Align Technology Stock: The Short-Sellers Are Wrong (Rating Upgrade) (NASDAQ:ALGN)

RichLegg/E+ via Getty Images Introduction & Investment Thesis I initiated a “hold” rating on Align Technology (NASDAQ:ALGN) on March 1, where my thesis was predicated on my belief that the stock could remain under pressure as its operating margin had been declining, even though the company was showing signs of recovering revenue growth. Since then, the medical device company known for its Invisalign product has underperformed the S&P 500 (SPY) and Nasdaq 100 (QQQ) and is down 19% since the time of my writing. The company is due to report its Q2 FY24 earnings on June 24, where revenue is expected to grow approximately 4% YoY to $1.04B while non-GAAP operating margin is projected to increase slightly on a sequential basis. In its Q1 FY24 earnings, management raised its revenue target to approximately 7% for the whole year after a stronger than expected start to the year across both its Clear Aligner and Systems and Services segments. Since the earnings report, Hedgeye has added Align to its list of short recommendations with a projected downside of 20% as it expects management to report a weaker Q2 and lower growth forecast for H2 and FY25. They mostly cited macroeconomic factors as the main culprit. I believe their concerns are misguided. I think we may be at a turnaround point for Align where revenue and profitability will likely accelerate as inflationary pressures subside. Plus, given my valuation assumptions, I believe that there is likely a 40% upside from its current levels, providing sufficient margin of safety to initiate a position in the stock. As a result, I will upgrade my rating from “hold” to “buy.” A preview of Align’s Q1 earnings Align reported its Q1 FY24 earnings, where it grew its revenue 5.8% YoY to $997.5. Out of the $997.5M, Clear Aligner segment contributed close to 82% of Total Revenue, growing 3.5% YoY, while the Imaging Systems and CAD/CAM Services revenue contributed the remaining 18% of Total Revenue, growing 17.5% YoY. I will break down some of the highlights of the business performance in each of these segments in the sections below. Q1 FY24 Earnings Slides: Revenue growth across the quarters Let’s start with the Clear Aligner segment, where revenue growth was up across all regions, especially in the Asia-Pacific region, with total global shipments growing 2.1% sequentially as well as higher Average Selling Price (“ASP”) for Invisalign used for comprehensive treatments. Specifically, strength in the teen market continues, with over 200,000 teens and younger patients starting treatment in Q1, which is up 5.8% YoY. In terms of product innovation, the company launched the Palatal Expander system in the US and Canada, which is a 3D printed orthodontic device to address widening the upper arch in growing patients. During the earnings call, the management discussed that the initial response from doctors and patients using the Invisalign Palatal Expander system has been positive, as it is less painful than traditional expanders and facilitates better oral hygiene. In order to drive awareness of the Palatal Expander System, the company invested in its marketing engine across channels such as TikTok, Instagram, YouTube, Snapchat, and more through influencers and creator-centric campaigns across regions, which I believe should boost the topline in the coming quarters. Moving on to the second business segment, which is Systems and Services, the company saw revenue grow 17.5% YoY, driven primarily by non-Systems revenue from iTero Lumina wand upgrades in North America as well as higher Service revenue from larger volumes of scanners sold. During the quarter, the company also launched the iTero Lumina intraoral scanner, which will deliver faster scanning speeds, higher accuracy, better visualization, and a more comfortable scanning experience. Shifting gears to profitability, the company generated $197.5M in non-GAAP operating income, which grew 13% YoY with a margin of 19.8%, an improvement of 130 basis points from the previous year. In my previous post, I wrote about my concern that the company was seeing its non-GAAP operating margin shrink, driven by weakness in demand as well as not being able to streamline its operating expenses. Although non-GAAP operating margin declined sequentially primarily due to increased investments in go-to-market teams, I am optimistic that the company was able to drive margin expansion on a year-over-year basis as it was able to better manage costs with non-GAAP operating expenses growing at a slower rate of 3.2% YoY. Simultaneously, the company is also benefiting from increased operating leverage from higher ASPs across Clear Aligner and its Services segment. Q1 FY24 Earnings Slides: Trend of profitability across quarters Looking forward, the management has raised its revenue guidance from its previous estimate of mid-single-digit growth to a range of 6-8% while keeping its non-GAAP operating margin estimate unchanged. I find this particularly optimistic, as this probably marks a trough, with acceleration ahead, especially when it comes to the strength in shipments for its Invisalign products and scanners, particularly in international markets, where it is well positioned among teen and young adult demographics, along with its robust product innovation. Key updates since the last earnings call On June 28th, Hedgeye added Align to its list of short recommendations, forecasting a downside of 20%. Tom Tobin of Hedgeye believes that it will come shy of its revenue estimates, as he expects continued softness in North America’s GP utilization rate. Given that the management has already raised its revenue guidance for FY24, a weaker Q2 result might result in aggressive selling. Plus, Tobin expected that the management would give a softer outlook for H2, with lower estimates for