UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________________________
FORM 10-Q
____________________________
(Mark One)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended June 30, 2018
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number: 0-32259
____________________________
ALIGN TECHNOLOGY, INC.
(Exact name of registrant as specified in its charter)
____________________________
Delaware | 94-3267295 |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification Number) |
2820 Orchard Parkway
San Jose, California 95134
(Address of principal executive offices)
(408) 470-1000
(Registrant’s telephone number, including area code)
____________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer | x | Accelerated filer | ¨ |
Non-accelerated filer | o (Do not check if a smaller reporting company) | Smaller reporting company | ¨ |
Emerging growth company | ¨ | ||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act. | |||
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares outstanding of the registrant’s Common Stock, $0.0001 par value, as of July 27, 2018 was 80,320,082.
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ALIGN TECHNOLOGY, INC.
INDEX
PART I | ||
ITEM 1. | ||
ITEM 2. | ||
ITEM 3. | ||
ITEM 4. | ||
PART II | ||
ITEM 1. | ||
ITEM 1A. | ||
ITEM 2. | ||
ITEM 3. | ||
ITEM 4. | ||
ITEM 5. | ||
ITEM 6. | ||
Invisalign, Align, the Invisalign logo, ClinCheck, Made to Move, Invisalign Assist, Invisalign Teen, Invisalign Go, Vivera, SmartForce, SmartTrack, SmartStage, iTero, iTero Element, Orthocad, iCast and iRecord, among others, are trademarks and/or service marks of Align Technology, Inc. or one of its subsidiaries or affiliated companies and may be registered in the United States and/or other countries.
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PART I—FINANCIAL INFORMATION
ITEM 1 FINANCIAL STATEMENTS
ALIGN TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||
2018 | 2017 | 2018 | 2017 | ||||||||||||
Net revenues | $ | 490,259 | $ | 356,482 | $ | 927,183 | $ | 666,823 | |||||||
Cost of net revenues | 124,677 | 85,565 | 234,193 | 160,281 | |||||||||||
Gross profit | 365,582 | 270,917 | 692,990 | 506,542 | |||||||||||
Operating expenses: | |||||||||||||||
Selling, general and administrative | 212,087 | 162,964 | 411,712 | 314,112 | |||||||||||
Research and development | 30,804 | 24,384 | 60,395 | 47,188 | |||||||||||
Total operating expenses | 242,891 | 187,348 | 472,107 | 361,300 | |||||||||||
Income from operations | 122,691 | 83,569 | 220,883 | 145,242 | |||||||||||
Interest income | 1,917 | 1,441 | 4,093 | 2,636 | |||||||||||
Other income (expense), net | (7,099 | ) | 1,771 | (6,922 | ) | 2,221 | |||||||||
Net income before provision for income taxes and equity in losses of investee | 117,509 | 86,781 | 218,054 | 150,099 | |||||||||||
Provision for income taxes | 7,703 | 15,387 | 10,605 | 8,164 | |||||||||||
Equity in losses of investee, net of tax | 3,701 | 2,215 | 5,478 | 3,336 | |||||||||||
Net income | $ | 106,105 | $ | 69,179 | $ | 201,971 | $ | 138,599 | |||||||
Net income per share: | |||||||||||||||
Basic | $ | 1.32 | $ | 0.86 | $ | 2.52 | $ | 1.73 | |||||||
Diluted | $ | 1.30 | $ | 0.85 | $ | 2.48 | $ | 1.70 | |||||||
Shares used in computing net income per share: | |||||||||||||||
Basic | 80,216 | 80,188 | 80,127 | 80,047 | |||||||||||
Diluted | 81,471 | 81,631 | 81,575 | 81,668 | |||||||||||
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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ALIGN TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(unaudited)
Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
2018 | 2017 | 2018 | 2017 | |||||||||||||
Net income | $ | 106,105 | $ | 69,179 | $ | 201,971 | $ | 138,599 | ||||||||
Net change in foreign currency translation adjustment | 759 | 1,199 | (283 | ) | 740 | |||||||||||
Change in unrealized (losses) gains on investments, net of tax | (186 | ) | 27 | (57 | ) | 42 | ||||||||||
Other comprehensive income (loss) | 573 | 1,226 | (340 | ) | 782 | |||||||||||
Comprehensive income | $ | 106,678 | $ | 70,405 | $ | 201,631 | $ | 139,381 | ||||||||
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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ALIGN TECHNOLOGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
(unaudited)
June 30, 2018 | December 31, 2017 | ||||||
ASSETS | |||||||
Current assets: | |||||||
Cash and cash equivalents | $ | 547,993 | $ | 449,511 | |||
Marketable securities, short-term | 164,629 | 272,031 | |||||
Accounts receivable, net of allowance for doubtful accounts of $2,729 and $5,814, respectively | 374,371 | 324,189 | |||||
Inventories | 47,252 | 31,688 | |||||
Prepaid expenses and other current assets | 126,754 | 80,948 | |||||
Total current assets | 1,260,999 | 1,158,367 | |||||
Marketable securities, long-term | 8,061 | 39,948 | |||||
Property, plant and equipment, net | 447,933 | 348,793 | |||||
Equity method investments | 49,128 | 54,606 | |||||
Goodwill and intangible assets, net | 85,307 | 89,068 | |||||
Deferred tax assets | 45,859 | 49,334 | |||||
Other assets | 19,302 | 43,893 | |||||
Total assets | $ | 1,916,589 | $ | 1,784,009 | |||
LIABILITIES AND STOCKHOLDERS’ EQUITY | |||||||
Current liabilities: | |||||||
Accounts payable | $ | 48,744 | $ | 36,776 | |||
Accrued liabilities | 196,754 | 195,562 | |||||
Deferred revenues | 321,148 | 267,713 | |||||
Total current liabilities | 566,646 | 500,051 | |||||
Income tax payable | 115,701 | 114,091 | |||||
Other long-term liabilities | 15,283 | 15,579 | |||||
Total liabilities | 697,630 | 629,721 | |||||
Commitments and contingencies (Notes 8 and 9) | |||||||
Stockholders’ equity: | |||||||
Preferred stock, $0.0001 par value (5,000 shares authorized; none issued) | — | — | |||||
Common stock, $0.0001 par value (200,000 shares authorized; 80,313 and 80,040 issued and outstanding, respectively) | 8 | 8 | |||||
Additional paid-in capital | 844,599 | 886,435 | |||||
Accumulated other comprehensive income (loss), net | 911 | 571 | |||||
Retained earnings | 373,441 | 267,274 | |||||
Total stockholders’ equity | 1,218,959 | 1,154,288 | |||||
Total liabilities and stockholders’ equity | $ | 1,916,589 | $ | 1,784,009 | |||
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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ALIGN TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Six Months Ended June 30, | |||||||
2018 | 2017 | ||||||
CASH FLOWS FROM OPERATING ACTIVITIES: | |||||||
Net income | $ | 201,971 | $ | 138,599 | |||
Adjustments to reconcile net income to net cash provided by operating activities: | |||||||
Deferred taxes | 3,667 | 6,145 | |||||
Depreciation and amortization | 24,066 | 16,743 | |||||
Stock-based compensation | 32,720 | 29,057 | |||||
Equity in losses of investee | 5,478 | 3,336 | |||||
Other non-cash operating activities | 4,543 | 5,837 | |||||
Changes in assets and liabilities, net of effects of acquisitions: | |||||||
Accounts receivable | (44,266 | ) | (52,038 | ) | |||
Inventories | (15,586 | ) | (8,616 | ) | |||
Prepaid expenses and other assets | (9,366 | ) | 388 | ||||
Accounts payable | 10,743 | 4,410 | |||||
Accrued and other long-term liabilities | (53,442 | ) | (14,802 | ) | |||
Long-term income tax payable | 1,610 | (551 | ) | ||||
Deferred revenues | 54,983 | 29,580 | |||||
Net cash provided by operating activities | 217,121 | 158,088 | |||||
CASH FLOWS FROM INVESTING ACTIVITIES: | |||||||
Acquisitions, net of cash acquired | — | (8,953 | ) | ||||
Purchase of property, plant and equipment | (115,295 | ) | (78,045 | ) | |||
Purchase of marketable securities | (78,405 | ) | (212,226 | ) | |||
Proceeds from maturities of marketable securities | 207,475 | 173,094 | |||||
Proceeds from sales of marketable securities | 9,560 | 32,352 | |||||
Loan advances to equity investee | — | (15,000 | ) | ||||
Loan repayment from equity investee | 30,000 | — | |||||
Other investing activities | 668 | (2,940 | ) | ||||
Net cash provided by (used in) investing activities | 54,003 | (111,718 | ) | ||||
CASH FLOWS FROM FINANCING ACTIVITIES: | |||||||
Proceeds from issuance of common stock | 8,585 | 7,521 | |||||
Common stock repurchases | (100,000 | ) | (38,793 | ) | |||
Equity forward contract related to accelerated share repurchase | — | (15,000 | ) | ||||
Employees’ taxes paid upon the vesting of restricted stock units | (79,330 | ) | (37,968 | ) | |||
Net cash used in financing activities | (170,745 | ) | (84,240 | ) | |||
Effect of foreign exchange rate changes on cash, cash equivalents, and restricted cash | (1,923 | ) | 3,640 | ||||
Net increase (decrease) in cash, cash equivalents, and restricted cash | 98,456 | (34,230 | ) | ||||
Cash, cash equivalents, and restricted cash at beginning of the period | 450,125 | 393,019 | |||||
Cash, cash equivalents, and restricted cash at end of the period | $ | 548,581 | $ | 358,789 | |||
SUPPLEMENTAL CASH FLOW INFORMATION: | |||||||
Accounts payable or accrued liabilities related to property, plant and equipment | 20,854 | 20,291 | |||||
Conversion of convertible notes receivable into equity securities | 4,862 | — | |||||
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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ALIGN TECHNOLOGY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note 1. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying unaudited Condensed Consolidated Financial Statements have been prepared by Align Technology, Inc. (“we”, “our”, or “Align”) in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”) and contains all adjustments, including normal recurring adjustments, necessary to state fairly our results of operations for the three and six months ended June 30, 2018 and 2017, our comprehensive income for the three and six months ended June 30, 2018 and 2017, our financial position as of June 30, 2018 and our cash flows for the six months ended June 30, 2018 and 2017. The Condensed Consolidated Balance Sheet as of December 31, 2017 was derived from the December 31, 2017 audited financial statements and have been recast to reflect the adoption of accounting standards as described below. It does not include all disclosures required by accounting principles generally accepted in the United States of America (“U.S.”).
