly up from 2017 operating margin of 24%. With that, I'll turn it back over to Joe for final comments.

Joe?.

Thanks, John, and thanks to those of you for joining our call today.

2018 is shaping up to be a very good year for Align, which reflects the continued execution of our four strategic goals and growth drivers that we focus on driving international expansion; increasing orthodontist utilization of Invisalign, especially with teenagers; enabling GP dentists to treat or refer more Invisalign cases; and generating consumer demand for Invisalign treatment for millions of people worldwide.

We are pleased to see continued momentum across all of our regions and customer channels and believe that the investments we are making will continue to drive our growth well above the underlying industry.

There is still a lot of work to be done to fully optimize the enormous market potential, but we remain steadfast in our vision to bring clear aligner orthodontics to the masses through our partnership with Invisalign doctors. I look forward to updating you on our continued progress.

With that, I'll turn it over to the operator, and we'll open the call up to your questions.

Operator?.

Thank you. We will now be conducting a question-and-answer session. Thank you. Our first question comes from the line of Jon Block with Stifel. Please proceed..

Great. Thanks, guys. Good afternoon. Two questions. Maybe the first one just on the guidance, certainly solid 3Q guidance, but curious if you can talk about at a high level what that allows for if anything from the incremental competition? In other words, you guys always seem to be a bit conservative on the guide.

Are you even leaving a bit more wiggle room due to the unknown uptake around SureSmile and Clarity? And maybe just as a follow-on to that one, what if anything, Joe, have you heard about these offerings over the past few months since the ortho show? And then I've got a follow-up. Thanks..

Hey, Jon. This is John. I'll start with the first part of your question. We guide like we always guide taking the best information that we have. No change in terms of how we've taken this guidance. So we factor in many different factors into our forecast and this is no different from a guidance standpoint..

Hey, Jon. And from a competitive standpoint, there's nothing really different than what we saw from an AAO standpoint. I mean, obviously, you saw the Clarity product from Ormco that came out in Australia here recently. From what we see, there's again – it's just in line with other offerings that we see out there.

And we'll take a stronger beat on that in the future. But right now I wouldn't say we have changed in any way our assessment of the competition that we saw at the AAO..

Okay. Helpful. And then the follow up, I'm going to put you a little bit on the gross margin trend. So, I know the long-term of 73% to 78% appears unchanged but the 2Q Invisalign gross margin is 76.5%. In my model, it's one of the lowest in the past handful of years. And guys maybe if we can talk about how that trends over the next 12 months.

You talked about some of the deterioration being attributable to globalizing the supply chain. So do we think about, hey, as volumes start to go through those sites in coming quarters, maybe we see the GM specific to Invisalign stabilize and maybe even possibly reverse that trend? Thanks..

That's right, Jon. As we're investing and globalizing, we think it's a long-term strategic importance to us. We'll see some of those investments. But as we add capacity and as we add production in those facilities, we'll see some improvement. And you also have to remember too we had a lot of – from a mix standpoint a lot of iTero in Q2.

So the Q2 iTero affects us from a gross margin standpoint. But, as you know, it's a part of our long-term strategy and important for us from a growth standpoint..

Thank you..

Thanks, Jon..

Thanks, Jon..

Next question?.

Thank you. Our next question comes from the line of Robert Jones with Goldman Sachs. Please proceed..

Great. Thanks for the questions. I guess just a few on the Aspen deal and the DSO opportunity, more broadly.

I guess, maybe, Joe, or John, could you share how this deal came about? And, more importantly, would you be willing to share anything around any economic structure around the arrangement, if there's any kind of commitments or targets with Aspen? And then, Joe, if I heard you correctly I think you said that Heartland expects to have 90% of their practices within iTero by the end of the year.

Curious if you'd maybe be willing to share how the Invisalign growth or uptake has tracked at Heartland as we think about that as a proxy for Aspen?.

Yeah. First, on the Aspen deal and the Heartland deal, just from a high level standpoint is I think you know we've had a really strong GP focus in this business. But it's difficult at times to have an individual just focus on accounts and to drive the kind of penetration in the marketplace that we want.

We find that DSOs are great partners for us in the sense of their ability to be able to spread what we want to do with our digital workflow and with our aligners across their base.

