Document
Table of Contents

 
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 March 31, 2017
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)
2560 Orchard Parkway
San Jose, California 95131
(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 April 28, 2017 was 80,331,340.

 

1

Table of Contents

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, Invisalign Assist, Invisalign Teen, Invisalign Go, Vivera, SmartForce, SmartTrack, SmartStage, Power Ridge, 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.




2

Table of Contents

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
March 31,
 
2017
 
2016
Net revenues
$
310,341

 
$
238,720

Cost of net revenues
74,716

 
58,093

Gross profit
235,625

 
180,627

Operating expenses:
 
 
 
Selling, general and administrative
151,148

 
112,210

Research and development
22,804

 
15,083

Total operating expenses
173,952

 
127,293

Income from operations
61,673

 
53,334

Interest and other income (expense), net
1,645

 
(427
)
Net income before provision (benefit) for income taxes and equity
in losses of investee
63,318

 
52,907

Provision (benefit) for income taxes
(7,223
)
 
12,361

Equity in losses of investee, net of tax
1,121

 

Net income
$
69,420

 
$
40,546

 
 
 
 
Net income per share:
 
 
 
Basic
$
0.87

 
$
0.51

Diluted
$
0.85

 
$
0.50

Shares used in computing net income per share:
 
 
 
Basic
79,904

 
79,831

Diluted
81,534

 
81,320

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

3

Table of Contents

ALIGN TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(unaudited)
 
 
Three Months Ended
March 31,
 
2017
 
2016
Net income
$
69,420

 
$
40,546

Net change in foreign currency translation adjustment
(459
)
 
(150
)
Change in unrealized gains on investments, net of tax
15

 
1,152

Other comprehensive income (loss)
(444
)
 
1,002

Comprehensive income
$
68,976

 
$
41,548

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

4

Table of Contents


ALIGN TECHNOLOGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
(unaudited)


 
 
March 31,
2017
 
December 31,
2016
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
261,027

 
$
389,275

Marketable securities, short-term
284,559

 
250,981

Accounts receivable, net of allowance for doubtful accounts and returns of $5,253 and $4,310, respectively
267,128

 
247,415

Inventories
35,174

 
27,131

Prepaid expenses and other current assets
70,279

 
38,176

Total current assets
918,167

 
952,978

Marketable securities, long-term
98,574

 
59,783

Property, plant and equipment, net
231,692

 
175,167

Equity method investments
43,940

 
45,061

Goodwill and intangible assets, net
92,447

 
81,998

Deferred tax assets
60,068

 
67,844

Other assets
14,405

 
13,320

Total assets
$
1,459,293

 
$
1,396,151

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
37,028

 
$
28,596

Accrued liabilities
125,631

 
134,332

Deferred revenues
202,895

 
191,407

Total current liabilities
365,554

 
354,335

Income tax payable
46,322

 
45,133

Other long-term liabilities
2,542

 
1,294

Total liabilities
414,418

 
400,762

Commitments and contingencies (Note 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; 80,324 and 79,553 issued and outstanding, respectively)
8

 
8

Additional paid-in capital
850,092

 
864,871

Accumulated other comprehensive income (loss), net
(1,382
)
 
(938
)
Retained earnings
196,157

 
131,448

Total stockholders’ equity
1,044,875

 
995,389

Total liabilities and stockholders’ equity
$
1,459,293

 
$
1,396,151

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

5

Table of Contents

ALIGN TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
Three Months Ended
March 31,
 
2017
 
2016
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
69,420

 
$
40,546

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Deferred taxes
7,789

 
(6,113
)
Depreciation and amortization
7,867

 
4,792

Stock-based compensation
14,812

 
12,524

Net tax benefits from stock-based awards

 
7,220

Excess tax benefit from share-based payment arrangements

 
(8,082
)
Equity in losses of investee
1,121

 

Other non-cash operating activities
2,079

 
3,754

Changes in assets and liabilities, net of effects of acquisitions:
 
 
 
Accounts receivable
(24,525
)
 
(20,839
)
Inventories
(7,923
)
 
(3,155
)
Prepaid expenses and other assets
(527
)
 
(618
)
Accounts payable
5,522

 
447

Accrued and other long-term liabilities
(39,702
)
 
(14,544
)
Deferred revenues
11,688

 
14,748

Net cash provided by operating activities
47,621

 
30,680

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Acquisitions, net of cash acquired
(8,953
)
 

Purchase of property, plant and equipment
(59,569
)
 
(20,207
)
Purchase of marketable securities
(169,777
)
 
(143,926
)
Proceeds from maturities of marketable securities
87,003

 
128,524

Proceeds from sales of marketable securities
11,684

 
293

Loan advance to privately held companies
(8,000
)
 

Other investing activities
2,314

 

Net cash used in investing activities
(145,298
)
 
(35,316
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock
7,288

 
5,384

Common stock repurchases
(3,793
)
 

Excess tax benefit from share-based payment arrangements

 
8,082

Employees’ taxes paid upon the vesting of restricted stock units
(36,496
)
 
(22,572
)
Net cash used in financing activities
(33,001
)
 
(9,106
)
Effect of foreign exchange rate changes on cash and cash equivalents
2,430

 
446

Net decrease in cash and cash equivalents
(128,248
)
 
(13,296
)
Cash and cash equivalents, beginning of the period
389,275

 
167,714

Cash and cash equivalents, end of the period
$
261,027

 
$
154,418

SUPPLEMENTAL CASH FLOW INFORMATION:

 
 
 
Accounts payable or accrued liabilities related to property, plant and equipment
7,662

 
10,842



The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.


6

Table of Contents

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 contain all adjustments, including normal recurring adjustments, necessary to state fairly our results of operations for the three months ended March 31, 2017 and 2016, our comprehensive income for the three months ended March 31, 2017 and 2016, our financial position as of March 31, 2017 and our cash flows for the three months ended March 31, 2017 and 2016. The Condensed Consolidated Balance Sheet as of December 31, 2016 was derived from the December 31, 2016 audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America.

The results of operations for the three months ended March 31, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017 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, 2016.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles ("GAAP") in the United States of America (“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, long-lived assets and goodwill, equity method investments, useful lives of intangible assets and property and equipment, revenue recognition, stock-based compensation, equity losses of investee, 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.

Recent Accounting Pronouncements

(i) New Accounting Updates Recently Adopted

In March 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-09, "Improvements to Employee Share-Based Payment Accounting" (Topic 718). We adopted the standard in the first quarter of fiscal year 2017. With this adoption, excess tax benefits related to stock-based compensation expense are reflected in our condensed consolidated statement of operations as a component of the provision for income taxes instead of additional paid-in capital in our condensed consolidated balance sheet. For the three months ended March 31, 2017, we recognized excess tax benefits of $21.3 million in our provision for income taxes. Excess tax benefits from share-based payment arrangements are classified as an operating activity in our condensed consolidated statement of cash flows in the same manner as other cash flows related to income taxes. We have elected to apply the standard on a prospective basis. In addition, we elected to continue to estimate expected forfeitures rather than as they occur to determine the amount of compensation cost to be recognized in each period.

In October 2016, the FASB issued ASU 2016-16, "Intra-Entity Transfers of Assets Other Than Inventory," (Topic 740) which requires entities to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. We early adopted the standard in the first quarter of fiscal year 2017 by applying the modified retrospective approach. For the three months ended March 31, 2017, we recognized a $1.3 million decrease to retained earnings as a cumulative-effect adjustment.

(ii) Recent Accounting Updates Not Yet Effective

In May 2014, the FASB released ASU 2014-9, "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

7

Table of Contents

goods or services. The new standard defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing GAAP including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. In addition, the new standard requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. We are required to adopt this standard starting in the first quarter of fiscal year 2018 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within the standard; or (ii) retrospective with the cumulative effect of initially applying the standard recognized at the date of initial application and providing certain additional disclosures as defined per the standard. We plan to adopt the standard in the first quarter of fiscal year 2018 by applying the full retrospective method. Our ability to adopt using the full retrospective method is dependent on the completion of our analysis of information necessary to restate prior period financial statements. We are continuing to assess the impact of the adoption of this update on our consolidated financial statements and related disclosures.

In April 2016, the FASB released ASU 2016-10, "Revenue from Contracts with Customers," to clarify the following two aspects of Topic 606: identifying performance obligations and the licensing implementation guidance, while retaining the principles for those areas of the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.

In May 2016, the FASB released ASU 2016-12, "Revenue from Contracts with Customers," to address certain issues in the Topic 606 guidance on assessing the collectability, presentation of sales taxes, non-cash consideration, and completed contracts and contract modifications at transition. The ASU provides narrow-scope improvements and practical expedients to the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.

In December 2016, the FASB released ASU 2016-20, "Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers," to clarify certain aspects of guidance in the Topic 606 including its scope, disclosure requirements and contract cost accounting, while retaining the principles for those areas of the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.
 
In February 2016, the FASB issued ASU 2016-02, “Leases” (Topic 842). The FASB issued this update 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. Early adoption of the standard is permitted. We plan to adopt the standard in the first quarter of fiscal year 2019 by electing practical expedients available in the standard. 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 the assets and liabilities of 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 as of the 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 August 2016, the FASB issued ASU 2016-15, "Classification of Certain Cash Receipts and Cash Payments" (Topic 230). This FASB 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. Early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial statements and related disclosures.