During the first quarter of fiscal year 2018, we adopted the Accounting Standards Codification (“ASC”) 606, “Revenues from Contracts with Customers,” using the full retrospective method and Accounting Standards Update (“ASU”) 2016-18, “Statement of Cash Flows - Restricted Cash,” on a retrospective basis. The Condensed Consolidated Balance Sheet as of December 31, 2017 and the Condensed Consolidated Statement of Cash Flow for the six months ended June 30, 2017 have been recast to comply with the adoption of these standards.
The results of operations for the three and six months ended June 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018 or any other future period, and we make no representations related thereto. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Quantitative and Qualitative Disclosures About Market Risk” and the Consolidated Financial Statements and notes thereto included in Items 7, 7A and 8, respectively, in our Annual Report on Form 10-K for the year ended December 31, 2017.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) in the U.S. requires our management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. On an ongoing basis, we evaluate our estimates, including those related to the fair values of financial instruments, valuation of investments in privately held companies, useful lives of intangible assets and property and equipment, revenue recognition, stock-based compensation, long-lived assets and goodwill, income taxes and contingent liabilities, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.
Significant Accounting Policies
Our significant accounting policies are described in Note 1 “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K. Significant changes to the Revenue Recognition policy and Investments in Privately Held Companies policy are discussed below:
Revenue Recognition
Our revenues are derived primarily from the sale of aligners, scanners, and services from our Clear Aligner and Scanner segments. We enter into sales contracts that may consist of multiple distinct performance obligations where certain performance obligations of the sales contract are not delivered in one reporting period. We measure and allocate revenue according to ASC 606-10, “Revenues from Contracts with Customers.”
We identify a performance obligation as distinct if both of the following criteria are true: the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer and the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract. Determining the standalone selling price (“SSP”) and allocation of consideration from a contract to the individual performance obligations, and the appropriate timing of revenue recognition, is the result of significant qualitative and quantitative judgments. Management considers a variety of factors such as historical sales, usage rates, costs, and expected margin, which may vary over time depending
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upon the unique facts and circumstances related to each performance obligation in making these estimates. While changes in the allocation of the SSP between performance obligations will not affect the amount of total revenue recognized for a particular contract, any material changes could impact the timing of revenue recognition, which would have a material effect on our financial position and result of operations. This is because the contract consideration is allocated to each performance obligation, delivered or undelivered, at the inception of the contract based on the SSP of each distinct performance obligation.
Clear Aligner
We enter into contracts (“treatment plan(s)”) that involve multiple future performance obligations. Invisalign Full, Invisalign Teen, and Invisalign Assist products include optional additional aligners at no charge for a period of up to five years after initial shipment and Invisalign Go includes optional additional aligners at no charge for a period of up to two years after initial shipment. Invisalign Teen also includes up to six optional replacement aligners in the price of the product and may be ordered by the dental professional any time throughout treatment. Invisalign Lite includes one optional case refinement in the price of the product. Case refinement is a finishing tool used to adjust a patient’s teeth to the desired final position and may be elected by the dental professional at any time during treatment; however, it is generally ordered in the last stages of orthodontic treatment.
We determined that our treatment plans comprise the following performance obligations that also represent distinct deliverables: initial aligners, additional aligners, case refinement, and replacement aligners. We elected to take the practical expedient to consider shipping and handling costs as activities to fulfill the performance obligation. We allocate revenue for each treatment plan based on each unit’s SSP and recognize the revenue over the manufacturing period, typically 1 to 3 days, as the aligners do not have an alternative use and we have enforceable rights to payment. As we collect most consideration upfront, we considered whether a significant financing component exists; however, as the delivery of the performance obligations are at the customer’s discretion, we concluded that no significant financing component exists.
Scanner
We sell intraoral scanners and computer-aided design/computer-aided manufacturing (“CAD/CAM”) services through both our direct sales force and distribution partners. The intraoral scanner sales price includes one year of warranty and unlimited scanning services. The customer may, for additional fees, also select extended warranty and unlimited scanning services for periods beyond the initial year. When intraoral scanners are sold with an unlimited scanning service agreement and/or extended warranty, we allocate revenue based on each element’s SSP. We estimate the SSP of each element, taking into consideration historical prices as well as our discounting strategies. Revenue is then recognized over time as the monthly services are rendered and upon shipment for the scanner, as that is when we deem the customer to have obtained control. Most consideration is collected upfront and in cases where there are payment plans, consideration is collected by the 1 year mark and therefore, there are no significant financing components.
Warranties
For both Clear Aligner and Scanner segments, we offer an assurance warranty which provides the customer assurance that the product will function as the parties intended because it complies with agreed-upon specifications, and thus is not treated as a separate performance obligation and will continue to be accrued in accordance with the Financial Accounting Standards Board (“FASB”) guidance on guarantees.
Volume Discounts
In certain situations, we offer promotions in which the discount will increase depending upon the volume purchased over time. We concluded that in these situations, the promotions can represent either variable consideration or options, depending upon the specifics of the promotion. In the event the promotion contains an option, the option is considered a material right and, therefore, included in the accounting for the initial arrangement. We estimate the average anticipated discount over the lifetime of the promotion or contract, and apply that discount to each unit as it is sold. On a quarterly basis, we review our estimates and, if needed, updates are made and changes are applied prospectively.
Costs to Obtain a Contract
We offer a variety of commission plans to our salesforce; each plan has multiple components. To match the costs to obtain a contract to the associated revenue, we evaluate the individual components and capitalize the eligible components, recognizing the costs over the treatment period.
8
Unfulfilled Performance Obligations for Clear Aligners and Scanners
Our unfilled performance obligations as of June 30, 2018 and the estimated revenue expected to be recognized in the future related to these performance obligations are $358.0 million. This includes performance obligations from the Clear Aligner segment, primarily the shipment of additional aligners, which are fulfilled over 1 to 5 years, and performance obligations from the iTero scanner segment, primarily contracted deliveries of additional scanners and support, which are fulfilled over 1 to 5 years. The estimate includes both product and service unfulfilled performance obligations and the time range reflects our best estimate of when we will transfer control to the customer and may change based on customer usage patterns, timing of shipments, readiness of customers’ facilities for installation, and manufacturing availability.
Contract Balances
The timing of revenue recognition results in deferred revenues being recognized on the Condensed Consolidated Balance Sheet. For both aligners and scanners, we usually collect the total consideration owed prior to all performance obligations being performed and payment terms vary from net 30 to net 90 days. Contract liabilities are recorded as deferred revenue balances, which are generated based upon timing of invoices and recognition patterns, not payments. If the revenue recognition exceeds the billing, the exceeded amount is considered unbilled receivable and a contract asset. Conversely, if the billing occurs prior to the revenue recognition, the amount is considered deferred revenue and a contract liability.
Investments in Privately Held Companies
Investments in privately held companies in which we can exercise significant influence but do not own a majority equity interest or otherwise control are accounted for under ASC 323, “Investments—Equity Method and Joint Ventures.” Equity securities qualified as equity method investments are reported on our Condensed Consolidated Balance Sheet as a single amount, and we record our share of their operating results within equity in losses of investee, net of tax, in our Condensed Consolidated Statement of Operations. Investments in privately held companies in which we can not exercise significant influence and do not own a majority equity interest or otherwise control are accounted for under ASC 321, “Investments—Equity Securities.” The equity securities without readily determinable fair values are recorded at cost and adjusted for impairments and observable price changes with a same or similar security from the same issuer (“Measurement Alternative”). Equity securities under ASC 321 are reported on our Condensed Consolidated Balance Sheet as other assets, and we record a change in carrying value of our equity securities, if any, in other income (expense), net in our Condensed Consolidated Statement of Operations.
Equity securities are evaluated for impairment as events or circumstances indicate that there is an other-than-temporary loss in value. The decrease in value is recognized in the period the impairment occurs and recorded in other income (expense), net in the Condensed Consolidated Statement of Operations.
Recent Accounting Pronouncements
(i) New Accounting Updates Recently Adopted
In May 2014, the FASB released ASU 2014-09, “Revenue from Contracts with Customers,” (Topic 606) to supersede nearly all existing revenue recognition guidance under GAAP. The core principle of the standard is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for the goods or services. We adopted the guidance in the first quarter of fiscal year 2018 by applying the full retrospective method. The impact of adoption was primarily related to the Clear Aligner segment. Our disaggregation of revenue can be found in Note 14 “Segments and Geographical Information.” We elected to take the practical expedient to exclude from the transaction price all taxes assessed by a governmental authority. In preparation for adoption of the standard, we have reviewed and, where necessary, implemented additional key system functionalities and internal controls to enable the preparation of financial information. Prior periods have been retrospectively adjusted, and we recognized cumulative effect of adopting the guidance as an adjustment to our opening balance of retained earnings as of January 1, 2016.
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The adoption of ASU 2014-09 did not have a material impact on our Condensed Consolidated Statements of Operations, Condensed Consolidated Statements of Comprehensive Income or Condensed Consolidated Statements of Cash Flows for the historical periods presented in the Item 1 Financial Statements section. Consolidated Balance Sheet line items, which reflect the adoption of the ASU 2014-09 are as follows (in thousands):
December 31, 2017 | ||||||||||||
As Previously Reported | Adjustment | As Adjusted | ||||||||||
Asset Accounts: | ||||||||||||
Accounts receivable, net | $ | 322,825 | $ | 1,364 | $ | 324,189 | ||||||
Deferred tax assets | 50,059 | (725 | ) | 49,334 | ||||||||
Other assets | 38,379 | 5,514 | 43,893 | |||||||||
Liability and Stockholders’ Equity Accounts: | ||||||||||||
Accrued liabilities | $ | 194,198 | $ | 1,364 | $ | 195,562 | ||||||
Deferred revenues | 266,842 | 871 | 267,713 | |||||||||
Retained earnings | 263,356 | 3,918 | 267,274 | |||||||||
In August 2016, the FASB issued ASU 2016-15, “Classification of Certain Cash Receipts and Cash Payments,” which clarifies the presentation and classification of certain cash receipts and cash payments in the statements of cash flows. The amendments are effective for fiscal years and interim periods within those years beginning after December 15, 2017. We adopted the standard in the first quarter of fiscal year 2018 on a retrospective basis, and it did not have an impact on our Condensed Consolidated Statements of Cash Flows.