And so, Heartland and Aspen both have been very open in the sense of working with us and frontloading their businesses with iTero that will allow them to – give them a very strong position in clear aligners.

And so that's – it's just right in line with our GP strategy and it allows us to be able to multiply that strategy across a number of different locations with the DSOs that really help us. We've been working with Heartland for a while on clear aligners and their uptake of iTero scanners have been great.

Our growth with Heartland has really been terrific. And they've been able to translate it across their organizations well. We haven't shared a whole lot of numbers in the sense of how that's going and we won't. That's how we want to handle that internally and how Heartland wants to handle that internally, too. But we're excited about the development.

We think it's a way for us to be able to – it's a force multiplier for us in the sense of getting Align out there and getting it in front of a lot of customers. And iTero is still critical from a digital workflow standpoint to make it really productive. And at GP offices, you do that..

No, no, I appreciate that, Joe. And then maybe I could just sneak one more in for John. On the 3Q EBIT margins, looks a little maybe softer than expected following a relatively strong 2Q on the EBIT margin line. And so just was wondering if you could talk about some of the moving pieces.

I think you talked about some of the spending – areas of spend in your prepared remarks.

So maybe just what informs that 3Q EBIT guide?.

I mean I think when we look at – as was noted earlier, we are investing globally to try to – as we regionalize some of our manufacturing and treatment clients, so there's some costs associated with that. We saw that in the second quarter. Some of that will continue into the third quarter.

But we'll also see from an investment standpoint, from an operating expenditure standpoint, it's balanced. The high end of our guide is 24.9%, which is pretty consistent to what we saw in Q2..

Thanks..

Yeah. Thanks..

Thank you. Our next question comes from the line of Elizabeth Anderson with Evercore ISI. Please proceed..

Hey, guys. This is Suzie Yoon on for Elizabeth. Thanks for taking my question, and congrats on another nice quarter. Looks like total utilization was up nicely in the quarter. Could you just talk about some of the factors that drove the uptick in North America? And then a quick follow-up.

Given your findings from the stores so far, how are you thinking about the future store plans?.

As far as the strong uptick, internationally, APAC, EMEA, but also North America. I'd say a lot of what you can see the growth from – there's good growth from an orthodontic standpoint and a lot of that is a teen marketplace. And I think you've known from previous calls, Suzie, we focused a lot on teens.

And that's a really important focus for us because that's a majority of what we see in the orthodontic marketplace is the teen piece. So just seeing further evidence of our ability to be able to go after that marketplace. We're excited about the teen first launch we put in place. It allows you to do Phase 1 treatment – dental treatment on teens.

And we have a good start, like we talked about, almost 1,000 starts (35:04) for the month. So it just reflects overall momentum that we continue to have that you've seen in other quarters too. From a store standpoint, we just opened up two stores, one in Maryland and one in King of Prussia, Pennsylvania. We'll open up some more stores this year.

I think we're doing much better in the sense of preparing doctors of how to integrate those consumers with doctors, and also we're learning a lot in the sense of how to communicate with patients, with visualization tools and things in the store that excite them about the Invisalign treatment.

And then we do the proper hands-off to the doctor's office to do that. So it's just another vector for growth for us and a continuation of our consumer interaction from an advertising standpoint and be able to monetize that with the doctor base..

Great. That's very helpful. Thank you..

Welcome..

Thank you. Our next question comes from the line of Glen Santangelo with Deutsche Bank. Please proceed..

Yeah. Thanks for taking the questions. Hey, Joe, I just want to talk to you about North America in a little bit more detail. I mean you have posted decent growth in that business, I think, 22% case shipment growth this quarter. But over the last six quarters it's trended pretty steadily in that 20% to 25% range.

And I'm kind of curious to get your perspective like what percentage of the docs in this region have already been trained? And I guess what I'm really trying to get at is what's really the key to sort of breaking out of that 20% to 25% range and accelerating that growth because it feels like we're seeing very strong growth on the ortho side? We're seeing strong growth in terms of teens, but that number seems to be flat lined in that 20% to 25% range.

So can you give us a little bit more color in terms of what's going on there?.

We feel good about our North American marketplace. When you talk about North America, look at Canada and the United States. And as you mentioned and I'll reemphasize, the teen piece is going extremely well.