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, and early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial statements and related disclosures.

8

Table of Contents

In January 2017, the FASB issued ASU 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business,” to clarify the definition of a business when evaluating whether transactions should be accounted for as acquisitions of assets or businesses. The amendments are effective for fiscal years and interim periods within those years beginning after December 15, 2017 on a retrospective basis, early adoption is permitted. 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 simply 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, early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial statements and related disclosures.

Note 2. Marketable Securities and Fair Value Measurements

As of March 31, 2017 and December 31, 2016, 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
March 31, 2017
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
Commercial paper
 
$
42,160

 
$

 
$

 
$
42,160

Corporate bonds
 
152,169

 
30

 
(107
)
 
152,092

Municipal securities
 
3,853

 

 
(1
)
 
3,852

U.S. government agency bonds
 
21,879

 

 
(16
)
 
21,863

U.S. government treasury bonds
 
54,767

 

 
(28
)
 
54,739

Certificates of deposit
 
9,787

 

 

 
9,787

Asset-backed securities
 
66

 

 

 
66

Total marketable securities, short-term
 
$
284,681

 
$
30

 
$
(152
)
 
$
284,559


Long-term
March 31, 2017
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
U.S. government agency bonds
 
$
11,295

 
$
19

 
$
(12
)
 
$
11,302

Corporate bonds
 
79,267

 
48

 
(65
)
 
79,250

U.S. government treasury bonds
 
8,034

 
3

 
(15
)
 
8,022

Total marketable securities, long-term
 
$
98,596

 
$
70

 
$
(92
)
 
$
98,574


Short-term
December 31, 2016
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
Commercial paper
 
$
42,397

 
$

 
$
(6
)
 
$
42,391

Corporate bonds
 
122,788

 
22

 
(121
)
 
122,689

Municipal securities
 
5,852

 

 
(5
)
 
5,847

U.S. government agency bonds
 
28,903

 
9

 
(4
)
 
28,908

U.S. government treasury bonds
 
45,146

 
7

 
(7
)
 
45,146

Certificates of deposit
 
6,000

 

 

 
6,000

Total marketable securities, short-term
 
$
251,086

 
$
38

 
$
(143
)
 
$
250,981


9

Table of Contents

Long-term 
December 31, 2016
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
U.S. government agency bonds
 
$
6,805

 
$

 
$
(16
)
 
$
6,789

Corporate bonds
 
40,889

 
8

 
(85
)
 
40,812

U.S. government treasury bonds
 
12,016

 
5

 
(16
)
 
12,005

Asset-backed securities
 
177

 

 

 
177

Total marketable securities, long-term
 
$
59,887

 
$
13

 
$
(117
)
 
$
59,783

 Cash and 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 March 31, 2017 and December 31, 2016. Amounts reclassified to earnings from accumulated other comprehensive income (loss), net related to unrealized gains or losses were not material for the three months ended March 31, 2017 and 2016. For the three months ended March 31, 2017 and 2016, realized gains or losses were not material.

Our fixed-income securities investment portfolio consists of investments that have a maximum effective maturity of 27 months. 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 9 months and 7 months as of March 31, 2017 and December 31, 2016, 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 maturity as of March 31, 2017 and December 31, 2016 (in thousands):
 
March 31, 2017
 
December 31, 2016
One year or less
$
284,559

 
$
250,981

Due in greater than one year
98,574

 
59,783

Total available for sale short-term and long-term marketable securities
$
383,133

 
$
310,764


Fair Value Measurements

We measure the fair value of our cash equivalents and marketable securities 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.

Our Level 1 assets consist of money market funds and U.S. government treasury bonds. We did not hold any Level 1 liabilities as of March 31, 2017 and December 31, 2016.

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.

Our Level 2 assets consist of commercial paper, corporate bonds, municipal securities, certificates of deposit, U.S. government agency bonds, asset-backed securities and our Israeli funds that are mainly invested in insurance policies. 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. We did not hold any Level 2 liabilities as of March 31, 2017 and December 31, 2016.


10

Table of Contents

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. Our Level 3 assets consist of long-term notes receivable and are included in other assets on our condensed consolidated balance sheet. In 2016, we entered into a long-term notes receivable for $2.0 million. As of March 31, 2017, the fair value of the long-term receivable was $2.1 million as compared to $2.0 million as of December 31, 2016, the change was recognized in our earnings during the first quarter of 2017. We did not hold any Level 3 liabilities as of March 31, 2017 and December 31, 2016.

The following tables summarize our financial assets measured at fair value on a recurring basis as of March 31, 2017 and December 31, 2016 (in thousands): 
Description
 
Balance as of
March 31, 2017
 
Quoted Prices in
Active  Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable  Inputs
(Level 2)
 
Significant Other
Observable  Inputs
(Level 3)
Cash equivalents:
 
 
 
 
 
 
 
 
Money market funds
 
$
141,256

 
$
141,256

 
$

 
$

Commercial paper
 
20,026

 

 
20,026

 

U.S. government treasury bonds
 
5,521

 
5,521

 

 

Municipal securities
 
2,001

 

 
2,001

 

Short-term investments:
 
 
 
 
 
 
 
 
Commercial paper
 
42,160

 

 
42,160

 

Corporate bonds
 
152,092

 

 
152,092

 

Municipal securities
 
3,852

 

 
3,852

 

U.S. government agency bonds
 
21,863

 

 
21,863

 

U.S. government treasury bonds
 
54,739

 
54,739

 

 

Certificates of deposit
 
9,787

 

 
9,787

 

Asset-backed securities
 
66

 

 
66

 

Long-term investments:
 
 
 
 
 
 
 
 
U.S. government agency bonds
 
11,302

 

 
11,302

 

Corporate bonds
 
79,250

 

 
79,250

 

U.S. government treasury bonds
 
8,022

 
8,022

 

 

Prepaid expenses and other current assets:
 
 
 
 
 
 
 
 
Israeli funds
 
3,191

 

 
3,191

 

Other assets:
 
 
 
 
 
 
 
 
Long-term notes receivable
 
2,084

 

 

 
2,084

 
 
$
557,212

 
$
209,538

 
$
345,590

 
$
2,084



11

Table of Contents

 
Description
 
Balance as of
December 31, 2016
 
Quoted Prices in
Active  Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable  Inputs
(Level 2)
 
Significant Other
Observable  Inputs
(Level 3)
Cash equivalents:
 
 
 
 
 
 
 
 
Money market funds
 
$
87,179

 
$
87,179

 
$

 
$

Commercial paper
 
2,499

 

 
2,499

 

Corporate bonds
 
750

 

 
750

 

Short-term investments:
 
 
 
 
 
 
 
 
Commercial paper
 
42,391

 

 
42,391

 

Corporate bonds
 
122,689

 

 
122,689

 

Municipal securities
 
5,847

 

 
5,847

 

U.S. government agency bonds
 
28,908

 

 
28,908

 

U.S. government treasury bonds
 
45,146

 
45,146

 

 

Certificates of deposit
 
6,000

 

 
6,000

 

Long-term investments:
 
 
 
 
 
 
 
 
U.S. government agency bonds
 
6,789

 

 
6,789

 

Corporate bonds
 
40,812

 

 
40,812

 

U.S. government treasury bonds
 
12,005

 
12,005

 

 

Asset-backed securities
 
177

 

 
177

 

Prepaid expenses and other current assets:
 
 
 
 
 
 
 
 
Israeli funds
 
2,956

 

 
2,956

 

Other assets:
 
 
 
 
 
 
 
 
Long-term notes receivable
 
2,047

 

 

 
2,047

 
 
$
406,195

 
$
144,330

 
$
259,818

 
$
2,047


Derivative Financial Instruments

We have in the past and may in the future enter into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations associated with certain assets and liabilities. We had no foreign exchange forward contracts outstanding as of March 31, 2017 and no net gain or loss from the settlement of foreign currency forward contracts during the three months ended March 31, 2017. The net gain or loss on forward contracts was not material during the three months ended March 31, 2016. Certain investments in private companies contain embedded derivatives, which do not require bifurcation as we elected to measure these investments at fair value.

Note 3. Balance Sheet Components

Inventories

Inventories consist of the following (in thousands): 
 
March 31,
2017
 
December 31,
2016
Raw materials
$
14,630

 
$
9,793

Work in process
14,061

 
10,773

Finished goods
6,483

 
6,565

Total inventories
$
35,174

 
$
27,131




12

Table of Contents

Accrued Liabilities

Accrued liabilities consist of the following (in thousands): 
 
March 31,
2017
 
December 31,
2016
Accrued payroll and benefits
$
56,292

 
$
79,214

Accrued sales and marketing expenses
14,230

 
11,970

Accrued sales rebate
10,751

 
10,342

Accrued sales tax and value added tax
7,080

 
5,032

Accrued income taxes
4,760

 
4,210

Accrued professional fees
4,092

 
3,604

Accrued warranty
4,301

 
3,841

Other accrued liabilities
24,125

 
16,119

Total accrued liabilities
$
125,631

 
$
134,332


Warranty

We regularly review the accrued balances and update these balances 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.