In November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows—Restricted Cash,” which provides guidance to address the classification and presentation of changes in restricted cash in the statements of cash flows. The amendments are effective for fiscal years and interim periods within those years beginning after December 15, 2017 on a retrospective basis. We adopted the guidance in the first quarter of fiscal year 2018 on a retrospective basis and presented the changes in the total of cash, cash equivalents, and restricted cash in the Condensed Consolidated Statements of Cash Flows. Condensed Consolidated Statement of Cash Flows line items, which reflect the adoption of the ASU 2016-18, are as follows (in thousands):
Six Months Ended June 30, 2017 | ||||||||||||
As Previously Reported | Adjustment | As Adjusted | ||||||||||
Cash Flows from Investing Activities | ||||||||||||
Other investing activities | $ | 224 | $ | (3,164 | ) | $ | (2,940 | ) | ||||
Net cash used in investing activities | (108,554 | ) | (3,164 | ) | (111,718 | ) | ||||||
Effect of foreign exchange rate changes on cash, cash equivalents, and restricted cash | 3,613 | 27 | 3,640 | |||||||||
Net decrease in cash, cash equivalents, and restricted cash | (31,093 | ) | (3,137 | ) | (34,230 | ) | ||||||
Cash, cash equivalents, and restricted cash at beginning of the period | 389,275 | 3,744 | 393,019 | |||||||||
Cash, cash equivalents, and restricted cash at end of the period | $ | 358,182 | $ | 607 | $ | 358,789 | ||||||
In May 2017, the FASB issued ASU 2017-09, “Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting,” to clarify when to account for a change to the terms or conditions of a share-based payment award as a modification. The amendments are effective for fiscal years and interim periods within those years beginning after December 15, 2017 on a prospective basis. We adopted the standard in the first quarter of fiscal year 2018 on a prospective basis which did not have an impact on our condensed consolidated financial statements and related disclosures.
(ii) Recent Accounting Updates Not Yet Effective
In February 2016, the FASB issued ASU 2016-02, “Leases” (Topic 842) to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The updated guidance is effective for annual periods beginning after December 15, 2018, including interim periods within those fiscal years. We plan to adopt the standard in the first quarter of fiscal year 2019 by electing the package of practical expedients available in the standard. We are in the process of evaluating changes to our systems, processes and controls in order
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to adopt the new standard in the first quarter of fiscal year 2019. While we are currently evaluating the impact of the adoption of this guidance on our consolidated financial statements, we expect the adoption will have a material increase in assets and liabilities on our consolidated balance sheet.
In June 2016, the FASB issued ASU 2016-13, “Financial Instruments - Credit Losses” (Topic 326). The FASB issued this update to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. The amendments in this update replace the existing guidance of incurred loss impairment methodology with an approach that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The updated guidance is effective for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption of the update is permitted in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We are currently evaluating the impact of this guidance on our consolidated financial statements and related disclosures.
In January 2017, the FASB issued ASU 2017-04, “Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment,” to simplify the subsequent measurement of goodwill by eliminating step two from the goodwill impairment test. Under the amendments, an entity will recognize an impairment charge for the amount by which the carrying value exceeds the fair value. The amendments are effective for fiscal years and interim periods within those years beginning after December 15, 2019 on a prospective basis and early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial statements and related disclosures.
In February 2018, the FASB issued ASU 2018-02, “Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income,” which gives entities the option to reclassify to retained earnings the tax effects resulting from the U.S. Tax Cuts and Jobs Act (the “TCJA”) related to items in accumulated other comprehensive income. The amendments are effective for fiscal years and interim periods within those years beginning after December 15, 2018 on a retrospective basis and early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial statements and related disclosures.
Note 2. Investments and Fair Value Measurements
Marketable Securities
As of June 30, 2018 and December 31, 2017, the estimated fair value of our short-term and long-term marketable securities, classified as available for sale, are as follows (in thousands):
Short-term
June 30, 2018 | Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value | ||||||||||||
Commercial paper | $ | 32,656 | $ | — | $ | — | $ | 32,656 | ||||||||
Corporate bonds | 84,246 | 1 | (205 | ) | 84,042 | |||||||||||
U.S. government agency bonds | 14,013 | — | (41 | ) | 13,972 | |||||||||||
U.S. government treasury bonds | 32,953 | 3 | (19 | ) | 32,937 | |||||||||||
Certificates of deposit | 1,022 | — | — | 1,022 | ||||||||||||
Total marketable securities, short-term | $ | 164,890 | $ | 4 | $ | (265 | ) | $ | 164,629 | |||||||
Long-term
June 30, 2018 | Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value | ||||||||||||
U.S. government agency bonds | $ | 7,006 | $ | — | $ | (74 | ) | $ | 6,932 | |||||||
Corporate bonds | 1,128 | 1 | — | 1,129 | ||||||||||||
Total marketable securities, long-term | $ | 8,134 | $ | 1 | $ | (74 | ) | $ | 8,061 | |||||||
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Short-term
December 31, 2017 | Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value | ||||||||||||
Commercial paper | $ | 58,503 | $ | — | $ | (1 | ) | $ | 58,502 | |||||||
Corporate bonds | 145,728 | 3 | (174 | ) | 145,557 | |||||||||||
U.S. government agency bonds | 3,013 | — | (7 | ) | 3,006 | |||||||||||
U.S. government treasury bonds | 60,650 | — | (70 | ) | 60,580 | |||||||||||
Certificates of deposit | 4,386 | — | — | 4,386 | ||||||||||||
Total marketable securities, short-term | $ | 272,280 | $ | 3 | $ | (252 | ) | $ | 272,031 | |||||||
Long-term
December 31, 2017 | Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value | ||||||||||||
U.S. government agency bonds | $ | 15,023 | $ | — | $ | (68 | ) | $ | 14,955 | |||||||
Corporate bonds | 25,067 | 2 | (76 | ) | 24,993 | |||||||||||
Total marketable securities, long-term | $ | 40,090 | $ | 2 | $ | (144 | ) | $ | 39,948 | |||||||
Cash equivalents are not included in the table above as the gross unrealized gains and losses are not material. We have no short-term or long-term investments that have been in a continuous material unrealized loss position for greater than twelve months as of June 30, 2018 and December 31, 2017. Amounts reclassified to earnings from accumulated other comprehensive income (loss), net related to unrealized gains or losses were not material for the three and six months ended June 30, 2018 and 2017. For the three and six months ended June 30, 2018 and 2017, realized gains or losses were not material.
Our fixed-income securities investment portfolio consists of investments that have a maximum effective maturity of 40 months on any individual security. The securities that we invest in are generally deemed to be low risk based on their credit ratings from the major rating agencies. The longer the duration of these securities, the more susceptible they are to changes in market interest rates and bond yields. As interest rates increase, those securities purchased at a lower yield show a mark-to-market unrealized loss. The unrealized losses are due primarily to changes in credit spreads and interest rates. We expect to realize the full value of all these investments upon maturity or sale. The weighted average remaining duration of these securities was approximately five months and six months as of June 30, 2018 and December 31, 2017, respectively.
As the carrying value approximates the fair value for our short-term and long-term marketable securities shown in the tables above, the following table summarizes the fair value of our short-term and long-term marketable securities classified by contractual maturity as of June 30, 2018 and December 31, 2017 (in thousands):
June 30, 2018 | December 31, 2017 | ||||||
One year or less | $ | 164,629 | $ | 272,031 | |||
Due in greater than one year | 8,061 | 39,948 | |||||
Total available for sale short-term and long-term marketable securities | $ | 172,690 | $ | 311,979 | |||
Investments in Privately Held Companies
Our investments in privately held companies as of June 30, 2018 and December 31, 2017 are as follows (in thousands):
June 30, 2018 | December 31, 2017 | ||||||
Equity securities under the equity method investment 1 | $ | 49,128 | $ | 54,606 | |||
Equity securities without readily determinable fair values 2 | $ | 4,862 | $ | — | |||
1 Refer to Note 4 “Equity Method Investments” of the Notes to Condensed Consolidated Financial Statements for more information.
2 In April 2018, the convertible notes receivable (recurring level 3 investment) was converted into equity securities as a result of qualified financing secured by the private company in accordance with ASC 321, “Investments—Equity Securities.” The equity securities issued upon conversion are reported as a nonrecurring investment within “Other Assets” in our Condensed Consolidated Balance Sheet. From the date of conversion through June 30, 2018, there were no fair value adjustments.
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Fair Value Measurements
We measure the fair value of financial assets as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. We use the GAAP fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. This hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of inputs that may be used to measure fair value:
Level 1 — Quoted (unadjusted) prices in active markets for identical assets or liabilities.
Level 2 — Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability. We obtain fair values for our Level 2 investments. Our custody bank and asset managers independently use professional pricing services to gather pricing data which may include quoted market prices for identical or comparable financial instruments, or inputs other than quoted prices that are observable either directly or indirectly, and we are ultimately responsible for these underlying estimates.
Level 3 — Unobservable inputs to the valuation methodology that are supported by little or no market activity and that are significant to the measurement of the fair value of the assets or liabilities. Level 3 assets and liabilities include those whose fair value measurements are determined using pricing models, discounted cash flow methodologies or similar valuation techniques, as well as significant management judgment or estimation.