Are we doing well with GPs also on the lighter cases as we work through that? Yeah, I'd say with the steady state of that, when you start to look at our year-over-year comparisons that's still a very strong performance from a North American standpoint.

So what we're doing to continue to expand that? In the orthodontics segment, of course, we've trained probably the majority of the orthodontists out there. But obviously there's refreshes. There's new products. There's a lot of things we have to continue to reenergize that market with and educate the market as we change that.

On the GP side, obviously we just talked about the DSOs and that kind of an opportunity for us too. And then we feel the stores really help with that consumer initiation and turning those consumers into patients. So overall we have momentum in that marketplace.

The third quarter is always a time where you see less of a GP marketplace and a strong orthodontic marketplace. That kind of reverses in the fourth quarter and so you will see in our third quarter piece we have a big number in there for teens on the ortho side to help that growth number..

And maybe just one quick follow-up on the DSOs.

What percentage of the North American market would you say is now represented by DSOs? And any other contracts above Heartland and Aspen sort of worth calling out? And what I'm really also trying to understand is, are these GPOs or DSOs rather – are they just replacing the existing technology they have or are they using iTero to sort of augment maybe what they already have? Thanks and I'll stop there..

Yeah. I think just to start with your last question. The iTero is new to their office in the sense it's not an augmentation or replacement of equipment they currently have. It's more of a commitment to the DSOs for just the whole idea of digital dentistry. And obviously there's a different workflow that you have inside GPs and you have on orthos.

And we've been able to more and more make sure that we have that kind of workflow capability within iTero and we continue to work with that so we can be a great tool for GPs in that sense. The DSOs – when you say what percentage of the market in North America, we normally quote 15% to 20%.

That number kind of varies around depending on what you call a DSO and what you don't. So, the upper number to use on that is 20% and the other one is 15%. I hope I've answered the question..

Thank you. Yep. That's fine. Thank you..

Thank you. Our next question comes from the line of Steve Beuchaw with Morgan Stanley. Please proceed..

Hey, team.

How are things?.

Hey, Steve..

Hey, Steve..

The first question is on China. So when I think about the drivers for this year that are incremental, clearly the China iTero launch is a big one. I wonder if you could dive in a little bit on how you think about the customer there.

Maybe, more specifically, are these people who had access to Intraoral scanners and you're going through a swap process where you give them a better mousetrap? Or are these customers where they were really using PVS or is it somewhere in between?.

Steve, it's amazing. I mean it's all PVS. This is not replacing scanners that are over there. So it's not a swap. So if you would see our offices in China at any point in time you just see rooms full of PVS boxes that would previously go to Mexico.

So those VPNs that (40:22) we're seeing the number of digital scans come out of China just start to skyrocket for us. John and I were going over that a couple days ago on a trip. So, it's a new foundation. This just is incredible.

I've been doing business in China now for over 20 years and I'm always amazed about the country's ability to target a new technology and just integrate it so quickly into the workflow. Just kind of – it's the fastest uptake in new technology in any country I've ever seen in the last 20 years. I saw that in the medical equipment business too.

You have to train the marketplace. You have to get them ready. You have to be ready to service it well. There's a lot of just foundational infrastructure things you have to put in place there to be successful and not to frustrate them. But once that's in place and you know what to do, the uptake is amazing. And that's what we're seeing right now..

That's what I was looking for. And then, just to follow-up. I mean you've given us between China and some of the DSO dynamics reasons to think that the iTero trajectory this year remains really, really strong, certainly beating our numbers.

Should we think about the first half as a reasonable barometer for iTero growth for the second half or are there other puts and takes that we ought to factor into the model? Thanks so much..

I think, Steve, you're right to call these out. I would call them anomalies in the sense of not – I mean there's going to be great uptake in China. This is the initial uptake in China. We expect more going forward. On the DSO side, I mean, Heartland and Aspen, two of the biggest DSOs going.

So, I wouldn't necessarily draw a line through this one and continue to draw it through the rest of the year. But we are having great success with iTero. You, as much as anybody, know how important that is from a standpoint of having an incredible foundation in place to be able to drive more Invisalign. And so you're seeing these big successes.

