Management's Discussion of Results of Operations (Excerpts)
For purposes of readability, Zenith attempts to strip out all tables in excerpts from the Management Discussion. That information is contained elsewhere in our articles. The idea of this summary is simply to review how well we believe Management does its reporting. Also, this highlights what Management believes is important.
In our Decision Matrix at the end of each article, a company with 0 to 2 gets a "-1", and 3 to 5 gets a "+1."
On a scale of 0 to 5, 5 being best, Zenith rates this company's Management's Discussion as a 5.
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: * 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). • 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. ? 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. • 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. 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. Clear Aligner revenues: 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. 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 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. 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 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): 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. 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. 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. 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). 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, 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 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. 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. 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. 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.