The following tables summarize our financial assets measured at fair value on a recurring basis as of June 30, 2018 and December 31, 2017 (in thousands):
Description | Balance as of June 30, 2018 | Level 1 | Level 2 | Level 3 | ||||||||||||
Cash equivalents: | ||||||||||||||||
Money market funds | $ | 390,103 | $ | 390,103 | $ | — | $ | — | ||||||||
Short-term investments: | ||||||||||||||||
Commercial paper | 32,656 | — | 32,656 | — | ||||||||||||
Corporate bonds | 84,042 | — | 84,042 | — | ||||||||||||
U.S. government agency bonds | 13,972 | — | 13,972 | — | ||||||||||||
U.S. government treasury bonds | 32,937 | 32,937 | — | — | ||||||||||||
Certificates of deposit | 1,022 | — | 1,022 | — | ||||||||||||
Long-term investments: | ||||||||||||||||
U.S. government agency bonds | 6,932 | — | 6,932 | — | ||||||||||||
Corporate bonds | 1,129 | — | 1,129 | — | ||||||||||||
Prepaid expenses and other current assets: | ||||||||||||||||
Israeli funds | 3,099 | — | 3,099 | — | ||||||||||||
$ | 565,892 | $ | 423,040 | $ | 142,852 | $ | — | |||||||||
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Description | Balance as of December 31, 2017 | Level 1 | Level 2 | Level 3 | ||||||||||||
Cash equivalents: | ||||||||||||||||
Money market funds | $ | 253,155 | $ | 253,155 | $ | — | $ | — | ||||||||
Commercial paper | 7,246 | — | 7,246 | — | ||||||||||||
Corporate bonds | 2,016 | — | 2,016 | — | ||||||||||||
Short-term investments: | ||||||||||||||||
Commercial paper | 58,502 | — | 58,502 | — | ||||||||||||
Corporate bonds | 145,557 | — | 145,557 | — | ||||||||||||
U.S. government agency bonds | 3,006 | — | 3,006 | — | ||||||||||||
U.S. government treasury bonds | 60,580 | 60,580 | — | — | ||||||||||||
Certificates of deposit | 4,386 | — | 4,386 | — | ||||||||||||
Long-term investments: | ||||||||||||||||
U.S. government agency bonds | 14,955 | — | 14,955 | — | ||||||||||||
Corporate bonds | 24,993 | — | 24,993 | — | ||||||||||||
Prepaid expenses and other current assets: | ||||||||||||||||
Israeli funds | 3,075 | — | 3,075 | — | ||||||||||||
Short-term notes receivable | 4,476 | — | — | 4,476 | ||||||||||||
$ | 581,947 | $ | 313,735 | $ | 263,736 | $ | 4,476 | |||||||||
Derivative Financial Instruments
In March 2018, we began entering into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations on certain trade and intercompany receivables and payables. These forward contracts are classified within Level 2 of the fair value hierarchy. The gain from the settlement of foreign currency forward contracts during both the three and six months ended June 30, 2018 was $5.4 million. As of June 30, 2018, the fair value of foreign exchange forward contracts outstanding was not material.
The following table presents the gross notional value of all our foreign exchange forward contracts outstanding as of June 30, 2018 (in thousands):
June 30, 2018 | |||||
Local Currency Amount | Notional Contract Amount (USD) | ||||
Euro | €64,400 | $ | 75,322 | ||
Chinese Yuan | ¥150,000 | 22,574 | |||
Canadian Dollar | C$28,000 | 21,277 | |||
British Pound | £13,000 | 17,159 | |||
Japanese Yen | ¥1,513,000 | 13,670 | |||
Brazilian Real | R$37,300 | 9,582 | |||
Australian Dollar | A$7,300 | 5,390 | |||
$ | 164,974 | ||||
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Note 3. Balance Sheet Components
Inventories
Inventories consist of the following (in thousands):
June 30, 2018 | December 31, 2017 | ||||||
Raw materials | $ | 22,976 | $ | 12,721 | |||
Work in process | 12,396 | 12,157 | |||||
Finished goods | 11,880 | 6,810 | |||||
Total inventories | $ | 47,252 | $ | 31,688 | |||
Other Assets
Other assets consist of the following (in thousands):
June 30, 2018 | December 31, 2017 | ||||||
Capitalized commissions | $ | 7,947 | $ | 5,515 | |||
Equity securities | 4,862 | — | |||||
Security deposits | 3,734 | 3,557 | |||||
Loan receivable from equity investee | — | 30,000 | |||||
Other long-term assets | 2,759 | 4,821 | |||||
Total other assets | $ | 19,302 | $ | 43,893 | |||
Accrued Liabilities
Accrued liabilities consist of the following (in thousands):
June 30, 2018 | December 31, 2017 | ||||||
Accrued payroll and benefits | $ | 87,697 | $ | 103,004 | |||
Accrued expenses | 36,776 | 27,318 | |||||
Accrued fixed assets | 12,889 | 11,362 | |||||
Accrued customer credits | 11,552 | 5,373 | |||||
Accrued income taxes | 7,764 | 12,405 | |||||
Accrued warranty | 7,286 | 5,929 | |||||
Accrued professional fees | 6,876 | 6,316 | |||||
Accrued sales tax and value added tax | 5,955 | 5,503 | |||||
Accrued sales return reserve 1 | 5,554 | 1,364 | |||||
Accrued sales rebate | 3,772 | 11,209 | |||||
Other accrued liabilities | 10,633 | 5,779 | |||||
Total accrued liabilities | $ | 196,754 | $ | 195,562 | |||
1 December 31, 2017 balance has been reclassified from accounts receivable, net to reflect the adoption of ASU 2014-09 (Refer to Note 1 “Summary of Significant Accounting Policies” of the Notes to Condensed Consolidated Financial Statements for more information).
Warranty
We regularly review the balance for accrued warranty and update based on historical warranty trends. Actual warranty costs incurred have not materially differed from those accrued; however, future actual warranty costs could differ from the estimated amounts.
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Warranty accrual as of June 30, 2018 and 2017 consists of the following activity (in thousands):
Six Months Ended June 30, | |||||||
2018 | 2017 | ||||||
Balance at beginning of period | $ | 5,929 | $ | 3,841 | |||
Charged to cost of revenues | 5,728 | 3,690 | |||||
Actual warranty expenditures | (4,371 | ) | (2,503 | ) | |||
Balance at end of period | $ | 7,286 | $ | 5,028 | |||
Deferred Revenues
Deferred revenues consist of the following (in thousands):
June 30, 2018 | December 31, 2017 | ||||||
Deferred revenues - current | $ | 321,148 | $ | 267,713 | |||
Deferred revenues - long-term 1 | 7,625 | 4,588 | |||||
1 Included in other long-term liabilities on our Condensed Consolidated Balance Sheet.
During the three months ended June 30, 2018 and June 30, 2017, we recognized revenue of $490.3 million and $356.5 million, respectively, of which $102.0 million and $61.3 million were included in the deferred revenue balance at December 31, 2017 and December 31, 2016, respectively.
During the six months ended June 30, 2018 and June 30, 2017, we recognized revenue of $927.2 million and $666.8 million, respectively, of which $187.7 million and $112.8 million were included in the deferred revenues balance at December 31, 2017 and December 31, 2016, respectively.
Note 4. Equity Method Investments
On July 25, 2016, we acquired a 17% equity interest, on a fully diluted basis, in SmileDirectClub, LLC (“SDC”) for $46.7 million. The investment is accounted for under an equity method investment and the investee, SDC, is considered a related party. The investment is reported in our Condensed Consolidated Balance Sheet under equity method investments, and we record our proportional share of SDC’s losses within equity in losses of investee, net of tax, in our Condensed Consolidated Statement of Operations. On July 24, 2017, we purchased an additional 2% equity interest in SDC for $12.8 million. As a result of this purchase, we hold a 19% equity interest in SDC on a fully diluted basis. As of June 30, 2018 and December 31, 2017, the balance of our equity method investments was $49.1 million and $54.6 million, respectively.
Concurrently with the investment on July 25, 2016, we also entered into a supply agreement with SDC to manufacture clear aligners for SDC’s doctor-led, at-home program for simple teeth straightening. The term of the supply agreement expires on December 31, 2019. We commenced supplying aligners to SDC in October 2016. The sale of aligners to SDC and the income from the supply agreement are reported in our Clear Aligner business segment. We eliminate unrealized profit on outstanding intercompany transactions. As of June 30, 2018 and December 31, 2017, the balance of accounts receivable due from SDC was $11.8 million and $14.3 million, respectively. For the three months ended June 30, 2018 and 2017, net revenues recognized from SDC were $8.6 million and $3.0 million, respectively, and for the six months ended June 30, 2018 and 2017, net revenues recognized from SDC were $13.9 million and $3.6 million, respectively.
On July 25, 2016, we entered into a Loan and Security Agreement (the “Loan Agreement”) with SDC and amended on July 24, 2017 where we agreed to provide SDC a loan of up to $30.0 million in one or more advances. On February 7, 2018, $30.0 million of outstanding loan advances and related accrued interest were repaid in full, and the Loan Agreement was terminated (Refer to Note 8 “Legal Proceedings” of the Notes to Condensed Consolidated Financial Statements for SDC legal proceedings discussion).
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Note 5. Business Combinations
During the first quarter of 2017, we completed the acquisitions of certain of our distributors for the total cash consideration of approximately $9.5 million including cash acquired. We recorded $1.9 million of net tangible liabilities, $8.2 million of identifiable intangible assets and $3.2 million of goodwill. The goodwill is primarily related to the benefit we expect to obtain from direct sales as we believe that the transition from our distributor arrangements to a direct sales model will increase our net revenues in the region as we will experience higher average sales prices (“ASP”) compared to our discounted ASP under the distribution agreements. The goodwill is not deductible for tax purposes.
Pro forma results of operations for these acquisitions have not been presented as they were not material to our results of operations, either individually or in aggregate, for the three and six months ended June 30, 2017.
Note 6. Goodwill and Intangible Assets
Goodwill
The change in the carrying value of goodwill for the six months ended June 30, 2018, all attributable to our Clear Aligner reporting unit, is as follows (in thousands):
Total | |||
Balance as of December 31, 2017 | $ | 64,614 | |
Adjustments 1 | (434 | ) | |
Balance as of June 30, 2018 | $ | 64,180 | |
1 The adjustments to goodwill during the period were a result of foreign currency translation.
During the fourth quarter of fiscal 2017, we performed the annual goodwill impairment testing and found no impairment as the fair value of our Clear Aligner reporting unit was significantly in excess of the carrying value.
