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ALIGN TECHNOLOGY INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) In addition to historical information, this annual 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, including Invisalign G3, 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 financial and strategic benefits of the Cadent Holdings, Inc. ("Cadent") acquisition, our expectations to increase our investment in manufacturing capacity, our expectations regarding the continued growth of our international markets, including the expected timing of the commercial launch of Invisalign in China , the anticipated number of new doctors trained and their impact on volumes, 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 II, 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. Align Technology, Inc ("We", "Our", "Align") designs, manufactures and markets the Invisalign system and the iTero and iOC scanning system and services. We received the United States Food and Drug Administration ("FDA") clearance to market Invisalign in 1998. The Invisalign system is regulated by the FDA as a Class II medical device. On April 29, 2011, we acquired Cadent Holdings, Inc, the manufacturer of the iTero and iOC digital intra-oral scanners and provider of CAD/CAM (computer-aided design and computer-aided manufacturing) restorative models for use by general dentists and/or labs and of services for orthodontic digital procedures. The Invisalign system products represent approximately ninety-five percent of worldwide revenue, while the scanning products and services represent the remaining five percent of worldwide revenues. Invisalign System and Services We design, manufacture and market the Invisalign system, a proprietary method for treating malocclusion, or the misalignment of teeth. Invisalign corrects malocclusion using a series of clear, nearly invisible, removable appliances that gently move teeth to a desired final position. Because it does not rely on the use of metal or ceramic brackets and wires, Invisalign significantly reduces the aesthetic and other limitations associated with metal arch wires and brackets, commonly referred to as braces. We received the United States Food and Drug Administration ("FDA") clearance to market Invisalign in 1998. The Invisalign system is regulated by the FDA as a Class II medical device. We distribute the vast majority of Invisalign products directly to our customers: the orthodontist and the general practitioner dentist, or GP. Orthodontists and GPs must complete an initial Invisalign training course in order to begin providing the Invisalign treatment solution to their patients. The Invisalign system is sold in North America, Europe, Asia Pacific, Latin America and Japan. We use a distributor model for the sale of our products in parts of the Asia Pacific, Latin American and EMEA (Europe, Middle East and Africa) regions. Each Invisalign treatment plan is unique to the individual patient. Our Invisalign Full treatment consists of as many aligners as indicated by ClinCheck in order to achieve the doctors' treatment goals. Our Invisalign Express is a dual arch orthodontic treatment for cases that meet certain predetermined clinical criteria and consist of up to ten sets of aligners. Invisalign Express treatment is intended to assist dental professionals to treat a broader range of patients by providing a lower-cost option for adult relapse cases, for minor crowding and spacing, or as a pre-cursor to restorative or cosmetic treatments such as veneers. In April 2010, we replaced Invisalign Express in international markets with the launch of Invisalign Lite. Invisalign Lite offers doctors a new option for less complex orthodontic cases, such as short-term aesthetic cases, relapsed cases and pre-restorative treatments, using up to 14 stages. Invisalign Teen is designed to meet the specific needs of the non-adult comprehensive or teen treatment market particularly younger teenagers aged 11 to 15 years. Invisalign Assist is intended to help newly-trained and lower volume Invisalign GPs accelerate the adoption and frequency of use of Invisalign into their practice. Upon completion of an Invisalign or non-Invisalign treatment, the patient may be prescribed our 20-------------------------------------------------------------------------------- Table of Contents traditional retainer product, or our Vivera retainers, a clear aligner set designed for ongoing retention. Our goal is to establish Invisalign as the standard method for treating malocclusion ultimately driving increased product adoption by dental professionals by focusing on the four key objectives: driving product innovation and clinical effectiveness, enhancing the customer experience, generating consumer demand and expanding into international markets. Each of these four key objectives is described more fully in Item