We have little ones too. But these are big penetration moves and I wouldn't necessarily say that you should take it times 2X as you go into the second half..

Really appreciate it. Thanks again..

Thank you. Our next question comes from the line of Brandon Couillard with Jefferies. Please proceed..

Thanks. Good afternoon..

Good afternoon..

Joe, if you would kind of discuss the decision to manufacture iTero systems in China.

Is that a cost play or a market access play? And would you expect, over some period of time, to actually shift some manufacturing to that location?.

That's actually a really good question, okay. That's a market access play. And having some experience of seeing that before, it's really important in the sense of how it's being done. And the Chinese government – those provincial governments have worked with us really well to make that work.

And it's just so much easier to be able to address those Chinese regulations from a Chinese standpoint than it is, in this case, from an Israeli standpoint too. So that's why we're doing it. From a cost standpoint, this is not a cost play. I'd say expect cost to be neutral.

If they are a little worse or a little better, you won't see it in our numbers in any way. So I wouldn't put it in your model..

Thanks and a couple for John.

First, any chance you could quantify the gross margin impact on the clear aligner business from the manufacturing capacity expansions? And then any pockets of inflation or material costs or freight or shipping costs that you're seeing in the business?.

Nothing from a freight or material cost that is of note. It simply comes down to as we regionalize both from treatment planning as well as manufacturing going live in China from a manufacturing standpoint in Q4. There's start-up costs. You're adding that facility. You're training workers. You're getting that manufacturing up and running.

And we saw some of that in Q2. We will see some of that in Q3. And then as we grow and as we get more volume out of those facilities, you see some normalize again. So, it's short-term. It's something that we've expected. And then once we're fully up and running, we get the benefits of being local, faster to our customers. We reduce freight costs.

There's a lot of other offsets that we see, but we have to get that facility up and running and that will be in Q4..

Very good. Thank you..

Thank you. Our next question comes from the line of Erin Wright with Credit Suisse. Please proceed..

Hey. Thanks. On your retail store pilot, I understand it's still early days here, but you gave some preliminary metrics at your Investor Day as it relates to the sell-through traction with the retail stores and with, I guess, the majority of the scanned patient scheduling appointments after visiting.

I guess I'm curious, do you have an update on any of these metrics and if there's a conversion rate at all that you could speak to into actual Invisalign customers? Thanks..

Thanks for the question and thanks for the interest. I think, at this point in time, we gave you as much as we wanted to give you at the Investors Meeting. We still call these pilot stores and they are. We're making a lot of iterations as we go through that. But we feel good about the progress.

As we get more stores out there and we move this thing more firmly as our stores and not call them pilots, and I'd say as we move into next year we'll be more open with you in the sense of the close rates, number of patients going through.

But, as I mentioned on our announcement, we have about 8,000 patients that have gone through those stores already. And then there's varying conversion rates. But, again, not ready to share that yet..

Okay. Totally fair. On the DSO relationships, I guess can you speak to how the conversation and the sales cycle had evolved, I guess, at Aspen and potentially with other DSOs and the opportunity there.

Is there any sort of new approach that you're taking from a DSO perspective in that sales process?.

We take a broad approach to both of them. These are very good businesses. They're extremely successful what I call businesses too because they operate in a business sense. So we're able to, I think, communicate well in a broad sense what we can bring to the practice and how we can help to drive growth throughout.

I mean, obviously, DSOs – one of the keys are going to be in-store sales. And being able to have an iTero inside that store and be able to drive more aligner sales, Invisalign sales through those is a big help.

So, it's just we have organized within the business to be able to work with DSOs much better, bring the resources in place and we put those things in place under Frank Quinn and North American organization over the last 18 months. He's done a terrific job. So, it's not just us. It's the DSOs reaching out for us too.

These are good partnerships that are well understood and we're excited about both of them and we feel they'll be successful..

Okay. Great. Thank you..

Thank you..

Thank you. Our next question comes from the line of Richard Newitter with Leerink Partners. Please proceed..

Hi. Thanks for taking the questions. First one on just competition.

Joe, is there anything since some of the competitors launched back in May that you're hearing in terms of how they're approaching their customers there and potentially your customer bases with respect to trialing or getting some initial kind of traction in the field or has it been relatively kind of quiet? And then with respect to the guidance question and competition is there anything at all factored into your 2018 growth outlook, including the revised one, any kind of impact from competition? Thanks..