Intangible Long-Lived Assets
Acquired intangible long-lived assets are being amortized as follows (in thousands):
Weighted Average Amortization Period (in years) | Gross Carrying Amount as of June 30, 2018 | Accumulated Amortization | Accumulated Impairment Loss | Net Carrying Value as of June 30, 2018 | |||||||||||||
Trademarks | 15 | $ | 7,100 | $ | (1,838 | ) | $ | (4,179 | ) | $ | 1,083 | ||||||
Existing technology | 13 | 12,600 | (4,986 | ) | (4,328 | ) | 3,286 | ||||||||||
Customer relationships | 11 | 33,500 | (15,612 | ) | (10,751 | ) | 7,137 | ||||||||||
Reacquired rights | 3 | 7,500 | (2,894 | ) | — | 4,606 | |||||||||||
Patents | 8 | 6,796 | (1,919 | ) | — | 4,877 | |||||||||||
Other | 2 | 618 | (480 | ) | — | 138 | |||||||||||
Total intangible assets | $ | 68,114 | $ | (27,729 | ) | $ | (19,258 | ) | $ | 21,127 | |||||||
Weighted Average Amortization Period (in years) | Gross Carrying Amount as of December 31, 2017 | Accumulated Amortization | Accumulated Impairment Loss | Net Carrying Value as of December 31, 2017 | |||||||||||||
Trademarks | 15 | $ | 7,100 | $ | (1,769 | ) | $ | (4,179 | ) | $ | 1,152 | ||||||
Existing technology | 13 | 12,600 | (4,704 | ) | (4,328 | ) | 3,568 | ||||||||||
Customer relationships | 11 | 33,500 | (14,681 | ) | (10,751 | ) | 8,068 | ||||||||||
Reacquired rights | 3 | 7,500 | (1,356 | ) | — | 6,144 | |||||||||||
Patents | 8 | 6,798 | (1,504 | ) | — | 5,294 | |||||||||||
Other | 2 | 618 | (390 | ) | — | 228 | |||||||||||
Total intangible assets | $ | 68,116 | $ | (24,404 | ) | $ | (19,258 | ) | $ | 24,454 | |||||||
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The total estimated annual future amortization expense for these acquired intangible assets as of June 30, 2018 is as follows (in thousands):
Fiscal Year Ending December 31, | Amortization | |||
Remainder of 2018 | $ | 3,149 | ||
2019 | 6,184 | |||
2020 | 3,855 | |||
2021 | 3,389 | |||
2022 | 2,116 | |||
Thereafter | 2,434 | |||
Total | $ | 21,127 | ||
Amortization for the three months ended June 30, 2018 and 2017 was $1.5 million and $1.8 million, respectively, and amortization for the six months ended June 30, 2018 and 2017 was $3.0 million and $3.2 million, respectively.
Note 7. Credit Facilities
On February 27, 2018, we entered into a new credit facility for a $200.0 million revolving line of credit, with a $50.0 million letter of credit sublimit, and a maturity date of February 27, 2021, replacing the existing credit facility which provided for a $50.0 million revolving line of credit with a $10.0 million letter of credit. The credit facility requires us to comply with specific financial conditions and performance requirements. The loans bear interest, at our option, at either a rate based on the reserve adjusted LIBOR for the applicable interest period or a base rate, in each case plus a margin. The base rate is the highest of the credit facility’s publicly announced prime rate, the federal funds rate plus 0.50% and one month LIBOR plus 1.0%. The margin ranges from 1.25% to 1.75% for LIBOR loans and 0.25% to 0.75% for base rate loans. Interest on the loans is payable quarterly in arrears with respect to base rate loans and at the end of an interest period (and at three month intervals if the interest period exceeds three months) in the case of LIBOR loans. Principal, together with accrued and unpaid interest, is due on the maturity date. As of June 30, 2018, we had no outstanding borrowings under this credit facility and were in compliance with the conditions and performance requirements.
Note 8. Legal Proceedings
Patent Infringement Lawsuit
On November 14, 2017, Align filed six patent infringement lawsuits asserting 26 patents against 3Shape A/S, a Danish corporation, and a related U.S. corporate entity, asserting that 3Shape’s Trios intraoral scanning system and Dental System software infringe Align patents. Align filed two Section 337 complaints with the U.S. International Trade Commission (“ITC”) alleging that 3Shape violates U.S. trade laws by selling for importation and importing its infringing Trios intraoral scanning system and Dental System software. Align’s ITC complaints seek cease and desist orders and exclusion orders prohibiting the importation of 3Shape’s Trios scanning system and Dental System software products into the U.S. Align also filed four separate complaints in the United States District Court for the District of Delaware alleging patent infringement by 3Shape’s Trios intraoral scanning system and Dental System software. All of these district court complaints seek monetary damages and injunctive relief against further infringement.
SDC Dispute
On April 5, 2018, SDC Financial LLC, SmileDirectClub LLC, and the Members of SDC Financial LLC other than Align (collectively, the "SDC Entities") initiated proceedings that seek, among other forms of relief, to preliminarily and permanently enjoin all activities related to the Invisalign store pilot project, require Align to close the existing Invisalign stores, prohibit Align from opening any additional stores, and allow the SDC Entities to exercise a right to repurchase all of Align's SDC Financial LLC membership interests for a purchase price equal to the current capital account balance. On June 29, 2018, the Chancery Court for Davidson County, Tennessee, denied the SDC Entities’ request for a temporary injunction to prevent Align from opening additional Invisalign stores. Align continues to dispute the allegations that it has breached its obligations to the SDC Entities under applicable law and will oppose and vigorously defend itself at the arbitration proceedings currently scheduled for December 2018. This dispute does not impact Align’s existing supply agreement with SDC which remains in place through 2019 and includes a minimum volume commitment. We are currently unable to predict the outcome of this dispute and therefore cannot determine the likelihood of loss, if any, nor estimate a range of possible loss.
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In addition, in the course of Align’s operations, Align is involved in a variety of claims, suits, investigations, and proceedings, including actions with respect to intellectual property claims, patent infringement claims, government investigations, labor and employment claims, breach of contract claims, tax, and other matters. Regardless of the outcome, these proceedings can have an adverse impact on us because of defense costs, diversion of management resources, and other factors. Although the results of complex legal proceedings are difficult to predict and Align’s view of these matters may change in the future as litigation and events related thereto unfold; Align currently does not believe that these matters, individually or in the aggregate, will materially affect Align’s financial position, results of operations or cash flows.
Note 9. Commitments and Contingencies
Operating Leases
As of June 30, 2018, minimum future lease payments for non-cancelable operating leases are as follows (in thousands):
Fiscal Year Ending December 31, | Operating Leases | |||
Remainder of 2018 | $ | 9,213 | ||
2019 | 17,350 | |||
2020 | 13,503 | |||
2021 | 11,827 | |||
2022 | 9,617 | |||
Thereafter | 20,738 | |||
Total minimum future lease payments | $ | 82,248 | ||
Sublease income is not material and excluded from the table above.
Other Commitments
On July 25, 2016, we entered into a Loan and Security Agreement (the “Loan Agreement”) with SDC and subsequently amended on July 24, 2017 to provide a loan of up to $30.0 million in one or more advances to SDC (the “Loan Facility”). On February 7, 2018, $30.0 million of outstanding advances and related accrued interest were repaid in full, and the Loan Agreement was terminated (Refer to Note 4 “Equity Method Investments” of the Notes to Condensed Consolidated Financial Statements for more information on our investments in SDC).
On November 27, 2017, we entered into a Purchase Agreement with one of our existing single source suppliers. Under the terms of the original agreement, we are required to purchase a minimum approximately $305.2 million of aligner materials over the next 4 years. On May 29, 2018, we entered into an amendment to the Purchase Agreement with the existing single source supplier to increase the original term of the agreement to 5 years and total minimum purchase amount to approximately $425.9 million.
Off-Balance Sheet Arrangements
As of June 30, 2018, we had no material off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources other than certain items disclosed in Note 9 “Commitments and Contingencies” of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K.
Indemnification Provisions
In the normal course of business to facilitate transactions in our services and products, we indemnify certain parties: customers, vendors, lessors, and other parties with respect to certain matters, including, but not limited to, services to be provided by us and intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and our executive officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim.
It is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our
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results of operations, cash flows or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of June 30, 2018, we did not have any material indemnification claims that were probable or reasonably possible.
Note 10. Stockholders’ Equity
Summary of Stock-Based Compensation Expense
As of June 30, 2018, the 2005 Incentive Plan (as amended) has a total reserve of 27,783,379 shares of which 6,066,597 shares are available for issuance.
Stock-based compensation is based on the estimated fair value of awards, net of estimated forfeitures, and recognized over the requisite service period. Estimated forfeitures are based on historical experience at the time of grant and may be revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The stock-based compensation related to all of our stock-based awards and employee stock purchases for the three and six months ended June 30, 2018 and 2017 is as follows (in thousands):
Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||
2018 | 2017 | 2018 | 2017 | ||||||||||||
Cost of net revenues | $ | 900 | $ | 768 | $ | 1,781 | $ | 1,693 | |||||||
Selling, general and administrative | 13,216 | 11,218 | 25,794 | 22,934 | |||||||||||
Research and development | 2,774 | 2,259 | 5,145 | 4,430 | |||||||||||
Total stock-based compensation | $ | 16,890 | $ | 14,245 | $ | 32,720 | $ | 29,057 | |||||||
Stock Options
We have not granted options since 2011 and all outstanding options were fully vested and associated stock-based compensation expenses was recognized as of December 31, 2015. Activity for the six months ended June 30, 2018 under the stock option plans is set forth below:
Number of Shares Underlying Stock Options (in thousands) | Weighted Average Exercise Price per Share | Weighted Average Remaining Contractual Term (in years) | Aggregate Intrinsic Value (in thousands) | |||||||||
Outstanding as of December 31, 2017 | 75 | $ | 11.36 | |||||||||
Exercised | (61 | ) | 12.13 | |||||||||
Cancelled or expired | — | — | ||||||||||
Outstanding as of June 30, 2018 | 14 | $ | 7.96 | 0.62 | $ | 4,651 | ||||||
Vested at June 30, 2018 | 14 | $ | 7.96 | 0.62 | $ | 4,651 | ||||||
Exercisable at June 30, 2018 | 14 | $ | 7.96 | 0.62 | $ | 4,651 | ||||||
Restricted Stock Units (“RSUs”)
The fair value of RSUs is based on our closing stock price on the date of grant. A summary for the six months ended June 30, 2018 is as follows:
Shares Underlying RSUs (in thousands) | Weighted Average Grant Date Fair Value | Weighted Remaining Contractual Term (in years) | Aggregate Intrinsic Value (in thousands) | |||||||||
Nonvested as of December 31, 2017 | 1,341 | $ | 82.30 | |||||||||
Granted | 214 | 256.85 | ||||||||||
Vested and released | (491 | ) | 71.93 | |||||||||
Forfeited | (65 | ) | 98.99 | |||||||||
Nonvested as of June 30, 2018 | 999 | $ | 123.73 | 1.44 | $ | 341,829 | ||||||
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As of June 30, 2018, we expect to recognize $98.3 million of total unamortized compensation cost, net of estimated forfeitures, related to RSUs over a weighted average period of 2.3 years.
Market-performance Based Restricted Stock Units (“MSUs”)
We grant MSUs to our executive officers. Each MSU represents the right to one share of Align’s common stock. The actual number of MSUs which will be eligible to vest will be based on the performance of Align’s stock price relative to the performance of a stock market index over the vesting period, and certain MSU grants are also based on Align’s stock price at the end of the performance period. Generally, the vesting period of MSUs is two to three years. For MSUs granted during the six months ended June 30, 2018, the maximum number of MSUs which will be eligible to vest are between 250% to 300% of the MSUs initially granted.