I-Business-Business Strategy of our 2010 Annual Report on Form 10-K. As we execute on our business strategy, we will continue to deliver significant evolutions in product features and functionality, as well as customer facing systems. Scanner Systems and CAD/CAM Services On April 29, 2011, we acquired privately-held Cadent Holdings, Inc, a manufacturer of 3D digital intra-oral scanners and provider of CAD/CAM (computer-aided design and computer-aided manufacturing) restorative models for use by GPs and/or labs and of services for orthodontic digital procedures. We paid approximately $187 million in exchange for all shares of Cadent. Our second quarter of 2011 financial results include two months of Cadent's operations. Intra-oral scanners which are comprised of a mobile computer unit, display screen, a control foot pedal and scanning wand are used by dental professionals to scan a patient's full or partial arch dentition. The iTero software captures the contours of the patient's dentition, gingival structures and the bite, without the use of powder, resulting in an accurate digital orthodontic scan in minutes ready for immediate viewing on the screen. The 3D digital model file can then be used for various procedures and services including, fabrication of physical dental models for use by labs to create restorative units such as veneers, inlays, onlays, crowns, bridges and implant abutments; manufacturing of Invisalign treatment aligners; digital records storage; or orthodontic diagnosis and computer aided placement of traditional braces. The Cadent family of products includes the iTero and iOC scanning systems, both based on the iTero platform but modified slightly with features to better suit our two distinct channels; the orthodontist (iOC system) and the GP (iTero system). In addition, we offer a range of iTero restorative services and OrthoCAD services - OrthoCAD iCast™, OrthoCAD iQ™, and OrthoCAD iRecord™. iTero restorative services including models and dies provides a GP or lab of choice with a fabricated or milled physical dental model used to create restorative units such as veneers, inlays, onlays, crowns, bridges and implant abutments, from single units to full arches. OrthoCAD iCast provides an orthodontist with a clean, digital model with American Board of Orthodontics base for use as study models from the scan. OrthoCAD iRecord is a digital alternative to traditional stone cast models which allows for simplified storage and digital record retrieval. OrthoCAD iQ uses the 3D digital model as a digital guide for optimal bracket placement and the creation of customized indirect bonding trays. Upon purchase of a scanner, one of our technical trainers will help install and train the dental professional on the system and services. To start a new digital full arch impression, upon completion of the digital prescription, the dental professional places the wand on one side of the patient's mouth as indicated by the system and activates the wand to capture 1-3 teeth per scan, then moves the wand to the next set of teeth. This process continues until all of the teeth are captured. The software system merges the images together and notes where images need to be recaptured, were scanned out of sequence or were missed. Currently, our iOC customers who wish to submit scans for Invisalign treatment options must first take the initial one day Invisalign training course and then enable the Invisalign option on the system. On May 16, 2011, we introduced iOC 4.0 which includes new software features such as the eraser tool and edge trim tool, a simplified graphic user interface and application tools including connectivity to the Invisalign Doctor Site, providing orthodontists with expanded features to ensure accurate digital impressions for Invisalign treatment. We expect to introduce the iTero 4.0 for GP in the fall of 2011 which will also include new software features and connectivity to the Invisalign Doctor Site. We distribute scanners and services to our customers: the orthodontist and the GP. In North America, scanners and services are sold through our direct sales force and distributors. In Europe, and other regions outside of North America, we use a distributor model for the sale of our scanner products and services. In addition to the successful execution of our business strategy, which is set forth in our Annual Report in Form 10-K, there are a number of other factors which may affect our results in 2011 and beyond, both of which are updated below: • Accelerate product and clinical innovation. In October 2010, we launched Invisalign G3 in North America, the most significant collection of new features and innovation in our company history touching virtually every system and product. Significant improvements and enhancements were made in to all our customer-facing systems. For instance, the Invisalign Doctor Site now consolidates