Yeah. I'd say from a competitive standpoint what we see in the marketplace is kind of what you expect. I'd say it's a cautious approach from a competition standpoint. I'd call – if you take a look at 3M, they more like slipstream into the marketplace behind their wires and brackets business and try to get a few uptakes.

We'll be on road this week in North America just out talking to many customers, most of the EMC staff. And the feedback that we get is they're being contacted, but there's nothing really that's different from what was the output from the AAO in that piece.

And so there's some interest and curiosity I'd say from a customer base, but there's not a momentum piece or anything that we are adjusting the business around right now..

And I would say, Rich, as we guide and as we forecast we're always looking at what's happening in the market, products that are coming, what's happening with competition. So that's in our way that we look at our guidance and what we expect to see coming.

So when we look at our revenue that we talk to for 2018 to low to mid-30s that is inclusive of what we see from a competitive standpoint..

Okay. Great. And then maybe just one quick follow-up. You're still guiding to Mandibular Advancement FDA approval in the back half of 2018. Anything that occurred intra quarter to kind of give you the confidence to reiterate that timeline? Any color there would be helpful. Thank you..

It's an old saying no news on the FDA is good news. So we're still looking at the fourth quarter for this year..

Thank you..

Yeah. You're welcome..

Thank you. Our next question comes from the line of Steven Valiquette with Barclays. Please proceed..

Thanks. Good afternoon. Thanks for taking the question. I guess, just for me, given that you mentioned that you do not plan to renew your current agreement with SmileDirectClub next year, just curious kind of thinking out loud about this.

Would you still consider partnering with other players in that direct market? Or is it more likely you'll just kind of abandon any partnerships, maybe just try your best on your own to just capture any volume in that direct market through your various initiatives? Thanks..

Yeah. I don't have any interest from a manufacturing standpoint of supporting other, what we call, direct to consumer kind of aligner companies. We're going to run our play in a sense of our stores and how we work with our doctor partners.

We feel strongly that a doctor's office approach is a great approach to take, given the seriousness of moving teeth. And that's the vector we're pursuing in this business. And so it'd be kind of disingenuine is after our agreement with SDC runs out that we go find someone else to supply aligners to.

We have no interest in that from a strategic standpoint at all..

Okay. Got it. Okay. Thanks..

Okay, thanks..

Thank you. Our next question comes from the line of Michael Ryskin with Bank of America Merrill Lynch. Please proceed..

Hi, guys. Thanks for taking the call. Congrats on the quarter. Real quick one for Joe and then one for John. For the second half outlook and for the fiscal year, I noticed you bumped up the revenue guide incrementally.

Is there anything there in terms of that you're seeing from the new products, whether it's Mandibular Advancement internationally, or from the new iTero launches, or Invisalign First that's giving you a little bit more confidence with how that's started? Or is it more let's call it the legacy business that you're just seeing stability in?.

Mike, this is John. I think it's a combination. I think we're seeing, as we've seen in the last couple quarters here, great growth across our legacy business. We're driving great teenage growth. We have a lot of momentum internationally, and we're seeing that. But then as we've seen we've seen great iTero volume as well.

So, the DSO business that we've talked about being able to have a release in China, so that in the second quarter we expect that to continue into the second half.

So there's a lot of momentum given our existing business, but we have either new products on iTero with the various products that we have, Flex and iTero, too, and then also some of the expansion that we're doing in China and other places..

Great. Thanks. And then a quick follow-up on a previous question specifically about iTero in China. You mentioned that right now or previously it was all predominantly PVS.

How quickly do you see that market evolving? And in five years can you get similar rates of digital submission as you get in North America or at least elsewhere internationally? Or how long of a timeframe is it going to take to ramp that up?.

As I talked about in the last call, these ramp-up times in China will be faster than they were in the Western world. We know that. The intervening variable in that equation is we're signing up more and more doctors in China, not just orthodontists but GPs. And so those could entitle more PVS impressions, too.

So if we look at the current kind of installed base of docs and who submits through that, I feel very confident you'll see this ramped up really dramatically in the next two to three years. But outside of that we might have just other doctors who maybe not buy an iTero but still want to submit for that could come into the equation.