The following table summarizes the MSU performance for the six months ended June 30, 2018:
Number of Shares Underlying MSUs (in thousands) | Weighted Average Grant Date Fair Value | Weighted Average Remaining Contractual Term (in years) | Aggregate Intrinsic Value (in thousands) | |||||||||
Nonvested as of December 31, 2017 | 428 | $ | 78.53 | |||||||||
Granted | 208 | 261.86 | ||||||||||
Vested and released | (312 | ) | 62.41 | |||||||||
Forfeited | — | — | ||||||||||
Nonvested as of June 30, 2018 | 324 | $ | 211.91 | 1.66 | $ | 110,922 | ||||||
As of June 30, 2018, we expect to recognize $48.6 million of total unamortized compensation cost, net of estimated forfeitures, related to MSUs over a weighted average period of 1.7 years.
Employee Stock Purchase Plan (“ESPP”)
In May 2010, our shareholders approved the 2010 Employee Stock Purchase Plan (the “2010 Purchase Plan”) which will continue until terminated by either the Board of Directors or its administrator. The maximum number of shares available for purchase under the 2010 Purchase Plan is 2,400,000 shares. As of June 30, 2018, we have 647,363 shares available for future issuance.
The fair value of the option component of the 2010 Purchase Plan shares was estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions:
Six Months Ended June 30, | |||||||
2018 | 2017 | ||||||
Expected term (in years) | 1.3 | 1.2 | |||||
Expected volatility | 35.7 | % | 26.1 | % | |||
Risk-free interest rate | 1.9 | % | 0.9 | % | |||
Expected dividends | — | — | |||||
Weighted average fair value at grant date | $ | 78.38 | $ | 26.09 | |||
As of June 30, 2018, there was $1.6 million of total unamortized compensation costs related to employee stock purchases which we expect to be recognized over a weighted average period of 0.4 year.
Note 11. Common Stock Repurchase Programs
April 2014 Repurchase Program
In January 2017, we repurchased on the open market approximately 0.04 million shares of our common stock at an average price of $96.37 per share, including commission for an aggregate purchase price of approximately $3.8 million, completing the April 2014 Repurchase Program.
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April 2016 Repurchase Program
On April 28, 2016, we announced that our Board of Directors had authorized a plan to repurchase up to $300.0 million of our common stock (“April 2016 Repurchase Program”).
In May 2017, we entered into an accelerated share repurchase agreement ("2017 ASR") to repurchase $50.0 million of our common stock. The 2017 ASR was completed in August 2017. We received a total of approximately 0.4 million shares for an average share price of $146.48. In November 2017, we repurchased on the open market approximately 0.2 million shares of our common stock at an average price of $243.40 per share, including commissions, for an aggregate purchase price of approximately $50.0 million.
In February 2018, we repurchased on the open market approximately 0.4 million shares of our common stock at an average price of $252.24 per share, including commission for an aggregate purchase price of approximately $100.0 million.
In July 2018, we repurchased on the open market approximately 0.3 million shares of our common stock at an average price of $350.08 per share, including commissions for an aggregate purchase price of approximately $100.0 million, completing the April 2016 Repurchase Program.
May 2018 Repurchase Program
On May 23, 2018, we announced that our Board of Directors had authorized a plan to repurchase up to $600.0 million of our common stock (“May 2018 Repurchase Program”).
As of June 30, 2018, we have not made any stock repurchases under the May 2018 Repurchase Program.
Note 12. Accounting for Income Taxes
Our provision for income taxes was $7.7 million and $15.4 million for the three months ended June 30, 2018 and 2017, respectively, representing effective tax rates of 6.6% and 17.7%, respectively. Our provision for income taxes was $10.6 million and $8.2 million for the six months ended June 30, 2018 and 2017, respectively, representing effective tax rates of 4.9% and 5.4%, respectively. As a result of the enactment of the TCJA, the U.S. federal statutory tax rate decreased from 35% to 21% effective January 1, 2018. Our effective tax rate differs from the statutory federal income tax rate of 21% and 35% for both the three and six months ended June 30, 2018 and 2017, respectively, mainly as a result of recognition of excess tax benefits related to stock-based compensation and certain foreign earnings, primarily from the Netherlands and Costa Rica, being taxed at lower tax rates. The decrease in effective tax rate for the three and six months ended June 30, 2018 compared to the same periods in 2017 is primarily attributable to the decrease in the corporate tax rate from 35% to 21% pursuant to the enactment of the TCJA, offset in part by reduced benefits from foreign earnings being taxed at a lower tax rate, and the increase in excess tax benefits related to stock-based compensation.
For the three and six months ended June 30, 2018, we recognized excess tax benefits of $16.6 million and $39.9 million, respectively, in our provision for income taxes.
We exercise significant judgment in regards to estimates of future market growth, forecasted earnings and projected taxable income in determining the provision for income taxes and for purposes of assessing our ability to utilize any future benefit from deferred tax assets.
We file U.S. federal, U.S. state, and non-U.S. income tax returns. Our major tax jurisdictions include U.S. federal, the State of California and the Netherlands. For U.S. federal and state tax returns, we are no longer subject to tax examinations for years before 2000. We are currently under examination by the Internal Revenue Service for tax year 2015. With few exceptions, we are no longer subject to examination by foreign tax authorities for years before 2010.
Our total gross unrecognized tax benefits, excluding interest and penalties, was $53.2 million and $47.7 million as of June 30, 2018 and December 31, 2017, respectively, all of which would impact our effective tax rate if recognized. Our total interest and penalties accrued as of June 30, 2018 was $3.6 million. We have elected to recognize interest and penalties related to unrecognized tax benefits as a component of income taxes. The timing and resolution of income tax examinations is uncertain, and the amounts ultimately paid, if any, upon resolution of issues raised by the taxing authorities may differ materially from the amounts accrued for each year. It is reasonably possible that the gross unrecognized tax benefits related to the years that are subject to examination could decrease, whether by payment, release, or a combination of both, in the next 12 months by $28.0 million, which would impact our effective tax rate.
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In June 2017, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted an extension of certain income tax incentives for an additional twelve year period. Under these incentives, all of the income in Costa Rica is subject to a reduced tax rate. In order to receive the benefit of these incentives, we must hire specified numbers of employees and maintain certain minimum levels of fixed asset investment in Costa Rica. If we do not fulfill these conditions for any reason, our incentive could lapse and our income in Costa Rica would be subject to taxation at higher rates which could have a negative impact on our operating results. The Costa Rica corporate income tax rate that would apply, absent the incentives, is 30% for 2018 and 2017. For the three and six months ended June 30, 2018, the reduction in income taxes due to the reduced tax rate was minimal.
As of December 31, 2017, undistributed earnings of the Company totaled $606.5 million. We reassessed our capital needs and investment strategy with regard to the indefinite reinvestment of the undistributed earnings from certain of our foreign subsidiaries as a result of the one-time transition tax on cumulative foreign earnings under the TCJA. During the fourth quarter of 2017, we determined that approximately $591.9 million of the total undistributed foreign earnings are no longer considered to be indefinitely reinvested outside the U.S. As a result, in the fourth quarter of 2017, we recorded a deferred tax liability of approximately $3.3 million, which represents the provisional amount of U.S. state income taxes that would be due in the event these foreign earnings are distributed. The remaining amount of undistributed foreign earnings of approximately $14.7 million continues to be indefinitely reinvested in our international operations. Since U.S. federal income tax has already been provided under the provisions of the TCJA, the additional tax impact of the distribution of such foreign earnings to the U.S. parent would be limited to U.S. state income and withholding taxes and is not significant.
As of December 31, 2017, we recorded a provisional tax charge for the estimated impact of the TCJA of $84.3 million, of which $73.9 million was related to a provisional transition tax liability on the mandatory deemed repatriation of foreign earnings and $10.4 million was related to the remeasurement of certain deferred tax assets and liabilities. During the six months ended June 30, 2018, the additional provisional tax charge recorded was $0.5 million, primarily resulting from further analysis of our cumulative foreign earnings balances affecting the transition tax liability and the corresponding state tax impact. As we complete our analysis of the TJCA, we may make further adjustments to the provisional amounts, which may impact our provision for income taxes in the period in which the adjustments are made.
The TCJA subjects a U.S. shareholder to tax on global intangible low-taxed income (“GILTI”) earned by certain foreign subsidiaries. The FASB Staff Q&A, Topic 740, No. 5, Accounting for Global Intangible Low-Taxed Income, states that an entity can make an accounting policy election to either recognize deferred taxes for temporary basis differences expected to reverse as GILTI in future years or provide for the tax expense related to GILTI in the year the tax is incurred as a period expense only. Given the complexity of the GILTI provisions, we are still evaluating the effects of the GILTI provisions and have not yet determined our accounting policy. As of June 30, 2018, we are still evaluating the GILTI provisions and our analysis of future taxable income that is subject to GILTI. We have included GILTI related to current-year operations only in our estimated annual effective tax rate and have not provided additional GILTI on deferred items.
Note 13. Net Income per Share
Basic net income per share is computed using the weighted average number of shares of common stock outstanding during the period. Diluted net income per share is computed using the weighted average number of shares of common stock, adjusted for any dilutive effect of potential common stock. Potential common stock, computed using the treasury stock method, includes RSUs, MSUs, stock options and our ESPP.
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The following table sets forth the computation of basic and diluted net income per share attributable to common stock (in thousands, except per share amounts):
Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||
2018 | 2017 | 2018 | 2017 | ||||||||||||
Numerator: | |||||||||||||||
Net income | $ | 106,105 | $ | 69,179 | $ | 201,971 | $ | 138,599 | |||||||
Denominator: | |||||||||||||||
Weighted-average common shares outstanding, basic | 80,216 | 80,188 | 80,127 | 80,047 | |||||||||||
Dilutive effect of potential common stock | 1,255 | 1,443 | 1,448 | 1,621 | |||||||||||
Total shares, diluted | 81,471 | 81,631 | 81,575 | 81,668 | |||||||||||
Net income per share, basic | $ | 1.32 | $ | 0.86 | $ | 2.52 | $ | 1.73 | |||||||
Net income per share, diluted | $ | 1.30 | $ | 0.85 | $ | 2.48 | $ | 1.70 | |||||||
For the three and six months ended June 30, 2018 and 2017, potentially anti-dilutive shares excluded from diluted net income per share related to RSUs, MSUs, stock options and ESPP were not material.