Warranty accrual as of March 31, 2017 and 2016 consists of the following activity (in thousands): 
 
Three Months Ended
March 31,
 
2017
 
2016
Balance at beginning of period
$
3,841

 
$
2,638

Charged to cost of revenues
1,822

 
816

Actual warranty expenditures
(1,362
)
 
(750
)
Balance at end of period
$
4,301

 
$
2,704


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, and account for this as an equity method investment. The investment is reported in our condensed consolidated balance sheet under equity method investments, and we record our proportional share of SDC's earnings or losses within equity in losses of investee in our condensed consolidated statement of operations. As of March 31, 2017, the balance of our equity method investments was $43.9 million.

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 after eliminating outstanding intercompany transactions.

Note 5. Business Combinations

During the first quarter of 2017, we completed the acquisitions of certain of our distributors for the total estimated cash consideration of approximately $9.5 million including cash acquired. We preliminary recorded $1.9 million of net tangible liabilities, $8.2 million of identifiable intangible assets and $3.2 million of goodwill. The preliminary fair values of net tangible liabilities and identifiable intangible assets acquired are based on preliminary valuations, and our estimates and assumptions are subject to change within the measurement period (up to one year from the acquisition date).

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

13

Table of Contents

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 are not material to our results of operations, either individually or in aggregate, for the three months ended March 31, 2017.

Note 6. Goodwill and Intangible Assets

Goodwill

The change in the carrying value of goodwill for the three months ended March 31, 2017, all attributable to our Clear Aligner reporting unit, is as follows (in thousands):
 
Total
Balance as of December 31, 2016
$
61,044

Goodwill from distributor acquisitions
3,247

Adjustments 1
254

Balance as of March 31, 2017
$
64,545

1 The adjustments to goodwill during the period were a result of foreign currency translation.

During the fourth quarter of fiscal 2016, 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
March 31, 2017
 
Accumulated
Amortization
 
Accumulated
Impairment Loss
 
Net Carrying
Value as of
March 31, 2017
Trademarks
15
 
$
7,100

 
$
(1,665
)
 
$
(4,179
)
 
$
1,256

Existing technology
13
 
12,600

 
(4,282
)
 
(4,328
)
 
3,990

Customer relationships
11
 
33,500

 
(13,284
)
 
(10,751
)
 
9,465

Reacquired rights1
3
 
7,500

 
(125
)
 

 
7,375

Patents
8
 
6,316

 
(912
)
 

 
5,404

Other
1
 
548

 
(136
)
 

 
412

Total intangible assets
 
 
$
67,564

 
$
(20,404
)
 
$
(19,258
)
 
$
27,902

 
Weighted Average Amortization Period (in years)
 
Gross Carrying
Amount as of
December 31, 2016
 
Accumulated
Amortization
 
Accumulated Impairment Loss
 
Net Carrying
Value as of
December 31, 2016
Trademarks
15
 
$
7,100

 
$
(1,631
)
 
$
(4,179
)
 
$
1,290

Existing technology
13
 
12,600

 
(4,141
)
 
(4,328
)
 
4,131

Customer relationships
11
 
33,500

 
(12,819
)
 
(10,751
)
 
9,930

Patents
8
 
6,316

 
(713
)
 

 
5,603

Total intangible assets
 
 
$
59,516

 
$
(19,304
)
 
$
(19,258
)
 
$
20,954


1 The fair value of reacquired rights obtained from distributor acquisitions during the three months ended March 31, 2017 is valued using the income approach. In addition, we effectively settled the pre-existing relationship with the distributors by assessing whether the distributor agreements include favorable or unfavorable terms compared to current market rates. Based on the assessment, we determined that the distributor agreements had terms that are consistent with market rates and, therefore, no settlement gains or losses are recorded associated with the acquisitions during the three months ended March 31, 2017.

14

Table of Contents


The total estimated annual future amortization expense for these acquired intangible assets as of March 31, 2017 is as follows (in thousands):
 
 
Remainder of 2017
$
4,713

2018
5,989

2019
5,873

2020
3,758

2021
3,339

Thereafter
4,230

Total
$
27,902


Amortization for the three months ended March 31, 2017 was $1.4 million.

Note 7. Credit Facilities

The credit facility provides for a $50.0 million revolving line of credit with a $10.0 million letter of credit sublimit. The credit facility requires us to comply with specific financial conditions and performance requirements. On February 10, 2017, we amended the credit facility and extended maturity date to March 22, 2018. The loans bear interest, at our option, at a fluctuating rate per annum equal to the daily one-month adjusted LIBOR rate plus a spread of 1.75% or an adjusted LIBOR rate (based on one, three, six or twelve-month interest periods) plus a spread of 1.75%. As of March 31, 2017, we had no outstanding borrowings under this credit facility and were in compliance with the conditions and performance requirements.

Note 8. Legal Proceedings
    
Securities Class Action Lawsuit
    
On November 28, 2012, plaintiff City of Dearborn Heights Act 345 Police & Fire Retirement System filed a lawsuit against Align, Thomas M. Prescott (“Mr. Prescott”), Align’s former President and Chief Executive Officer, and Kenneth B. Arola (“Mr. Arola”), Align’s former Vice President, Finance and Chief Financial Officer, in the United States District Court for the Northern District of California on behalf of a purported class of purchasers of our common stock (the “Securities Action”). On July 11, 2013, an amended complaint was filed, which named the same defendants, on behalf of a purported class of purchasers of our common stock between January 31, 2012 and October 17, 2012. The amended complaint alleged that Align, Mr. Prescott and Mr. Arola violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and that Mr. Prescott and Mr. Arola violated Section 20(a) of the Securities Exchange Act of 1934. Specifically, the amended complaint alleged that during the purported class period defendants failed to take an appropriate goodwill impairment charge related to the April 29, 2011 acquisition of Cadent Holdings, Inc. in the fourth quarter of 2011, the first quarter of 2012 or the second quarter of 2012, which rendered our financial statements and projections of future earnings materially false and misleading and in violation of U.S. GAAP. The amended complaint sought monetary damages in an unspecified amount, costs and attorneys’ fees. On December 9, 2013, the court granted defendants’ motion to dismiss with leave for plaintiff to file a second amended complaint. Plaintiff filed a second amended complaint on January 8, 2014 on behalf of the same purported class. The second amended complaint states the same claims as the amended complaint. On August 22, 2014, the court granted our motion to dismiss without leave to amend. On September 22, 2014, Plaintiff filed a notice of appeal to the Ninth Circuit Court of Appeals. Briefing for the appeal was completed in May 2015 and the Ninth Circuit held oral arguments in October 2016. Align intends to vigorously defend itself against these allegations. Align is currently unable to predict the outcome of this amended complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible loss, if any.
    
Shareholder Derivative Lawsuit
    
On February 1, 2013, plaintiff Gary Udis filed a shareholder derivative lawsuit against several of Align’s current and former officers and directors in the Superior Court of California, County of Santa Clara. The complaint alleges that our reported income and earnings were materially overstated because of a failure to timely write down goodwill related to the April 29, 2011 acquisition of Cadent Holdings, Inc., and that defendants made allegedly false statements concerning our forecasts. The complaint asserts various state law causes of action, including claims of breach of fiduciary duty, unjust enrichment, and insider trading, among others. The complaint seeks unspecified damages on behalf of Align, which is named solely as nominal defendant against whom no recovery is sought. The complaint also seeks an order directing Align to reform and improve its corporate governance and internal procedures, and seeks restitution in an unspecified amount, costs, and attorneys’ fees. On July 8, 2013, an Order was

15

Table of Contents

entered staying this derivative lawsuit until an initial ruling on our first motion to dismiss the Securities Action. On January 15, 2014, an Order was entered staying this derivative lawsuit until an initial ruling on our second motion to dismiss the Securities Action. On October 14, 2014, an Order was entered staying this derivative lawsuit until a ruling by the Ninth Circuit in the Securities Action discussed above. Align is currently unable to predict the outcome of this complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible losses, if any.

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 March 31, 2017, minimum future lease payments for non-cancelable operating leases are as follows (in thousands):  
Fiscal Year Ending December 31,
 
Operating Leases
Remainder of 2017
 
$
10,113

2018
 
10,920

2019
 
8,930

2020
 
7,133

2021
 
6,481

Thereafter
 
9,170

Total minimum future lease payments
 
$
52,747


Other Commitments

On July 25, 2016, we entered into a Loan and Security Agreement (the "Loan Agreement") with SmileDirectClub, LLC ("SDC") where we agreed to provide a loan of up to $15.0 million in one or more advances to SDC (the "Loan Facility"). Available advances under the Loan Facility are subject to a borrowing base of 80% of SDC's eligible accounts receivable, determined in accordance with the terms of the Loan Agreement, and the satisfaction of other customary conditions. The advances bear interest, paid quarterly, at the rate of 7% per annum. Advances that are repaid or prepaid may be reborrowed. All outstanding principal and accrued and unpaid interest on the advances are due and payable on July 25, 2021. SDC's obligations in respect of the Loan Agreement are collateralized by a security interest in substantially all of SDC's assets. As of March 31, 2017, $8.0 million of advances under the Loan Facility were issued and outstanding (Refer to Note 4 "Equity Method Investments" of the Notes to Condensed Consolidated Financial Statements for more information on our investments in SDC).