all of a patient's Invisalign records and treatment tasks together in one location for easy access and the ClinCheck software now includes drag and drop features, additional clinical tools and a more intuitive interface. In addition, with the exception of our Vivera retainers, we introduced new and expanded features across our product line. Engineered to deliver even better 21 -------------------------------------------------------------------------------- Table of Contents clinical results, the Invisalign G3 new aligner and software features make it easier to use Invisalign with more complex and challenging cases, including Precision Cuts designed for use on patients with Class II and Class III malocclusion, new SmartForce features designed for increased predictability of certain tooth movements, and simpler, more intuitive software to streamline treatment planning and review. We believe that, in addition to an increase in the number of patients visiting dental offices throughout the first half of 2011 as reported by our customers, and patient interest in higher value procedures, Invisalign G3 is an important contributor to the increased utilization in the first half of 2011 by our North American Ortho customer. Additionally, since most of our international customers are Orthodontists, we believe the international launch of Invisalign G3 in May 2011 is important for continued growth both in our existing international markets and to support our expansion in new markets like China. • Investments to Increase Manufacturing Capacity. We expect capital expenditures to continue to increase in 2011 as we invest in our manufacturing facility in Juarez, Mexico to add incremental capacity. In addition, in order to meet the increased demands from expected volumes, we expect to open an additional aligner fabrication site in Juarez, Mexico by the end of 2011 and transition into this facility in 2012. Our ability to plan, construct and equip this additional manufacturing facility is subject to significant risk and uncertainty, including delays and cost overruns. If the opening of this facility is significantly delayed for any reason, or if demand for our product in 2011 exceeds our current expectations, or if the timing of receipt of case product orders during a given quarter is different from our expectations, we may not be able to fulfill orders timely, which may negatively impact our financial results and overall business. • Number of new doctors trained. In the second quarter of 2011 we trained approximately 1,365 new doctors worldwide compared to approximately 955 in the first quarter of 2011. We trained 845 in North America in the second quarter, compared to 790 on the first quarter. For international, we trained 520 new doctors, compared to around 165 in the first quarters as a result of training being resumed in the second quarter following the international launch of InvisalignG3. Primarily as a result of our decision to train fewer international doctors in the first quarter, we expect that the number of international doctors trained in 2011 will be approximately 700 fewer than the number trained in 2010. • Utilization rates. 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, or utilization. Our quarterly utilization rates for the previous nine quarters are as follows: [[Image Removed: LOGO]] Utilization rates = # of cases shipped divided by # of doctors cases were shipped to In the second quarter of 2011, total utilization increased to 4.0 cases per doctor, reflecting increased utilization rates by the North American Ortho to 6.9 cases per doctor. This increase in utilization reflected continued penetration into the North American Ortho practices due to a number of factors, including the availability of Invisalign G3 designed to make it easier to use Invisalign with more complex and challenging cases and increased growth in teenage cases driven by the Invisalign Teen product. Although we expect that over the long-term our utilization rates will gradually improve, we expect that period over period comparisons of our utilization rates will fluctuate. 22-------------------------------------------------------------------------------- Table of Contents • Seasonal fluctuations. Seasonal fluctuations in the number of doctors in their offices and available to take appointments have affected, and are likely to continue to affect our business. Specifically, our customers often take vacation during the summer months and therefore tend to start fewer cases, especially North American GPs and European doctors. In 2010, sequential case growth from second quarter to the third quarter in the North American Ortho channel was essentially flat. With the availability of Invisalign Teen, we can actively compete for a share of teen patient starts. Summer is typically the busiest season for orthodontists with practices that have a high