Note 14. Segments and Geographical Information
Segment Information
Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the Chief Operating Decision Maker (“CODM”), or decision-making group, in deciding how to allocate resources and in assessing performance. Our CODM is our Chief Executive Officer. We report segment information based on the management approach. The management approach designates the internal reporting used by CODM for decision making and performance assessment as the basis for determining our reportable segments. The performance measures of our reportable segments include net revenues, gross profit and income from operations. Income from operations for each segment includes all geographic revenues, related cost of net revenues and operating expenses directly attributable to the segment. Certain operating expenses are attributable to operating segments and each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Costs not specifically allocated to segment income from operations include various corporate expenses such as stock-based compensation and costs related to IT, facilities, human resources, accounting and finance, legal and regulatory, and other separately managed general and administrative costs outside the operating segments.
We group our operations into two reportable segments: Clear Aligner segment and Scanner segment.
• | Our Clear Aligner segment consists of Comprehensive Products, Non-Comprehensive Products and Non-Case revenues as defined below: |
• | Comprehensive Products include our Invisalign Full, Teen and Assist products. |
• | Non-Comprehensive Products include our Invisalign Express, Invisalign Lite, Invisalign i7 and Invisalign Go products in addition to revenues from the sale of aligners to SDC under our supply agreement. |
• | Non-Case includes our Vivera retainers along with our training and ancillary products for treating malocclusion. |
• | Our Scanner segment consists of intraoral scanning systems and additional services available with the intraoral scanners that provide digital alternatives to the traditional cast models. This segment includes our iTero scanner and OrthoCAD services. |
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These reportable operating segments are based on how our CODM views and evaluates our operations as well as allocation of resources. The following information relates to these segments (in thousands):
Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||
Net revenues | 2018 | 2017 | 2018 | 2017 | |||||||||||
Clear Aligner | $ | 433,241 | $ | 321,036 | $ | 818,746 | $ | 603,435 | |||||||
Scanner | 57,018 | 35,446 | 108,437 | 63,388 | |||||||||||
Total net revenues | $ | 490,259 | $ | 356,482 | $ | 927,183 | $ | 666,823 | |||||||
Gross profit | |||||||||||||||
Clear Aligner | $ | 331,612 | $ | 250,814 | $ | 628,588 | $ | 470,761 | |||||||
Scanner | 33,970 | 20,103 | 64,402 | 35,781 | |||||||||||
Total gross profit | $ | 365,582 | $ | 270,917 | $ | 692,990 | $ | 506,542 | |||||||
Income from operations | |||||||||||||||
Clear Aligner | $ | 190,287 | $ | 133,916 | $ | 351,741 | $ | 248,650 | |||||||
Scanner | 17,670 | 8,795 | 33,752 | 14,799 | |||||||||||
Unallocated corporate expenses | (85,266 | ) | (59,142 | ) | (164,610 | ) | (118,207 | ) | |||||||
Total income from operations | $ | 122,691 | $ | 83,569 | $ | 220,883 | $ | 145,242 | |||||||
Depreciation and amortization | |||||||||||||||
Clear Aligner | $ | 6,759 | $ | 5,600 | $ | 13,143 | $ | 9,963 | |||||||
Scanner | 1,169 | 1,082 | 2,273 | 2,119 | |||||||||||
Unallocated corporate depreciation and amortization | 4,704 | 2,194 | 8,650 | 4,661 | |||||||||||
Total depreciation and amortization | $ | 12,632 | $ | 8,876 | $ | 24,066 | $ | 16,743 | |||||||
The following table reconciles total segment income from operations in the table above to net income before provision for income taxes and equity losses of investee (in thousands):
Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||
2018 | 2017 | 2018 | 2017 | ||||||||||||
Total segment income from operations | $ | 207,957 | $ | 142,711 | $ | 385,493 | $ | 263,449 | |||||||
Unallocated corporate expenses | (85,266 | ) | (59,142 | ) | (164,610 | ) | (118,207 | ) | |||||||
Total income from operations | 122,691 | 83,569 | 220,883 | 145,242 | |||||||||||
Interest income | 1,917 | 1,441 | 4,093 | 2,636 | |||||||||||
Other income (expense), net | (7,099 | ) | 1,771 | (6,922 | ) | 2,221 | |||||||||
Net income before provision for income taxes and equity in losses of investee | $ | 117,509 | $ | 86,781 | $ | 218,054 | $ | 150,099 | |||||||
Geographical Information
Net revenues are presented below by geographic area (in thousands):
Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||
2018 | 2017 | 2018 | 2017 | ||||||||||||
Net revenues 1: | |||||||||||||||
United States | $ | 254,020 | $ | 207,021 | $ | 491,123 | $ | 390,294 | |||||||
The Netherlands | 156,428 | 109,532 | 295,959 | 209,331 | |||||||||||
Other International | 79,811 | 39,929 | 140,101 | 67,198 | |||||||||||
Total net revenues | $ | 490,259 | $ | 356,482 | $ | 927,183 | $ | 666,823 | |||||||
1 Net revenues are attributed to countries based on location of where revenue is recognized.
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Tangible long-lived assets are presented below by geographic area (in thousands):
June 30, 2018 | December 31, 2017 | ||||||
Long-lived assets 2: | |||||||
The Netherlands | $ | 190,130 | $ | 143,673 | |||
United States | 129,837 | 128,171 | |||||
Costa Rica | 61,609 | 30,738 | |||||
Mexico | 31,289 | 25,090 | |||||
China | 16,393 | 5,480 | |||||
Other International | 18,675 | 15,641 | |||||
Total long-lived assets | $ | 447,933 | $ | 348,793 | |||
2 Long-lived assets are attributed to countries based on entity that owns the assets.
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ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
In addition to historical information, this quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements include, among other things, our expectations regarding the anticipated impact of our new products and product enhancements will have on doctor utilization and our market share, our expectations regarding product mix and product adoption, our expectations regarding the existence and impact of seasonality, our expectations regarding the sales growth of our intra-oral scanner sales in international markets, our expectations regarding the financial and strategic benefits of establishing regional order acquisition, treatment planning and manufacturing facilities, as well as the anticipated timing of such facilities being operational, our expectations regarding the continued expansion of our international markets, our intention to open additional Invisalign stores, impact of the U.S. Tax Cuts and Jobs Act, the level of our operating expenses and gross margins and other factors beyond our control, as well as other statements regarding our future operations, financial condition and prospects and business strategies. These statements may contain words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” or other words indicating future results. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and in particular, the risks discussed below in Part 2, Item 1A “Risk Factors.” We undertake no obligation to revise or update these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.
The following discussion and analysis of our financial condition and results of operations should be read together with our condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2017, as filed with the Securities and Exchange Commission.
Overview
Our goal is to establish Invisalign clear aligners as the standard method for treating malocclusion and to establish the iTero intraoral scanner as the preferred scanning device for 3D digital scans, ultimately driving increased product adoption by dental professionals. We intend to achieve this by continued focus and execution of our strategic growth drivers set forth in the Business Strategy section in our Annual Report on Form 10-K.
The successful execution of our business strategy in 2018 and beyond may be affected by a number of other factors including:
• | New Invisalign Product Portfolio and Pricing. In July 2018, we launched a new expanded Invisalign product portfolio which includes new options and greater flexibility to treat a broader range of patients. The new Invisalign product portfolio offers doctors more choices by extending desirable features across the entire portfolio and creating new Invisalign treatment packages, as well as new options to treat young patients with early mixed dentition (with a mixture of primary/baby and permanent teeth). The new end-to-end Invisalign product portfolio will include clear aligner product offerings for almost every patient age group and case complexity to make it easier for our doctors to tailor treatment planning to the needs of each patient. Pricing and availability for the new Invisalign product offerings and the associated terms and conditions will vary by region. |
• | New Invisalign Products and Feature Enhancements. Product innovation drives greater treatment predictability, clinical applicability and ease of use for our customers which supports adoption of Invisalign treatment in their practices. Our focus is to develop solutions and features to treat a wide range of cases from simple to complex. |
◦ | In March 2017, we announced Invisalign Teen with mandibular advancement, the first clear aligner solution for Class II correction in growing tween and teen patients. This offering combines the benefits of the most advanced clear aligner system in the world with features for moving the lower jaw forward while simultaneously aligning the teeth. Invisalign Teen with mandibular advancement is available in Canada and in select Europe, Middle East and Africa (“EMEA”), Asia Pacific (“APAC”) and Latin America (“LATAM”) countries. Invisalign Teen with mandibular advancement is pending 510(k) clearance and is not yet available in the United States (“U.S.”). |
◦ | Beginning July 2018, Invisalign First clear aligners are commercially available to Invisalign-trained doctors in the U.S., Canada, Australia, New Zealand, Japan, and the EMEA region. Invisalign First clear aligners, a treatment option designed with features specifically for younger patients with early mixed dentition. Phase 1 treatment is early interceptive orthodontic treatment for young patients, traditionally done through arch expanders, or partial |
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metal braces, before all permanent teeth have erupted, typically at ages 6 through 10 years. Invisalign First clear aligners are designed specifically to address a broad range of younger patients’ malocclusions, including shorter clinical crowns, management of erupting dentition, and predictable dental arch expansion.
◦ | In April 2018, we announced a new Invisalign Go product with 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 that leverages our Invisalign patients treated to date. These improvements make it easier for dentists to tailor their treatment plans to the individual needs of each patient. |
We believe that over the long-term, clinical solutions and treatment tools will increase adoption of Invisalign and increase sales of our intraoral scanners; however, it is difficult to predict the rate of adoption which may vary by region and channel.