We have entered into certain investments with a privately held company where we have committed to purchase up to $5.0 million in convertible promissory notes. The first convertible promissory note for $2.0 million was issued in July 2016 and is outstanding as of March 31, 2017. The remaining $3.0 million is conditioned upon achievement of various business milestones. The notes all mature on December 30, 2018 and accrue interest annually at 2.5%.

Off-Balance Sheet Arrangements

As of March 31, 2017, we had no 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.


16

Table of Contents

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 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 March 31, 2017, 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 March 31, 2017, the 2005 Incentive Plan (as amended) has a total reserve of 27,783,379 shares of which 6,982,718 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 months ended March 31, 2017 and 2016 is as follows (in thousands): 
 
Three Months Ended
March 31,
 
2017
 
2016
Cost of net revenues
$
925

 
$
961

Selling, general and administrative
11,716

 
9,834

Research and development
2,171

 
1,729

Total stock-based compensation
$
14,812

 
$
12,524


Stock Options

We have not granted options since 2011 and all outstanding options were fully vested and associated stock-based compensation expenses were recognized as of December 31, 2015. Activity for the three months ended March 31, 2017 under the stock option plans is set forth below (in thousands, except years and per share amounts):
 

Number of Shares
Underlying
Stock Options
 
Weighted
Average
Exercise
Price per Share
 
Weighted  Average
Remaining
Contractual  Term (in Years)
 
Aggregate
Intrinsic
Value
Outstanding as of December 31, 2016
222

 
$
14.90

 
 
 
 
Granted

 

 
 
 
 
Exercised
(82
)
 
17.35

 
 
 
 
Cancelled or expired
(4
)
 
18.16

 
 
 
 
Outstanding as of March 31, 2017
136

 
$
13.33

 
1.35
 
$
13,809

Vested and expected to vest at March 31, 2017
136

 
$
13.33

 
1.35
 
$
13,809

Exercisable at March 31, 2017
136

 
$
13.33

 
1.35
 
$
13,809





17

Table of Contents

Restricted Stock Units (“RSUs”)

The fair value of nonvested RSUs is based on our closing stock price on the date of grant. A summary for the three months ended March 31, 2017 is as follows (in thousands, except years and per share amounts):
 
 
Shares
Underlying RSUs
 
Weighted Average Grant Date Fair Value
 
Weighted 
Remaining
Vesting 
Period (in years)
 
Aggregate
Intrinsic
 Value
Nonvested as of December 31, 2016
1,789

 
$
58.39

 
 
 
 
Granted
371

 
102.24

 
 
 
 
Vested and released
(689
)
 
51.59

 
 
 
 
Forfeited
(19
)
 
60.29

 
 
 
 
Nonvested as of March 31, 2017
1,452

 
$
72.80

 
1.70
 
$
166,598


As of March 31, 2017, the total unamortized compensation cost related to RSUs, net of estimated forfeitures, was $86.9 million, which we expect to recognize over a weighted average period of 2.6 years.

On an annual basis, we grant market-performance based restricted stock units (“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 the NASDAQ Composite Index over the vesting period, generally two to three years, up to 200% of the MSUs initially granted.

The following table summarizes the MSU performance for the three months ended March 31, 2017 (in thousands, except years): 
 
Number of Shares
Underlying MSUs
 
Weighted Average Grant Date Fair Value
 
Weighted Average
Remaining
Vesting Period (in years)
 
Aggregate
Intrinsic 
Value
Nonvested as of December 31, 2016
520

 
$
60.49

 
 
 
 
Granted
201

 
87.11

 
 
 
 
Vested and released
(283
)
 
49.51

 
 
 
 
Forfeited
(10
)
 
64.50

 
 
 
 
Nonvested as of March 31, 2017
428

 
$
78.53

 
1.72
 
$
49,107


As of March 31, 2017, we expect to recognize $19.4 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 ("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 March 31, 2017, 821,770 shares remain 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:
 
Three Months Ended
March 31,
 
2017
 
2016
Expected term (in years)
1.2

 
1.3

Expected volatility
26.1
%
 
33.7
%
Risk-free interest rate
0.9
%
 
0.8
%
Expected dividends

 

Weighted average fair value at grant date
$
26.09

 
$
19.96



18

Table of Contents

As of March 31, 2017, there was $3.9 million of total unamortized compensation costs related to employee stock purchases which we expect to be recognized over a weighted average period of 1.0 year.

Note 11. Common Stock Repurchase

April 2014 Repurchase Program

In April 2014, we announced that our Board of Directors had authorized a stock repurchase program ("April 2014 Repurchase Program") pursuant to which we may purchase up to $300.0 million of our common stock over the next three years.

During the three months ended March 31, 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. All repurchased shares were retired. As of March 31, 2017, we completed our April 2014 Repurchase Program.

April 2016 Repurchase Program

On April 28, 2016, we announced that our Board of Directors had authorized an additional plan to repurchase up to $300.0 million of the Company's stock ("the April 2016 Repurchase Plan"). Any purchases under this stock repurchase program may be made, from time-to-time, pursuant to open market purchases (including pursuant to Rule 10b5-1 plans), privately-negotiated transactions, accelerated stock repurchases, block trades or derivative contracts or otherwise in accordance with applicable federal securities laws, including Rule 10b-18 of the Securities Exchange Act of 1934. As of March 31, 2017, there were no repurchases under this plan. On May 2, 2017, we entered into an accelerated share repurchase ("ASR") to repurchase $50.0 million of our common stock (the "2017 ASR"). We paid $50.0 million on May 3, 2017 and received an initial delivery of approximately 0.3 million shares based on current market prices. The final number of shares to be repurchased will be based on our volume-weighted average stock price under the term of the 2017 ASR, less an agreed upon discount.

Note 12. Accounting for Income Taxes

Our provision (benefit) for income taxes was $(7.2) million and $12.4 million for the three months ended March 31, 2017 and 2016, respectively. This represents effective tax rates of (11.4)% and 23.4%, respectively. For the three months ended March 31, 2017, our effective tax rate differs from the statutory federal income tax rate of 35% 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, which are subject to lower tax rates. For the three months ended March 31, 2016, our effective tax rate differs from the statutory federal income tax rate of 35% due to certain foreign earnings, primarily from Costa Rica, which are subject to a lower tax rate, state income tax expense, the tax impact of certain stock-based compensation charges and unrecognized tax benefits.

The decrease in effective tax rate for the three months ended March 31, 2017 compared to the same period in 2016 is primarily attributable to the adoption of ASU 2016-09 which requires excess tax benefits related to stock-based compensation to be recognized as a reduction of income tax expense along with certain of our foreign earnings being taxed at a lower rate relative to the U.S. federal statutory rate as a result of our international corporate restructuring. For the three months ended March 31, 2017, we recognized excess tax benefits of $21.3 million 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.

Our total gross unrecognized tax benefits, excluding interest and penalties, was $47.2 million and $46.4 million as of March 31, 2017 and December 31, 2016, respectively, all of which would impact our effective tax rate if recognized. Our total interest and penalties accrued as of March 31, 2017 was $2.5 million. We have elected to recognize interest and penalties related to unrecognized tax benefits as a component of income taxes. We do not expect any significant changes to the amount of unrecognized tax benefit within the next twelve months.

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. With few exceptions, we are no longer subject to examination by foreign tax authorities for years before 2007. Our subsidiary in Israel is under audit by the local tax authorities for calendar years 2006 through 2013.

On July 1, 2016, we implemented a new international corporate structure. This changed the structure of our international procurement and sales operations, as well as realigned the ownership and use of intellectual property among our wholly-owned

19

Table of Contents

subsidiaries. We continue to anticipate that an increasing percentage of our consolidated pre-tax income will be derived from, and reinvested in our foreign operations. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over time.

In June 2009, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted a twelve year extension of certain income tax incentives, which were previously granted in 2002. The incentive tax rates expire over various years, starting in June 2017. We are seeking a renewal of these income tax incentives before they expire. Under these incentives, all of the income in Costa Rica during these twelve year incentive periods 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 2017 and 2016. For the three months ended March 31, 2017, the reduction in income taxes was minimal primarily due to the new international corporate structure implemented on July 1, 2016. For the three months ended March 31, 2016, income taxes were reduced by $8.6 million representing a benefit to diluted net income per share of $0.11.

We maintain sufficient cash reserves in the U.S. and do not intend to repatriate our foreign earnings which have not already been subject to U.S. income tax. As a result, income taxes have not been provided on these foreign earnings.  If these earnings were distributed in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, we would be subject to additional U.S. income taxes subject to an adjustment for foreign tax credits and foreign withholding taxes. We intend to use the undistributed earnings for local operating expansions and to meet local operating working capital needs. In addition, a significant amount of the cash earned by foreign subsidiaries is deployed to effect this international restructure.

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 RSU, MSU, stock options and our ESPP.

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
March 31,
 
2017
 
2016
Numerator:
 
 
 
Net income
$
69,420

 
$
40,546

Denominator:
 
 
 
Weighted-average common shares outstanding, basic
79,904

 
79,831

Dilutive effect of potential common stock
1,630

 
1,489

Total shares, diluted
81,534

 
81,320

 
 
 
 
Net income per share, basic
$
0.87

 
$
0.51

Net income per share, diluted
$
0.85

 
$
0.50


For the three months ended March 31, 2017 and 2016, the anti-dilutive effect on net income per share from RSUs, MSUs, and ESPP was not material.