percentage of adolescent and teenage patients. Many parents want to get their teens started in treatment before the start of the school year. We believe that Invisalign Teen helped moderate the historical downward trend we have typically seen for our North American orthodontic customers during the summer months. • Acquisition of Cadent. On April 29, 2011, we acquired privately-held Cadent, a leading provider of 3D digital scanning solutions for orthodontics and dentistry. Our second quarter financial results include two months of manufacture and sale of Cadent products. Interoperability with Invisalign is available on the OrthoCAD iOC system with the latest software version iOC 4.0. We expect to announce interoperability with the iTero 4.0 scanning software this fall. The acquisition of Cadent positions us as a leader in one of the best growth opportunities in dentistry and medical devices today. Over the next five years, we expect that intra-oral scanners will become widely used in dental practices. We believe that the combination of the two companies will help accelerate the use of intra-oral scanning in the dental industry by leveraging Align's global sales reach, extensive professional and consumer marketing capabilities and base of over 55 thousand ClinCheck software users. Cadent also strengthens our ability to drive adoption of Invisalign by integrating Invisalign treatment more fully with mainstream tools and procedures in doctors' practices. We may, however, experience difficulties in achieving the anticipated financial or strategic benefits of the acquisition. Information regarding risks associated with the Cadent acquisition may be found in Item 1A of this Quarterly Report on Form 10-Q under the heading "Risk Factors." • Foreign exchange rates. Although the U.S. dollar is our reporting currency, a portion of our revenues and profits are generated in foreign currencies. Revenues and profits generated by subsidiaries operating outside of the United States are translated into U.S. dollars using exchange rates effective during the respective period and as a result are affected by changes in exchange rates. We have generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this risk. Therefore, both positive and negative movements in currency exchanges rates against the U.S. dollar will continue to affect the reported amount of revenues and profits in our consolidated financial statements. • Growth of international markets. In October 2010, we announced regulatory approval to market and sell Invisalign in China and began sales the second quarter of 2011. While we do not expect meaningful revenue from China for several years, our focused strategy to launch Invisalign in key major cities of China provides us a large growth opportunity long term. • Operating Expenses. In the third quarter of 2011, we expect operating expenses to slightly decrease reflecting lower media spending and lower transaction related costs associated with the Cadent acquisition. 23 -------------------------------------------------------------------------------- Table of Contents Results of Operations Net revenues and case volume by channel and product: Invisalign, scanner, and CAD/CAM service revenues by channel and other Invisalign non-case revenues, which represents training, retainer and ancillary products, for the three and six months ended June 30, 2011 and 2010 are as follows (in millions): Three Months Ended June 30, Six Months Ended June 30, Net % Net % Net revenues 2011 2010 Change Change 2011 2010 Change Change North America: Ortho $ 39.9 $ 29.1 $ 10.8 37.1 % $ 74.9 $ 57.3 $ 17.6 30.7 % GP 45.1 37.4 7.7 20.6 % 84.3 74.6 9.7 13.0 % Total North America 85.0 66.5 18.5 27.8 % 159.2 131.9 27.3 20.7 % International 29.1 22.0 7.1 32.3 % 54.3 42.0 12.3 29.3 % Total revenues 114.1 88.5 25.6 28.9 % 213.5 173.9 39.6 22.8 % Invisalign Teen deferred revenue release - 14.3 (14.3 ) N/A - 14.3 (14.3 ) N/A Invisalign non-case revenues 6.0 5.4 0.6 11.1 % 11.4 10.1 1.3 12.9 % Total net revenues $ 120.1 $ 108.2 $ 11.9 11.0 % $ 224.9 $ 198.3 $ 26.6 13.4 % Case volume data which represents Invisalign case shipments by channel, for the three and six months ended June 30, 2011 and 2010 are as follows (in thousands): Three Months Ended June 30, Six Months Ended June 30, Net % Net % Invisalign case volume 2011 2010 Change Change 2011 2010 Change Change North America: Ortho 28.5 23.1 5.4 23.4 % 55.4 45.2 10.2 22.6 % GP 30.7 28.5 2.2 7.7 % 59.0 57.0 2.0 3.5 % Total North American Invisalign 59.2 51.6 7.6 14.7 % 114.4 102.2 12.2 11.9 % International Invisalign 16.8 15.9 0.9 5.7 % 33.0 28.9 4.1 14.2 % Total Invisalign case volume 76.0 67.5 8.5 12.6 % 147.4 131.1 16.3 12.4 % Invisalign, scanner, and CAD/CAM service revenues by product and other Invisalign non-case revenues, which represents training, retainer and ancillary products, for the three and six months ended June 