• | New iTero Products and Technology Innovation. The iTero scanner is an important component to customer experience and is central to a digital approach as well as overall customer utilization of Invisalign. |
◦ | In April 2018, we expanded the iTero Element portfolio with the launch of the iTero Element 2 and the iTero Element Flex scanners. These additions build on the existing high precision, full-color imaging and fast scan times of the iTero Element portfolio while streamlining orthodontic and restorative workflows. The next-generation iTero Element 2 is designed for greater performance with 2X faster start-up and 25% faster scan processing time compared to the iTero Element. The new iTero Element Flex wand-only configuration is a portable scanner for easy transport from office to office. iTero Element 2 and iTero Element Flex scanners are available in Canada, the U.S., the majority of European countries, including France, Germany, Italy, Spain, and the United Kingdom as well as select APAC markets. The existing iTero Element scanner will continue to be available in all markets. |
◦ | On April 25, 2018, we announced that we received market approval for the iTero Element intra-oral scanner from the China Food and Drug Administration, and we began offering this scanner in China. The iTero Element scanner launch in China not only supports growth of our base Invisalign clear aligner business but also represents a major milestone for digital dentistry in China. As we continue to expand the markets into which we sell our intra-oral scanners, we expect continued growth for the foreseeable future due to the size of the market opportunity and our relatively low market penetration of these regions. |
The use of iTero and other digital scanners for Invisalign case submission in place of PVS impressions continues to grow and remains a positive catalyst for Invisalign utilization. For the second quarter of 2018, total Invisalign cases submitted with a digital scanner in the Americas increased to 69.3%, up from 67.3% in the first quarter of 2018. International scans increased to 47.3%, up from 43.2% in the first quarter of 2018. While we believe that over the long-term, technology innovation and added features and functionality of our iTero scanners will increase adoption of Invisalign and increase sales of our intraoral scanners; it is, however, difficult to predict the rate of adoption which may vary by region and channel.
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• | Invisalign Adoption. Our goal is to establish Invisalign as the treatment of choice for treating malocclusion ultimately driving increased product adoption and frequency of use by dental professionals, also known as “utilization rates.” Our quarterly utilization rates for the last 9 quarters are as follows: |
* Invisalign utilization rates = # of cases shipped divided by # of doctors cases were shipped to. Beginning in the first quarter of 2018, we report International region to include EMEA and APAC. LATAM is excluded from above chart as it is not material. Our historical utilization numbers have been recasted to reflect this new classification.
◦ | Total utilization in the second quarter of 2018 increased to 6.0 cases per doctor compared to 5.6 in the second quarter of 2017. |
▪ | North America: Utilization among our North American orthodontist customers reached an all time high in the second quarter of 2018 at 16.4 cases per doctor. Compared to 13.6 cases per doctor utilized in the second quarter of 2017, the increase in North American orthodontist utilization in the second quarter of 2018 reflects improvements in product and technology which continues to strengthen our doctors’ clinical confidence such that they now utilize Invisalign more often and on more complex cases, including their teenage patients. |
▪ | International: International doctor utilization was 5.6 cases per doctor in the second quarter of 2018 compared to 5.3 in the second quarter of 2017. The increase in International utilization reflects growth in both the EMEA and APAC regions due to increasing adoption of the product due in part to its ability to treat more complex cases. |
We expect that over the long-term our utilization rates will gradually improve as a result of advancements in product and technology, which continue to strengthen our doctors’ clinical confidence in the use of Invisalign. In addition, since the teenage and younger market makes up 75% of the 12 million total orthodontic case starts each year, and as we continue to drive adoption of teenage and younger patients through sales and marketing programs, we expect our utilization rate to improve. Our utilization rates, however, may fluctuate from period to period due to a variety of factors, including seasonal trends in our business along with adoption rates of new products and features.
• | Number of New Invisalign Doctors Trained. We continue to expand our Invisalign customer base through the training of new doctors. In 2017, Invisalign growth was driven primarily by increased utilization across all regions as well as by the continued expansion of our customer base as we trained a total of 16,500 new Invisalign doctors, of which 62% were trained in the International region. During the six months ended June 30, 2018, we trained 9,345 new Invisalign doctors of which 3,400 were trained in the Americas region and 5,945 in the International region. |
• | International Invisalign Growth. We continue to focus our efforts towards increasing Invisalign clear aligner adoption by dental professionals in our direct EMEA and APAC markets. On a year-over-year basis, our International Invisalign |
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volume increased 45.4% driven primarily by increased adoption as well as expansion of our customer base in both EMEA and APAC regions. We continue to see growth from our international orthodontists and general practitioner (“GP”) customers and are seeing more positive traction in the GP channel from segmenting our sales and marketing resources and programs specifically around each channel. In addition, we believe that continuous product introductions and feature improvements, such as Invisalign treatment with mandibular advancement, provide our customers with continued confidence in treating complex cases as well as teen-aged patients with Invisalign clear aligners. In 2018, we are continuing to expand in our existing markets through targeted investments in sales coverage and professional marketing and education programs, along with consumer marketing in selected country markets. We expect International revenues to continue to grow at a faster rate than the Americas for the foreseeable future due to our continued investment in international market expansion, the size of the market opportunity, and our relatively low market penetration of these regions (Refer to Item 1A Risk Factors - “We are exposed to fluctuations in currency exchange rates, which could negatively affect our financial condition and results of operations.” for information on related risk factors).
• | Establish Regional Order Acquisition, Treatment Planning and Manufacturing Operations. We will continue to establish and expand additional order acquisition, treatment planning and manufacturing operations closer to our international customers in order to improve our operational efficiency and to provide doctors confidence in using Invisalign clear aligners to treat more patients and more often. In July 2018, we moved into new facilities in Costa Rica in order to support our expanding treatment planning as well as other support functions. In 2018, we expect to open a treatment planning facility in Madrid, Spain, a manufacturing facility in Ziyang, China as well as another new facility in Costa Rica to support treatment planning and administrative activities (Refer to Item 1A Risk Factors - “As we continue to grow, we are subject to growth related risks, including risks related to excess or constrained capacity at our existing facilities.” for information on related risk factors). |
• | Expenses. We expect expenses to increase in fiscal year 2018 due in part to: |
◦ | Investments in international expansion in new country markets; |
◦ | Product and technology innovation to enhance product efficiency and operational productivity; |
◦ | Investments in manufacturing capacity and facilities to enhance our regional capabilities; |
◦ | Increases in legal expenses primarily related to the continued protection of our intellectual property rights, including our patents; and |
◦ | Increases in sales, marketing, advertising and customer support resources. |
We believe that these investments will position us to increase our revenue and continue to grow our market share.
• | Stock Repurchases: |
◦ | April 2016 Repurchase Program. In February 2018, we repurchased $100.0 million of our common stock on the open market. In July 2018, we repurchased $100.0 million of our common stock on the open market, completing the April 2016 Repurchase Program. |
◦ | May 2018 Repurchase Program. In May 2018, we announced that our Board of Directors had authorized a plan to repurchase up to $600.0 million of our common stock. As of June 30, 2018, we have $600.0 million remaining under the May 2018 Repurchase Program (Refer to Note 11 “Common Stock Repurchase Programs” of the Notes to Condensed Consolidated Financial Statements for details on our stock repurchase programs). |
• | U.S. Tax Cuts and Jobs Act. The U.S. Tax Cuts and Jobs Act (the “TCJA”) was enacted into law on December 22, 2017 and impacted our effective tax rate. The TCJA made significant changes to the Internal Revenue Code, including, but not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings. We recorded a provisional one-time transition tax liability of $73.9 million in the fourth quarter of 2017 and an additional $0.5 million during the six months ended June 30, 2018. Additional work is necessary for a more detailed analysis of our historical foreign earnings as well as potential correlative adjustments. Any subsequent adjustment to these amounts will be recorded to provision from income taxes throughout the fiscal year of 2018 when the analysis is complete. |
• | SmileDirectClub. On April 5, 2018, SDC Financial LLC, SmileDirectClub LLC, and the Members of SDC Financial LLC other than Align (collectively, the "SDC Entities") initiated proceedings that seek, among other forms of relief, to preliminarily and permanently enjoin all activities related to the Invisalign store pilot project, require Align to close the |
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existing Invisalign stores, prohibit Align from opening any additional stores, and allow the SDC Entities to exercise a right to repurchase all of Align's SDC Financial LLC membership interests for a purchase price equal to the current capital account balance. On June 29, 2018, the Chancery Court for Davidson County, Tennessee, denied the SDC Entities’ request for a temporary injunction to prevent Align from opening additional Invisalign stores. Align continues to dispute the allegations that it has breached its obligations to the SDC Entities under applicable law and will oppose and vigorously defend itself at the arbitration proceedings currently scheduled for December 2018. This dispute does not impact Align’s existing supply agreement with SDC which remains in place through 2019 and includes a minimum volume commitment. We are currently unable to predict the outcome of this dispute and therefore cannot determine the likelihood of loss, if any, nor estimate a range of possible loss.
Results of Operations
Net Revenues by Reportable Segment
We group our operations into two reportable segments: Clear Aligner segment and Scanner segment.
• | Our Clear Aligner segment consists of Comprehensive Products, Non-Comprehensive Products and Non-Case revenues as defined below: |
• | Comprehensive Products include our Invisalign Full, Teen and Assist products. |
• | Non-Comprehensive Products include our Invisalign Express, Invisalign Lite, Invisalign i7 and Invisalign Go products in addition to revenues from the sale of aligners to SmileDirectClub (“SDC”) under our supply agreement. |
• | Non-Case includes our Vivera retainers along with our training and ancillary products for treating malocclusion. |
• | Our Scanner segment consists of intraoral scanning systems and additional services available with the intraoral scanners that provide digital alternatives to the traditional cast models. This segment includes our iTero scanner and OrthoCAD services. |
Effective in the first quarter of 2018, Americas region includes North America and LATAM. International region includes EMEA and APAC. Historical data has been recasted to reflect the change.
Net revenues for our Clear Aligner and Scanner segments by region for the three and six months ended June 30, 2018 and 2017 are as follows (in millions):
Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||||||||
Net Revenues | 2018 | 2017 | Net Change | % Change | 2018 | 2017 | Net Change | % Change | |||||||||||||||||||||
Clear Aligner revenues: | |||||||||||||||||||||||||||||
Americas | $ | 234.0 | $ | 188.6 | $ | 45.4 | 24.1 | % | $ | 443.6 | $ | 354.2 | $ | 89.4 | 25.2 | % | |||||||||||||
International | 173.0 | 111.8 | 61.1 | 54.7 | % | 324.7 | 210.7 | 114.0 | 54.1 | % | |||||||||||||||||||
Non-case | 26.2 | 20.6 | 5.6 | 27.4 | % | 50.4 | 38.5 | 11.9 | 31.0 | % | |||||||||||||||||||
Total Clear Aligner net revenues | $ | 433.2 | $ | 321.0 | $ | 112.2 | 35.0 | % | $ | 818.7 | $ | 603.4 | $ | 215.3 | 35.7 | % | |||||||||||||
Scanner net revenues | 57.0 | ||||||||||||||||||||||||||||