20

Table of Contents

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 and gross profit. In the fourth quarter of 2016, management decided to change the way it internally assesses the performance of our reportable segments by including income from operations measure in the performance metrics. 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 and accounting and finance, legal and regulatory, and other separately managed general and administrative costs outside the operating segments. We have included the new performance measure in the prior period presentation to conform to the current year's presentation.

We have grouped our operations into two reportable segments which are also our reporting units: Clear Aligner segment and Scanner segment.

Our Clear Aligner segment consists of our Invisalign System products along with our training and ancillary products for malocclusion. Clear Aligner segment also includes revenue from the sale of aligners to SDC under our supply agreement which is recorded after eliminating outstanding intercompany transactions.
Our Scanner and Services ("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.
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
March 31,
Net revenues
2017
 
2016
Clear Aligner
$
282,399

 
$
219,698

Scanner
27,942

 
19,022

Total net revenues
$
310,341

 
$
238,720

Gross profit
 
 
 
Clear Aligner
$
219,947

 
$
172,067

Scanner
15,678

 
8,560

Total gross profit
$
235,625

 
$
180,627

Income from operations
 
 
 
Clear Aligner
$
114,734

 
$
96,650

Scanner
6,004

 
1,542

Unallocated corporate expenses
(59,065
)
 
(44,858
)
Total income from operations
$
61,673

 
$
53,334

Depreciation and amortization
 
 
 
Clear Aligner
$
4,363

 
$
3,152

Scanner
1,037

 
1,048

Unallocated corporate expenses
2,467

 
592

Total depreciation and amortization
$
7,867

 
$
4,792



21

Table of Contents

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
March 31,
 
2017
 
2016
Total segment income from operations
$
120,738

 
$
98,192

Unallocated corporate expenses
(59,065
)
 
(44,858
)
Total income from operations
61,673

 
53,334

Interest and other income (expense), net
1,645

 
(427
)
Net income before provision (benefit) for income taxes and equity
in losses of investee
$
63,318

 
$
52,907


Geographical Information

Net revenues are presented below by geographic area (in thousands):
 
Three Months Ended
March 31,
 
2017
 
2016
Net revenues(1):
 
 
 
United States (2)
$
183,273

 
$
166,101

The Netherlands (2)
105,650

 
47,400

Other International
21,418

 
25,219

Total net revenues
$
310,341

 
$
238,720


(1) Net revenues are attributed to countries based on location of where revenue is recognized.
(2) Effective July 2016, we implemented a new international corporate structure. This changed the structure of our international procurement and sales operations.

Tangible long-lived assets are presented below by geographic area (in thousands):
 
March 31,
2017
 
December 31, 2016
Long-lived assets(1):
 
 
 
The Netherlands
$
120,513

 
$
111,515

United States
86,252

 
43,278

Mexico
17,952

 
17,918

Other International
6,975

 
2,456

Total long-lived assets
$
231,692

 
$
175,167

 

(1) Long-lived assets are attributed to countries based on entity that owns the assets.



22

Table of Contents

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 financial and strategic benefits of establishing regional order acquisition and treatment planning facilities, our expectations regarding the continued expansion of our international markets, the level of our operating expenses and gross margins, our expectation that the SmileDirectClub, LLC transaction will be incremental to revenue growth in 2017, 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 and with our audited consolidated financial statements included in our Annual Report on form 10-K for the year ended December 31, 2016, 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 2017 and beyond may be affected by a number of other factors including:
New Products, Feature Enhancements and Technology Innovation. Product innovation drives greater treatment predictability and clinical applicability and ease of use for our customers which supports adoption of Invisalign in their practices. Increasing applicability and treating more complex cases requires that we move away from individual features to more comprehensive solutions so that Invisalign providers can more predictably treat the whole case, such as with our Invisalign "G-Series" of product innovations, including our more recent October 2016 release of Invisalign G7. Invisalign G7 delivers better upper lateral control, improved root control and features to address prevention of posterior open bites. 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 new 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 now available in Canada and select EMEA countries (United Kingdom, Ireland, France, Spain, Czechoslovakia, Slovakia, Poland, Belgium, Luxembourg, the Netherlands), select APAC countries (China, Japan with select availability in Hong Kong, Macao, Singapore, Taiwan, Australia, New Zealand) and select LATAM countries (Argentina, Brazil, Chile, Colombia, Mexico). Invisalign Teen with mandibular advancement is pending 510(k) clearance and is not yet available in the United States. 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.
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:

23

Table of Contents

http://api.tenkwizard.com/cgi/image?quest=1&rid=23&ipage=11572556&doc=11
*    Invisalign utilization rates = # of cases shipped divided by # of doctors cases were shipped to

Total utilization in the first quarter of 2017 increased to 5.4 cases per doctor compared to 4.9 in the first quarter of 2016.
North America: Utilization among our North American orthodontist customers reached an all time high of 12.6 cases per doctor in the first quarter of 2017 compared to 10.4 in the first quarter of 2016. The increase in North America orthodontist utilization reflects improvements in product and technology which continues to strengthen our doctors’ clinical confidence in the use of Invisalign such that they now utilize Invisalign more often and on more complex cases, including their teenage patients.
International: International doctor utilization is 5.0 cases per doctor in the first quarter of 2017 compared to 4.7 in the first quarter of 2016. The International utilization reflects growth in both the Europe, Middle East and Africa ("EMEA") and Asia Pacific ("APAC") regions due to increasing adoption of the product and 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; however, we expect that our utilization rates 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 2016, 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 11,680 new Invisalign doctors, of which 60% were trained internationally. During the first quarter of 2017, we trained 3,260 new Invisalign doctors of which 980 were trained in North America and 2,280 in our International regions.

International Invisalign Growth. We will continue to focus our efforts towards increasing Invisalign adoption by dental professionals in our direct international markets. On a year over year basis, international Invisalign volume increased 41.3% driven primarily by strong performance in our APAC and in EMEA regions. In 2017, 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 Invisalign revenues to continue to grow at a faster rate than North America 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 in this region (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).

24

Table of Contents

Establish Regional Order Acquisition and Treatment Planning Facilities: We intend to establish additional order acquisition and treatment planning facilities closer to our international customers in order to improve our operational efficiency and provide doctors with a great experience to further improve their confidence in using Invisalign to treat more patients and more often (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).
Operating Expenses. We expect operating expenses to increase in 2017 due in part to:
investments in international expansion in new country markets particularly in the APAC, Latin America and Middle East regions;
investments in manufacturing to enhance our regional capabilities;
increases in legal expenses primarily related to the continued protection of our intellectual property rights, including our patents;
increases in sales and customer support resources; and
product and technology innovation to address such things as treatment times, indications unique to teens and predictability.
We believe that these investments will position us to increase our revenue and continue to grow our market share.
Provision (benefit) for Income Taxes. We expect our effective tax rate may vary significantly from period to period as a result of adoption of ASU 2016-09, "Improvements to Employee Share-Based Payment Accounting," during the first quarter of 2017. The effective tax rate for the first quarter of 2017 was (11.4)% which included $21.3 million of excess tax benefits related to stock-based compensation compared to 23.4% in the first quarter of 2016 when the excess tax benefits in the same nature were reflected in additional paid-in-capital (Refer to Item 1A Risk Factors - “Our effective tax rate may vary significantly from period to period.” for information on related risk factor and Note 1 "Summary of Significant Accounting Policies" and Note 12 "Accounting for Income Taxes" of the Notes to Condensed Consolidated Financial Statements for details on accounting treatment).
Stock Repurchases:

April 2014 Repurchase Program. During the three months ended March 31, 2017, we repurchased $3.8 million of our common stock repurchase in the open market. As of March 31, 2017, we completed our April 2014 Repurchase Plan (Refer to Note 11 "Common Stock Repurchase Program" of the Notes to Condensed Consolidated Financial Statements for details on stock repurchase program).

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 stock. As of March 31, 2017, there were no repurchases under this plan. On May 2, 2017, we entered into an ASR to repurchase $50.0 million of our common stock (the "2017 ASR"). We paid $50.0 million on May 3, 2017 and received an initial delivery of approximately 0.3 million shares based on current market prices. The final number of shares to be repurchased will be based on our volume-weighted average stock price under the term of the 2017 ASR, less an agreed upon discount.

SmileDirectClub. We provided a revolving line of credit to SmileDirectClub, LLC ("SDC") of up to $15.0 million to fund their working capital and general corporate needs. As of March 31, 2017, $8.0 million under the Loan Facility was issued and outstanding. (Refer to Note 4 "Equity Method Investments" of the Notes to Condensed Consolidated Financial Statements for details on accounting treatment). We expect the supply agreement to be incremental to revenue growth in 2017.

New Corporate Headquarters Office Purchase. We completed the purchase of our new headquarters on January 26, 2017 for the purchase price of $44.1 million. During the first quarter of 2017, we incurred $0.8 million related to the building improvements and expect to incur an additional $29.7 million during 2017.