And it's just hard to project what that could be..

Thanks. And then one really quick one, the 5 points of FX tail in the first quarter. Can you quantify? I'm sure it was down small in 2Q.

But how much was it?.

Actually 2Q was about 4%. So on a year-over-year basis, we saw a little bit less FX benefit on a year-over-year basis than the first quarter but still at 4%..

And the same one-third flow through to the bottom line?.

That's right. We saw, actually, about two-thirds flow through to the bottom line..

Okay. Thank you. Thanks a lot..

Yeah. Thanks, Michael..

Thank you. Our next question comes from the line of Jeff Johnson with Robert W. Baird. Please proceed..

Thank you. Good afternoon, guys. Maybe just a couple cleanup questions here. Joe, I didn't hear you say anything about the 19% equity stake with SDC.

Is there any change to that once you end the supply agreement at the end of 2019?.

I don't know, honestly, Jeff. I'd say we still own that. We'll have to find a way to reconcile that. But that's – after we get our operational conflict out of the way I think that will be addressed..

Okay. Fair enough and then on the store concept or the Pilot Store, sorry. How many more are you thinking about opening this year? And, I guess, John, maybe you can walk us through. There's obviously expenses involved in opening those stores. I'd assume maybe that's a little bit of some of the EBIT questions that have been on the call today, as well.

But I also hear that you guys are getting full list price on those cases or at least very good pricing on those cases. So, I would assume there's a breakeven here that's pretty quick on these stores. So any comments or kind of color you can provide on that would be helpful. Thanks..

Yeah. Jeff, this is John. Yes, you're right. Stores – we've got four now. By the end of the year, we'll have 10 stores or so. We continue to find places that are very strategic to us, the right place to turn those consumers into patients through our doctor's offices. There's expenses related to start-up.

There's also some targeted marketing that we do in the area. But don't think of it all as incremental. Think of it as we're spending money in certain places on some of the marketing and advertising. And instead of going as maybe as broad, we can go a little bit more targeted to be able to try to get that consumer conversion.

So when we look at the second half and what we've guided for the year, we've now said that we expect to be up in operating margins from 2014. So there's no flat anymore. So, with these investments that we're making, we still think that they're ultimately incremental to our business and a key part of our strategy..

Thank you..

Yeah. See you, Jeff..

Thank you. Our next question comes from the line of John Kreger with William Blair. Please proceed..

Hi. Thanks very much. Joe, I don't think you've mentioned the financing pilot.

Can you just give us your latest thoughts on that? And if you're considering taking it more broad, what the timing might be?.

I'll turn you over to my expert on the financing..

Hey, John. This is John. So, on financing, it's really moved from a pilot to – it's fully released now. And what it is is a tool that we have with our sales team as well as working with our doctors to be able to give patients options in terms of financing, so they can do some things where they can look to come up with financing over a period of time.

It's beneficial to the doctor. It's beneficial for the patients. Ultimately, we get paid faster. So there's a lot of wins.

But really what we're trying to do is make it easier for those end customers, those end patients to be able to come up with financing to be able to get them into treatment and we think it's a benefit to everybody in this value chain to be able to get a higher conversion. So it's gone from pilot to full release.

And we're actively working with doctors and potential patients to get the understanding of this..

Great. Thank you. And then just one more follow-up, another DSO question. I think there's maybe 50 of size in the U.S., at least that's my understanding.

How many of those would you say you've got relationships with at this point?.

Well, I'd say we probably have contact with over 75% of them. I wouldn't say we have a relationship to the degree we have with Aspen and Heartland in that sense, John. So obviously DSOs are on our list in a sense to work with (58:32) and we put together an organization to do that.

But right now we're really focused on the agreements we've put in place and we want to make sure that we really work and execute well on these..

Great. Thank you..

Yeah. You're welcome, John..

Thanks, John..

Thank you. We have reached the end of our Q&A session. Allow me to hand the floor back over for closing remarks..

Well, thank you, everyone, for joining us today. This concludes our conference call. If you have any follow-up questions, please contact our Investor Relations department. Have a great day..

Thank you. This concludes today's conference. You may disconnect your lines at this time and thank you for your participation..