30, 2011 and 2010 are as follows (in millions): Three Months Ended June 30, Six Months Ended June 30, Net % Net % Net revenues 2011 2010 Change Change 2011 2010 Change Change Invisalign Full $ 76.6 $ 67.5 $ 9.1 13.5 % $ 147.7 $ 133.2 $ 14.5 10.9 % Invisalign Express/Lite 11.1 8.8 2.3 26.1 % 21.2 17.4 3.8 21.8 % Invisalign Teen (1) 12.8 22.7 (9.9 ) (43.6 %) 24.7 30.9 (6.2 ) (20.1 %) Invisalign Assist 7.1 3.8 3.3 86.8 % 13.4 6.7 6.7 100.0 % Non-case revenues 6.0 5.4 0.6 11.1 % 11.4 10.1 1.3 12.9 % Scanners 2.7 - 2.7 N/A 2.7 - 2.7 N/A CAD/CAM Services 3.8 - 3.8 N/A 3.8 - 3.8 N/A Total net revenues $ 120.1 $ 108.2 $ 11.9 11.0 % $ 224.9 $ 198.3 $ 26.6 13.4 % (1) The three and six months ended June 30, 2010 include a $14.3 million release of previously deferred revenue for Invisalign Teen replacement aligners. 24 -------------------------------------------------------------------------------- Table of Contents Case volume data which represents Invisalign case shipments by product, for the three and six months ended June 30, 2011 and 2010 are as follows (in thousands): Three Months Ended June 30, Six Months Ended June 30, Net % Net % Invisalign case volume 2011 2010 Change Change 2011 2010 Change Change Invisalign Full 51.1 47.1 4.0 8.5 % 99.2 90.8 8.4 9.3 % Invisalign Express/Lite 11.3 9.6 1.7 17.7 % 21.8 18.8 3.0 16.0 % Invisalign Teen 8.6 6.8 1.8 26.5 % 16.5 14.2 2.3 16.2 % Invisalign Assist 5.0 4.0 1.0 25.0 % 9.9 7.3 2.6 35.6 % Total Invisalign case volume 76.0 67.5 8.5 12.6 % 147.4 131.1 16.3 12.4 % Total net revenues increased for the three and six months ended June 30, 2011 as compared to the same period in 2010 primarily as a result of worldwide volume growth across all customer channels as well as the sales of scanners and services resulting from our acquisition of Cadent, Inc. in April 2011. North America North America revenue increased 27.8% and 20.7% for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010 primarily due to case volume growth. Ortho Revenue from the North American Ortho channel increased 37.1% and 30.7% for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010 primarily due to case volume growth resulting from higher patient traffic and demand for Invisalign Full as well as the inclusion of revenue from CAD/CAM services for the two months since the acquisition date. Though case volume for Invisalign Teen increased, Invisalign Teen revenue decreased for the three and six months ended June 30, 2011, due to the one-time release of $14.3 million in the second quarter of 2010 of previously deferred revenue for Invisalign Teen replacement aligners. When we released the deferred revenue, we also established an estimated usage rate for Invisalign Teen replacement aligners, which reduced the deferral rate. GP Higher case volume was also the primarily driver for the 20.6% and 13.0% increase in North American GP channel revenue for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. Additionally we had increased revenue from our Invisalign Assist product primarily due to the shipment of final batches that were previously deferred in 2010, and the lower deferral rate for Invisalign Assist cases started in 2011. Effective January 1, 2011, we began recognize Invisalign Assist revenue over the course of treatment as each stage is shipped instead of deferring until the final batch shipment. Scanner and CAD/CAM services revenue for the GP channel was not significant for the two months since the acquisition date. International International revenue increased 32.3% and 29.3% for the three and six months ended June 30, 2011 compared to the same periods of 2010 primarily due to the impact of price increases as well as growth in case volumes of 5.7% and 14.2%, respectively, and favorable exchange rates of the Euro against the U.S. dollar. International sales of CAD/CAM services were not significant for the two months since the acquisition date. 25 -------------------------------------------------------------------------------- Table of Contents Cost of revenues and gross profit (in millions): Three Months Ended June 30, Six Months Ended June 30, 2011 2010 Change 2011 2010 Change Cost of revenues $ 28.9 $ 21.2 $ 7.7 $ 51.6 $ 41.6 $ 10.0 % of net revenues 24.1 % 19.6 % 22.9 % 21.0 % Gross profit $ 91.1 $ 87.0 $ 4.1 $ 173.4 $ 156.7 $ 16.7 Gross margin 75.9 % 80.4 % 77.1 % 79.0 % Cost of revenues includes salaries for staff involved in the production process, the cost of materials, packaging, shipping costs, depreciation on capital equipment used in the production process, amortization of identified intangibles and stock-based compensation expense. Gross margin decreased for the three and six months ended June 30, 2011 compared to the same period in 2010 primarily due to the addition of our scanner and services products related the acquisition of Cadent which carries a lower margin than our Invisalign products. Additionally, we