25

Table of Contents

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 our Invisalign System includes Invisalign Full, Teen and Assist ("Comprehensive Products"), Express/Lite ("Non-Comprehensive Products"), Vivera retainers, along with our training and ancillary products for treating malocclusion ("Non-Case"). Clear Aligner segment also includes revenues from the sale of aligners to SDC under our supply agreement which commenced in the fourth quarter of 2016, which is recorded after eliminating outstanding intercompany transactions.
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.
Net revenues for our Clear Aligner and Scanner segment by region for the three months ended March 31, 2017 and 2016 is as follows (in millions):
 
Three Months Ended
March 31,
Net Revenues
2017
 
2016
 
Net
Change
 
%
Change
Clear Aligner revenues:
 
 
 
 
 
 
 
North America
$
164.9

 
$
135.7

 
$
29.2

 
21.5
%
International
99.6

 
69.9

 
29.7

 
42.5
%
Non-case
17.9

 
14.1

 
3.8

 
27.0
%
Total Clear Aligner net revenues
$
282.4

 
$
219.7

 
$
62.7

 
28.5
%
Scanner net revenues
27.9

 
19.0

 
8.9

 
46.8
%
Total net revenues
$
310.3

 
$
238.7

 
$
71.6

 
30.0
%

Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.

Clear Aligner Case Volume by Region

Case volume data which represents Clear Aligner case shipments by region for the three months ended March 31, 2017 and 2016 is as follows (in thousands):
 
Three Months Ended
March 31,
Region
2017
 
2016
 
Net
Change
 
%
Change
North America
136.1

 
110.5

 
25.6

 
23.2
%
International
75.2

 
53.2

 
22.0

 
41.4
%
Total case volume
211.3

 
163.7

 
47.6

 
29.1
%

Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.

Total net revenues increased by $71.6 million for the three months ended March 31, 2017 as compared to the same period in 2016 primarily as a result of case volume growth across all regions and products as well as increased non-case revenues.

Clear Aligner - North America

North America net revenues increased by $29.2 million for the three months ended March 31, 2017 as compared to the same period in 2016 primarily due to case volume growth across all channels and products which increased net revenues by $31.5 million. The increase was offset in part by lower average selling prices (“ASP”) which decreased net revenues by $2.3 million. ASP declined for the three months ended March 31, 2017 as compared to the same period in 2016 as a result of higher promotional discounts of $5.4 million as well as a shift in product mix towards lower priced products which decreased revenues by $3.7 million. These declines were partially offset by price increases on our Comprehensive Products effective April 1, 2016 which contributed $7.1 million to net revenues.

26

Table of Contents


Clear Aligner - International

International net revenues increased by $29.7 million for the three months ended March 31, 2017 as compared to the same period in 2016 primarily driven by case volume growth across all channels and products which increased net revenues by $28.7 million and, to a lesser extent, higher ASP. The increase in ASP was primarily a result of price increases in our Comprehensive Products effective July 1, 2016 which contributed $3.0 million to net revenues as well as an increase in additional aligner revenue of $2.9 million. These increases were offset in part by the decline in foreign exchange rates of $3.2 million primarily due to the weakening of the Euro and British Pound to the U.S. dollar.

Clear Aligner - Non-Case

Non-case net revenues, consisting of training fees and ancillary product revenues, increased by $3.8 million for the three months ended March 31, 2017 as compared to the same period in 2016 primarily due to increased Vivera volume both in North America and International.

Scanner

Scanner net revenues increased $8.9 million for the three months ended March 31, 2017 as compared to the same period in 2016 due to an increase in both scanner and services net revenues. Scanner net revenues increased primarily as a result of an increase in the number of scanners recognized and, to a lesser extent, an increase in ASP. The increase in services net revenue was primarily due to an increase in the volume of CAD/CAM services resulting from a larger installed base of scanners.

Cost of net revenues and gross profit (in millions):
 
 
Three Months Ended
March 31,
 
2017
 
2016
 
Change
Clear Aligner
 
 
 
 
 
Cost of net revenues
$
62.5

 
$
47.6

 
$
14.9

% of net segment revenues
22.1
%
 
21.7
%
 
 
Gross profit
$
219.9

 
$
172.1

 
$
47.8

Gross margin %
77.9
%
 
78.3
%
 
 
Scanner
 
 
 
 
 
Cost of net revenues
$
12.3

 
$
10.5

 
$
1.8

% of net segment revenues
43.9
%
 
55.0
%
 
 
Gross profit
$
15.8

 
$
8.6

 
$
7.2

Gross margin %
56.1
%
 
45.0
%
 
 
Total cost of net revenues
$
74.7

 
$
58.1

 
$
16.6

% of net revenues
24.1
%
 
24.3
%
 
 
Gross profit
$
235.6

 
$
180.6

 
$
55.0

Gross margin %
75.9
%
 
75.7
%
 
 

Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.

Cost of net revenues for our Clear Aligner and Scanner segments includes personnel-related costs including payroll and stock-based compensation for staff involved in the production process, the cost of materials, packaging, shipping costs, depreciation on capital equipment and facilities used in the production process, amortization of acquired intangible assets from Cadent and training costs.

Clear Aligner

The gross margin percentage for the three months ended March 31, 2017 declined as compared to the same period in 2016 primarily driven by a higher number of aligners per case which was partially offset by higher absorption as a result of increased production volumes.


27

Table of Contents

Scanner

The gross margin for the three months ended March 31, 2017 increased compared to the same period in 2016 due to a higher ASP, a favorable product mix shift to our lower cost iTero Element scanner and lower service costs.

Selling, general and administrative (in millions):

 
Three Months Ended
March 31,
 
2017
 
2016
 
Change
Selling, general and administrative
$
151.1

 
$
112.2

 
$
38.9

% of net revenues
48.7
%
 
47.0
%
 
 

Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.

Selling, general and administrative expense includes personnel-related costs including payroll, commissions and stock-based compensation, marketing and administration in addition to media and advertising expenses, clinical education, trade shows and industry events, product marketing, outside consulting services, legal expenses, depreciation and amortization expense and allocations of corporate overhead expenses including facilities and IT.

Selling, general and administrative expense for the three months ended March 31, 2017 increased compared to the same period in 2016 primarily due to higher compensation related costs of $17.6 million mainly as a result of increased headcount. We also incurred higher expenses from advertising and marketing of $8.2 million, equipment and material costs of $5.5 million and outside services costs of $5.3 million.

Research and development (in millions):
 
Three Months Ended
March 31,
 
2017
 
2016
 
Change
Research and development
$
22.8

 
$
15.1

 
$
7.7

% of net revenues
7.3
%
 
6.3
%
 
 

Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.
Research and development expense includes the personnel-related costs including payroll and stock-based compensation and outside consulting expenses associated with the research and development of new products and enhancements to existing products and allocations of corporate overhead expenses including facilities and IT.

Research and development expense for the three months ended March 31, 2017 increased compared to the same period in 2016 due to higher compensation costs as a result of increased headcount.

Income from operations (in millions):
 
Three Months Ended
March 31,
 
2017
 
2016
 
Change
Clear Aligner
 
 
 
 
 
Income from operations
$
114.7

 
$
96.7

 
$
18.0

Operating margin %
40.6
%
 
44.0
%
 
 
Scanner
 
 
 
 
 
Income from operations
$
6.0

 
$
1.5

 
$
4.5

Operating margin %
21.5
%
 
8.1
%
 
 
Total income from operations (1)
$
61.7

 
$
53.3

 
$
8.4

Operating margin %
19.9
%
 
22.3
%
 
 

Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.


28

Table of Contents

(1) Refer to Note 14 "Segments and Geographical Information" of the Notes to Condensed Consolidated Financial Statements for details on unallocated corporate expenses and the reconciliation to total income from operations.

Clear Aligner

Operating margin percentage for the three months ended March 31, 2017 declined compared to the same period in 2016 primarily due to higher compensation costs as a result of increased headcount, higher number of aligners manufactured per case and lower ASP.

Scanner

Operating margin percentage for the three months ended March 31, 2017 increased compared to the same period in 2016 due to a higher ASP, a favorable product mix shift to our lower cost iTero Element scanner and lower service costs. We also incurred lower operating expenses as a percentage of revenues as we leveraged our operating expenses on higher revenues.

Interest and other income (expenses), net (in millions):
 
Three Months Ended
March 31,
 
2017
 
2016
 
Change
Interest and other income (expenses), net
$
1.6

 
$
(0.4
)
 
$
2.0


Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.

Interest and other income (expenses), net, includes foreign currency revaluation gains and losses, interest income earned on cash, cash equivalents and investment balances, gains and losses on foreign currency forward contracts and other miscellaneous charges.

Interest and other income (expenses), net for the three months ended March 31, 2017 increased compared to the same period in 2016 mainly due to higher foreign exchange gains as a result of the Euro strengthening to the U.S. dollar.

Equity in losses of investee, net of tax (in millions):

 
Three Months Ended
March 31,
 
2017
 
2016
 
Change
Equity in losses of investee, net of tax
$
1.1

 
$

 
$
1.1


Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.

We invested $46.7 million in SDC on July 25, 2016 and account for this investment based on the equity method of accounting. For the three months ended March 31, 2017, we recorded a $1.1 million charge representing our share of losses attributable to equity method investments (Refer to Note 4 "Equity Method Investments" of the Notes to Condensed Consolidated Financial Statements for details on equity method investments).