FY25, as real income growth continues to slow while treatment financing costs and dental labor costs continue to rise. While Tobin has correctly identified the plateauing of the utilization rate of Clear Aligner, I believe that we may see a reversal of that as demand slowly picks up from improving macroeconomic conditions. From late 2021 until now, the company has seen demand weaken as the US economy grappled with inflation, thus putting strains on consumer spending. We are finally starting to see clear evidence of disinflation after the latest CPI print after one of the longest stretches of tight monetary policy. With the Fed now likely to cut rates earlier than expected, I believe that it will reignite growth back in the economy, which will be conducive to consumer spending and hence boost Align’s top line. Plus, I also like that the company is focusing on international expansion, where it is seeing faster growth in international markets, specifically in Asia Pacific. As a result, I disagree with Hedgeye’s short position, as I don’t expect the management to guide for a weaker H2. Things to look for in Align’s Q2 earnings call 1. Revenue guidance: The company is set to report its Q2 earnings on June 24, where it expects revenue growth of approximately $1.04B, representing a growth rate of 4%. While beating its Q2 revenue guidance will be a positive sign, I believe it will be important to pay attention to the management’s commentary and guidance on the following sub metrics within individual business segments. Clear Aligner Segment: While volume is expected to be up sequentially and ASP is projected to decline slightly from the previous quarter because of foreign exchange headwinds, I believe it will be important to look for management’s direction on how it expects shipments to continue for the remainder of the year across regions. We have already seen that its teen market is growing steadily, so as long as it continues to onboard new teens and young adults at a steady pace, we should see shipments and ASPs trend higher for the remainder of the year, especially as more doctors and patients adopt its latest Palatal Expander System. Systems and Services: For Q2, the management expects Systems and Services revenue to be up sequentially as they ramp iTero Lumina. While Systems and Services contribute a smaller portion of the revenue, I believe investors should be paying attention to management’s guidance on the number of scanners sold and the upgrade cycle affecting ASPs. 2. Profitability: Management expects the non-GAAP operating margin to be slightly above Q1 FY24, which would mean that it will likely be flat on a year-over-year basis. I believe that a higher than expected non-GAAP operating margin will boost investor confidence, especially as the company has suffered from shrinking margins over the last couple of years. I don’t necessarily expect the management to cut back on its spending on Sales & Marketing and R&D; however, an expanding margin would be an indication that the company is finally unlocking operating leverage once again from higher ASPs in its business segments. Is Align stock a buy? Looking forward, assuming that Align meets its revenue expectation for FY24 at an approximately 7% growth rate, followed by an acceleration in the high single digit in FY25 and low teens in FY26, as it continues to drive its product innovation and go-to-market strategies to drive higher adoption of its products, especially in teen and young adult markets, while expanding internationally, it should generate close to $5.04B by FY26. From a profitability standpoint, management has guided non-GAAP operating margins to be slightly above FY23 levels. Therefore, assuming that it can generate a non-GAAP operating margin of 22% in FY24, followed by a 100 basis point improvement every year after that until FY26, it should generate $1.2B in non-GAAP operating income with a margin of 24%. This is equivalent to a present value of $1B in non-GAAP operating income when discounted at 10%. Taking the S&P 500 as a proxy, where its companies grow their earnings on average by 8% over a 10-year period, with a price-to-earnings ratio of 15-18, I believe Align should trade at 1.5 times the multiple, given the growth rate of its earnings during the period of time. This will translate to a PE ratio of 25.5, or a price target of $338, which represents an upside of approximately 40% from its current levels. Author’s Valuation Model My final verdict and conclusion I believe that Align may be at a turning point where revenue and profitability start to reaccelerate once again, especially after its Q1 earnings results, where we saw Clear Aligner shipments picking up sequentially, along with growing ASPs as it continues to expand internationally, drive a robust product innovation roadmap, and strength in its teen and young adults market. At the same time, the management is showing early signs of success with managing costs better, as non-GAAP operating margins expanded on a year-over-year basis. While Tom Tobin of Hedgeye believes that the management will likely guide for a weaker H2 and FY25 as macroeconomic pressures intensify, I believe the opposite will occur. As inflation pressures ease, along with a growing probability of an earlier interest rate cut, I think we may be on the cusp of reigniting economic growth, which will bode well for consumer spending and act as a tailwind for Align’s top line. Plus, I believe that the stock is attractively priced at its current level, with a potential upside of at least 40% over a three-year horizon. Even if we take Hedgeye’s 20% sell-off prediction as a maximum floor on the stock, the current risk-reward offers us a 20% margin of safety. Therefore, after assessing both the “good” and the “bad,” I believe that the stock is a buy prior to its Q2 earnings.

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