also incurred approximately $0.2 million of amortization costs related to the acquired technology from Cadent during the second quarter of 2011. Gross margin during the first quarter of 2010 included the final amortization of the Ormco royalties of $0.8 million. Sales and marketing (in millions): Three Months Ended June 30, Six Months Ended June 30, 2011 2010 Change 2011 2010 Change Sales and marketing $ 38.6 $ 28.9 $ 9.7 $ 71.4 $ 56.9 $ 14.5 % of net revenues 32.1 % 26.7 % 31.7 % 28.7 % Sales and marketing expense includes sales force compensation (including travel-related costs), marketing personnel-related costs, media and advertising, clinical education, product marketing and stock-based compensation expense. Our sales and marketing expense for the three months ended June, 2011 increased compared to the same period in 2010 primarily due to higher marketing, media, advertising, and travel costs of approximately $4.0 million related to the International launch of Invisalign G3. We incurred higher payroll and payroll-related costs of approximately $3.4 million resulting from additional international headcount as well as the inclusion of Cadent sales and marketing personnel. Additionally, clinical education costs increased approximately $1.5 million during the second quarter of 2011 primarily due to the Invisalign European Summit in the second quarter of 2011, which was not held during the same period in 2010. Our sales and marketing expense for the six months ended June, 2011 increased compared to the same period in 2010 primarily due to higher payroll and payroll-related costs of approximately $6.0 million resulting from an increase in headcount partly due to the Cadent acquisition. We incurred higher marketing, media, travel, and advertising costs of approximately $4.5 million primarily due to targeted TV advertising and the International launch of Invisalign G3. Additionally, clinical education costs increase of approximately $2.3 million during the second half of 2011 primarily due to the Invisalign European Summit in the second quarter of 2011, which was not held during the same period in 2010. 26 -------------------------------------------------------------------------------- Table of Contents General and administrative (in millions): Three Months Ended June 30, Six Months Ended June 30, 2011 2010 Change 2011 2010 Change General and administrative $ 26.1 $ 15.0 $ 11.1 $ 45.1 $ 30.0 $ 15.1 % of net revenues 21.7 % 13.9 % 20.0 % 15.1 % General and administrative expense includes salaries for administrative personnel, outside consulting services, legal expenses and stock-based compensation expense. General and administrative expense increased for the three months ended June 30, 2011 compared to the same period in 2010 primarily due higher payroll and payroll-related costs of approximately $4.1 million resulting from compensation adjustments and an increase in headcount due to the Cadent acquisition. We also incurred higher consulting, accounting, legal, and travel costs of approximately $6.7 million primarily related to the acquisition and integration of Cadent into our business operations. General and administrative expense increased for the six months ended June 30, 2011 compared to the same period in 2010 primarily due higher consulting, accounting, legal, and travel costs of approximately $8.6 million mostly related to the integration of Cadent into our business operations. We also incurred higher payroll and payroll-related costs of $6.2 million resulting from compensation adjustments and an increase in headcount due to the Cadent acquisition. Research and development (in millions): Three Months Ended June 30, Six Months Ended June 30, 2011 2010 Change 2011 2010 Change Research and development $ 9.3 $ 6.4 $ 2.9 $ 18.7 $ 12.5 $ 6.2 % of net revenues 7.7 % 5.9 % 8.3 % 6.3 % Research and development expense includes the personnel-related costs and outside consulting expenses associated with the research and development of new products and enhancements to existing products, conducting clinical and post-marketing trials and stock-based compensation expense. Research and development expense increased during the three months ended June 30, 2011 compared to the same period in 2010 primarily due to higher payroll related costs of approximately $1.9 million resulting from an increase in headcount due to the Cadent acquisition. We also incurred higher travel and outside service costs of approximately $0.4 million primarily related to the integration of Cadent into our business operations. Research and development expense increased during the six months ended June 30, 2011 compared to the same period in 2010 primarily due to higher payroll related costs of approximately $2.9 million resulting primarily from an increase in headcount due to the Cadent acquisition. We also incurred higher travel and outside service