Income tax (in millions):
 
Three Months Ended
March 31,
 
2017
 
2016
 
Change
Provision (benefit) for income taxes
$
(7.2
)
 
$
12.4

 
$
(19.6
)
Effective tax rates
(11.4
)%
 
23.4
%
 
 
    

29

Table of Contents

Our provision (benefit) for income taxes was $(7.2) million and $12.4 million for the three months ended March 31, 2017 and 2016, respectively. This represents effective tax rates of (11.4)% and 23.4%, respectively. The decrease in effective tax rate for the three months ended March 31, 2017 compared to the same period in 2016 is primarily attributable to the adoption of ASU 2016-09 which requires excess tax benefits related to stock-based compensation to be recognized as a reduction of income tax expense along with certain of our foreign earnings being taxed at a lower rate relative to the U.S. federal statutory rate as a result of our international corporate restructuring.For the three months ended March 31, 2017, we recognized excess tax benefits of $21.3 million in our provision for income taxes.

On July 1, 2016, we implemented a new international corporate structure. This changed the structure of our international procurement and sales operations, as well as realigned the ownership and use of intellectual property among our wholly-owned subsidiaries. We continue to anticipate that an increasing percentage of our consolidated pre-tax income will be derived from, and reinvested in our foreign operations. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over time.

In June 2009, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted a twelve year extension of certain income tax incentives, which were previously granted in 2002. The incentive tax rates expire over various years, starting in June 2017. We are seeking a renewal of these income tax incentives before they expire. Under these incentives, all of the income in Costa Rica during these twelve year incentive periods 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 2017 and 2016. For the three months ended March 31, 2017, the reduction in income taxes was minimal primarily due to the new international corporate structure implemented on July 1, 2016. For the three months ended March 31, 2016, income taxes were reduced by $8.6 million representing a benefit to diluted net income per share of $0.11 (Refer to Note 12 "Accounting for Income Taxes for details on income taxes).

Liquidity and Capital Resources

We fund our operations primarily from product sales and available cash and cash equivalents and marketable securities. As of March 31, 2017 and December 31, 2016, we had the following cash, cash equivalents, and short-term and long-term marketable securities (in thousands):
 
 
March 31, 2017
 
December 31, 2016
Cash and cash equivalents
 
$
261,027

 
$
389,275

Short-term marketable securities
 
284,559

 
250,981

Long-term marketable securities
 
98,574

 
59,783

Total
 
$
644,160

 
$
700,039


Cash flows (in thousands):
 
 
Three Months Ended
March 31,
 
 
2017
 
2016
Net cash flow provided by (used in):
 
 
 
 
Operating activities
 
$
47,621

 
$
30,680

Investing activities
 
(145,298
)
 
(35,316
)
Financing activities
 
(33,001
)
 
(9,106
)
Effect of exchange rate changes on cash and cash equivalents
 
2,430

 
446

Net decrease in cash and cash equivalents
 
$
(128,248
)
 
$
(13,296
)

As of March 31, 2017, we had $644.2 million in cash, cash equivalents and short-term and long-term marketable securities. Cash equivalents and marketable securities are comprised of money market funds and highly liquid debt instruments which primarily include commercial paper, corporate bonds, U.S. government agency bonds, U.S. government treasury bonds, municipal securities, asset-backed securities and certificates of deposit.

As of March 31, 2017, approximately $421.5 million of cash, cash equivalents and short-term and long-term marketable securities was held by our foreign subsidiaries. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation

30

Table of Contents

on repatriation to the U.S. The costs to repatriate our foreign earnings to the U.S. would likely be material; however, our intent is to permanently reinvest our earnings from foreign operations, and our current plans do not require us to repatriate them to fund our U.S. operations as we generate sufficient domestic operating cash flow and have access to external funding under our current revolving line of credit.

Stock Repurchases

Refer to Note 11 "Common Stock Repurchase Program" of the Notes to Condensed Consolidated Financial Statements for details on stock repurchase program.

April 2014 Repurchase Program. During the three months ended March 31, 2017, we repurchased $3.8 million of our common stock repurchase in the open market. As of March 31, 2017, we completed our April 2014 Repurchase Plan (Refer to Note 11 "Common Stock Repurchase Program" of the Notes to Condensed Consolidated Financial Statements for details on stock repurchase program).

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 stock. As of March 31, 2017, there were no repurchases under this plan. On May 2, 2017, we entered into an ASR to repurchase $50.0 million of our common stock (the "2017 ASR"). We paid $50.0 million on May 3, 2017 and received an initial delivery of approximately 0.3 million shares based on current market prices. The final number of shares to be repurchased will be based on our volume-weighted average stock price under the term of the 2017 ASR, less an agreed upon discount.

Operating Activities

For the three months ended March 31, 2017, cash flows from operations of $47.6 million resulted primarily from our net income of approximately $69.4 million as well as the following:

Significant non-cash activities

Stock-based compensation was $14.8 million related to equity incentive compensation granted to employees and directors,
Depreciation and amortization of $7.9 million related to our fixed assets and intangible assets, and
Net change in deferred tax assets of $7.8 million.

Significant changes in working capital

Decrease of $39.7 million in accrued and other long-term liabilities due to timing of payments and activities,
Increase of $24.5 million in accounts receivable which is a result of the increase in net revenues, and
Increase of $11.7 million in deferred revenues corresponding to the increases in case shipments.

Investing Activities

Net cash used in investing activities was $145.3 million for the three months ended March 31, 2017 primarily consisted of purchases of marketable securities of $169.8 million, property and plant and equipment purchases of $59.6 million of which $44.1 million is related to new headquarters office purchase, $9.0 million paid for the acquisitions of certain of our distributors, net of cash and $8.0 million loan advance to privately held companies. These outflows were partially offset by maturities and sales of marketable securities of $98.7 million.

For the remainder of 2017, we expect to invest an additional $115.0 million to $125.0 million on capital expenditures primarily related to building improvements on our new corporate headquarters office and additional manufacturing capacity to support our international expansion. Although we believe our current investment portfolio has little risk of impairment, we cannot predict future market conditions or market liquidity and can provide no assurance that our investment portfolio will remain unimpaired.

Financing Activities

Net cash used in financing activities was $33.0 million for the three months ended March 31, 2017 primarily resulting from payroll taxes paid for vesting of restricted stock units through share withholdings of $36.5 million. These outflows were offset in part by $7.3 million from proceeds due to issuance of common stock.


31

Table of Contents

Contractual Obligations

Our contractual obligations have not significantly changed since December 31, 2016 as disclosed in our Annual Report on Form 10-K. We believe that our current cash, cash equivalents and short-term marketable securities combined with our existing borrowing capacity will be sufficient to fund our operations for at least the next 12 months. If we are unable to generate adequate operating cash flows and need more funds beyond our available liquid investments and those available under our credit facility, we may need to suspend our stock repurchase program or seek additional sources of capital through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources in order to realize our objectives and to continue our operations. There can be no assurance that we will be able to obtain additional debt or equity financing on terms acceptable to us, or at all. If adequate funds are not available, we may need to make business decisions that could adversely affect our operating results such as modifications to our pricing policy, business structure or operations. Accordingly, the failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations and financial condition (Refer to Note 9 "Commitments and Contingencies", of the Notes to Condensed Consolidated Financial Statements for details on commitments and contingencies).

Off-Balance Sheet Arrangements

As of March 31, 2017, we had no 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.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of our financial condition and results of operations is based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of condensed consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses and disclosures at the date of the financial statements. We evaluate our estimates on an on-going basis, including those related to revenue recognition, stock-based compensation, goodwill and finite-lived assets and related impairment, and income taxes.  We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates.  Actual results could differ from those estimates.

We believe the following critical accounting policies and estimates affect our more significant judgments used in the preparation of our consolidated financial statements. These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2016:

Revenue Recognition;
Stock-Based Compensation Expense;
Goodwill and Finite-Lived Acquired Intangible Assets;
Impairment of Goodwill, Finite-Lived Acquired Intangible Assets and Long-Lived Assets; and
Accounting for Income Taxes.

Recent Accounting Pronouncements

See Note 1 “Summary of Significant Accounting Policies” of the Notes to Condensed Consolidated Financial Statements for a discussion of recent accounting pronouncements.

ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In the normal course of business, we are exposed to foreign currency exchange rate and interest rate risks that could impact our financial position and results of operations.

Interest Rate Risk

Changes in interest rates could impact our anticipated interest income on our cash equivalents and investments in marketable securities. Our cash equivalents and investments are fixed-rate short-term and long-term securities. Fixed-rate securities may have their fair market value adversely impacted due to a rise in interest rates, and, as a result, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates. As of March 31, 2017, we had approximately $380.6 million invested in available-for-sale marketable securities. An immediate 10% change in interest rates would not have a material adverse impact on our future operating results and cash flows.

32

Table of Contents


We do not enter into investments for trading or speculative purposes and have not used any derivative financial instruments to manage our interest rate risk exposure. We do not have interest bearing liabilities as of March 31, 2017 and therefore, we are not subject to risks from immediate interest rate increases.

Currency Rate Risk

As a result of our international business activities, our financial results could be affected by factors such as changes in foreign currency exchange rates or economic conditions in foreign markets, and there is no assurance that exchange rate fluctuations will not harm our business in the future. We generally sell our products in the local currency of the respective countries. This provides some natural hedging because most of the subsidiaries’ operating expenses are generally denominated in their local currencies as discussed further below. Regardless of this natural hedging, our results of operations may be adversely impacted by exchange rate fluctuations.

We have in the past and may in the future enter into currency hedging transactions in an effort to cover some of our exposure to foreign currency exchange fluctuations on cash and certain trade and intercompany receivables and payables. These forward contracts are not designated as hedging instruments and do not subject us to material balance sheet risk due to fluctuations in foreign currency exchange rates. The gains and losses on these forward contracts are intended to offset the gains and losses in the underlying foreign currency denominated monetary assets and liabilities being economically hedged. These instruments are marked to market through earnings every period and generally are one month in original maturity. We do not enter into foreign currency forward contracts for trading or speculative purposes. As our international operations grow, we will continue to reassess our approach to managing the risks relating to fluctuations in currency rates. It is difficult to predict the impact hedging activities could have on our results of operations. As of March 31, 2017, we did not have any outstanding foreign exchange forward contracts.

Although we will continue to monitor our exposure to currency fluctuations, and, where appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, the impact of an aggregate change of 10% in foreign currency exchange rates relative to the U.S. dollar on our results of operations and financial position could be material.

ITEM 4.CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures.

Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of March 31, 2017, to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.

Changes in internal control over financial reporting.

There were no changes in our internal control over financial reporting during the quarter ended March 31, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


33

Table of Contents

PART II—OTHER INFORMATION
 
ITEM 1.     LEGAL PROCEEDINGS

Securities Class Action Lawsuit
    
On November 28, 2012, plaintiff City of Dearborn Heights Act 345 Police & Fire Retirement System filed a lawsuit against Align, Thomas M. Prescott (“Mr. Prescott”), Align’s former President and Chief Executive Officer, and Kenneth B. Arola (“Mr. Arola”), Align’s former Vice President, Finance and Chief Financial Officer, in the United States District Court for the Northern District of California on behalf of a purported class of purchasers of our common stock (the “Securities Action”). On July 11, 2013, an amended complaint was filed, which named the same defendants, on behalf of a purported class of purchasers of our common stock between January 31, 2012 and October 17, 2012. The amended complaint alleged that Align, Mr. Prescott and Mr. Arola violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and that Mr. Prescott and Mr. Arola violated Section 20(a) of the Securities Exchange Act of 1934. Specifically, the amended complaint alleged that during the purported class period defendants failed to take an appropriate goodwill impairment charge related to the April 29, 2011 acquisition of Cadent Holdings, Inc. in the fourth quarter of 2011, the first quarter of 2012 or the second quarter of 2012, which rendered our financial statements and projections of future earnings materially false and misleading and in violation of U.S. GAAP. The amended complaint sought monetary damages in an unspecified amount, costs and attorneys’ fees. On December 9, 2013, the court granted defendants’ motion to dismiss with leave for plaintiff to file a second amended complaint. Plaintiff filed a second amended complaint on January 8, 2014 on behalf of the same purported class. The second amended complaint states the same claims as the amended complaint. On August 22, 2014, the court granted our motion to dismiss without leave to amend. On September 22, 2014, Plaintiff filed a notice of appeal to the Ninth Circuit Court of Appeals. Briefing for the appeal was completed in May 2015 and the Ninth Circuit held oral arguments in October 2016. Align intends to vigorously defend itself against these allegations. Align is currently unable to predict the outcome of this amended complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible loss, if any.
    
Shareholder Derivative Lawsuit
    
On February 1, 2013, plaintiff Gary Udis filed a shareholder derivative lawsuit against several of Align’s current and former officers and directors in the Superior Court of California, County of Santa Clara. The complaint alleges that our reported income and earnings were materially overstated because of a failure to timely write down goodwill related to the April 29, 2011 acquisition of Cadent Holdings, Inc., and that defendants made allegedly false statements concerning our forecasts. The complaint asserts various state law causes of action, including claims of breach of fiduciary duty, unjust enrichment, and insider trading, among others. The complaint seeks unspecified damages on behalf of Align, which is named solely as nominal defendant against whom no recovery is sought. The complaint also seeks an order directing Align to reform and improve its corporate governance and internal procedures, and seeks restitution in an unspecified amount, costs, and attorneys’ fees. On July 8, 2013, an Order was entered staying this derivative lawsuit until an initial ruling on our first motion to dismiss the Securities Action. On January 15, 2014, an Order was entered staying this derivative lawsuit until an initial ruling on our second motion to dismiss the Securities Action. On October 14, 2014, an Order was entered staying this derivative lawsuit until a ruling by the Ninth Circuit in the Securities Action discussed above. Align is currently unable to predict the outcome of this complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible losses, if any.

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.


34

Table of Contents


ITEM 1A.RISK FACTORS

We depend on the sale of the Invisalign system for the vast majority of our net revenues, and any decline in sales of Invisalign treatment for any reason, or a decline in average selling prices would adversely affect net revenues, gross margin and net income.

We expect that net revenues from the sale of the Invisalign System, primarily Invisalign Full and Invisalign Teen, will continue to account for the vast majority of our total net revenues for the foreseeable future. Continued and widespread market acceptance of Invisalign by orthodontists, GPs and consumers is critical to our future success. If orthodontists and GPs experience a reduction in consumer demand for orthodontic services, if consumers prove unwilling to adopt Invisalign as rapidly as we anticipate or in the volume that we anticipate, if orthodontists or GPs choose to use a competitive product rather than Invisalign or if the average selling price of our product declines, our operating results would be harmed.

Competition in the markets for our products is intense and we expect aggressive competition from existing competitors and other companies that may introduce new technologies in the future.

Currently, our products compete directly against products manufactured and distributed by various companies, both within and outside the U.S. Many of these manufacturers, including Danaher Corporation, Sirona Dental Systems, Inc., Dentsply International, Inc. and 3M, have substantially greater financial resources and manufacturing and marketing experience than we do. In addition, as a result of the expiration of certain key patents owned by us, commencing in 2017, we expect that these existing competitors as well as new entrants into the clear aligner market will begin offering an orthodontic system more similar to ours in the near future. Several of these competitors will likely have greater resources as well as the ability to leverage their existing channels in the dental market to compete directly with us, and therefore our share of the clear aligner market could decline which would likely have a material adverse effect on our business, results of operation and financial condition.  In addition, corresponding foreign patents will start to expire in 2018 which will likely result in increased competition in some of the markets outside the U.S. Large consumer product companies may also enter the orthodontic supply market. Furthermore, we also face competition from companies that now offer clear aligner therapy directly to the consumer eliminating the need for the consumer to visit a dental office. In addition, we may also face competition in the future from new companies that may introduce new technologies. We may be unable to compete with these competitors and one or more of these competitors may render our technology obsolete or economically unattractive. If we are unable to compete effectively with existing products or respond effectively to any products developed by new or existing competitors, our business could be harmed. Increased competition has resulted in the past and may in the future result in volume discounting and price reductions, reduced gross margins, reduced profitability and loss of market share, and reduce dental professionals’ efforts and commitment to expand their use of our products, any of which could have a material adverse effect on our net revenues, volume growth, net income and stock price. We cannot assure that we will be able to compete successfully against our current or future competitors or that competitive pressures will not have a material adverse effect on our business, results of operations and financial condition.

We are dependent on our international operations, which exposes us to foreign operational, political and other risks that may harm our business.

Our key production steps are performed in operations located outside of the U.S. At our facility in San Jose, Costa Rica, technicians use a sophisticated, internally developed computer-modeling program to prepare digital treatment plans, which are then transmitted electronically to Juarez, Mexico. These digital files form the basis of the ClinCheck treatment plan and are used to manufacture aligner molds. Our order acquisition, aligner fabrication and shipping operations are conducted in Juarez, Mexico, and we also have order acquisition for the EMEA region at our facility in Amsterdam, the Netherlands. In addition to the research and development efforts conducted in our North America facilities, we also carry out research and development in Moscow, Russia. We also have customer-care, accounts receivable, credit and collections, customer event registration and accounts payable organizations located at our facility in San Jose, Costa Rica. In addition, we have operations in Israel where the design and wand are assembled and our intraoral scanner is manufactured. Our reliance on international operations exposes us to risks and uncertainties that may affect our business or results of operation, including:

difficulties in hiring and retaining employees generally, as well as difficulties in hiring and retaining employees with the necessary skills to perform the more technical aspects of our operations;
difficulties in managing international operations, including any travel restrictions to or from our facilities located in Russia, Israel and other countries;
fluctuations in currency exchange rates;

35

Table of Contents

increased income taxes, and other restrictions and limitations, if we were to decide to repatriate any of our foreign cash balances back to the U.S.;
import and export license requirements and restrictions;
controlling production volume and quality of the manufacturing process;
political, social and economic instability, including as a result of increased levels of violence in Juarez, Mexico or the Middle East. We cannot predict the effect on us of any future armed conflict, political instability or violence in these regions. In addition, some of our employees in Israel are obligated to perform annual reserve duty in the Israeli military and are subject to being called for additional active duty under emergency circumstances. We cannot predict the full impact of these conditions on us in the future, particularly if emergency circumstances or an escalation in the political situation occurs. If many of our employees are called for active duty, our operations in Israel and our business may not be able to function at full capacity;
acts of terrorism and acts of war;
general geopolitical instability and the responses to it, such as the possibility of additional sanctions against Russia which continue to bring uncertainty to this region;