costs of approximately $2.4 million primarily related to the payment to Cadent under the Joint Development agreement that we entered into on January 2011 before the completion of our acquisition on April 2011. Amortization of acquired intangible assets (in millions): Three Months Ended June 30, Six Months Ended June 30, 2011 2010 Change 2011 2010 Change Amortization of acquired intangible assets $ 0.6 $ - $ 0.6 $ 0.6 $ - $ 0.6 % of net revenues 0.5 % 0.3 % Amortization of acquired intangibles related to operating expense for the three and six month ended June 30, 2011 was approximately $0.6 million which were related to trademarks and customer relationships that were acquired as part of the Cadent acquisition during the second quarter of 2011. 27-------------------------------------------------------------------------------- Table of Contents Insurance settlement (in millions): Three Months Ended June 30, Six Months Ended June 30, 2011 2010 Change 2011 2010 Change Insurance settlement $ - $ (8.7 ) $ 8.7 $ - $ (8.7 ) $ 8.7 % of net revenues 8.0 % 4.4 % In June 2010, we received an $8.7 million insurance settlement over a disputed coverage under our general liability umbrella that was not previously reimbursed by our insurer related to the OrthoClear litigation. Interest and other income (expense), net (in millions): Three Months Ended June 30, Six Months Ended June 30, 2011 2010 Change 2011 2010 Change Interest income $ 0.1 $ 0.1 $ - $ 0.3 $ 0.2 $ 0.1 Other income (expense), net (0.4 ) 0.1 (0.5 ) (0.5 ) (0.6 ) 0.1 Total interest income and other income (expense), net $ (0.3 ) $ 0.2 $ (0.5 ) $ (0.2 ) $ (0.4 ) $ 0.2 Interest and other income (expense), net, include interest income earned on cash and investment balances, foreign currency translation gains and losses, and other miscellaneous charges. Interest income for the three and six months ended June 30, 2011 was comparable to the same period in 2010. Other expense, net for the three months ended June 30, 2011 increased as compared with the same period in 2010 reflecting higher foreign exchange losses. Other expense, net for the six months ended June 30, 2011 was comparable to the same period in 2010. Income tax (in millions): Three Months Ended June 30, Six Months Ended June 30, 2011 2010 Change 2011 2010 Change Provision for income taxes $ 5.1 $ 12.9 $ (7.8 ) $ 10.4 $ 18.1 $ (7.7 ) We recorded an income tax provision of $5.1 million and $12.9 million for the three months ended June 30, 2011 and 2010, respectively, representing effective tax rates of 31.5% and 28.3%. We recorded an income tax provision of $10.4 million and $18.1 million for the six months ended June 30, 2011 and 2010, respectively, representing effective tax rates of 27.8% and 27.6%. As a result of our acquisition of Cadent, we recorded a deferred tax liability ("DTL") of $9.1 million related to the acquired intangible assets. Additionally, $5.2 million of valuation allowance related to Cadent's U.S. deferred tax assets ("DTA") was released due to Align's historical and expected taxable income and the ability to utilize Cadent's DTA. The Cadent DTL exceeded the acquired DTA by $3.9 million and serves to increase the acquired goodwill by a corresponding $3.9 million. The valuation allowance related to Cadent's foreign DTA is maintained due to a lack of historical profitability and uncertain future profitability. Of the $5.2 million of Cadent's DTA released, $4.0 million relate to U.S. Federal and state net operating losses. Our effective tax rate for the remainder of 2011 may fluctuate based upon our operating results for each taxable jurisdiction in which we operate and the amount of statutory tax that we incur in each jurisdiction. 28-------------------------------------------------------------------------------- Table of Contents We exercised 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. As of June 30, 2011, we have recorded a valuation allowance of approximately $20.9 million related to capital loss and foreign loss carryforwards because we cannot forecast sufficient future capital gains or foreign source income to realize these DTAs. Of the $20.9 million of valuation allowance, $14.8 million relates to Cadent's foreign DTAs. These net operating loss and capital loss carryforwards will result in an income tax benefit if and when we conclude it is more likely than not that the related DTAs will be realized. Liquidity and Capital Resources We fund our operations from product sales and the proceeds from the sale of our common stock. As of June 30, 2011 and December 31, 2010, we had the following cash and cash equivalents, and short-term and long-term investments (in thousands): June 30 , December 31, 2011 2010 Cash and cash equivalents $ 168,607 $ 294,664 Marketable securities, short-term 6,755 8,615 Marketable securities, long-term 4,112 9,089 Total $ 179,474 $ 312,368 Cash flows (in thousands): |