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Align Technology Inc – ‘10-Q’ for 9/30/04

On:  Friday, 11/5/04, at 4:47pm ET   ·   For:  9/30/04   ·   Accession #:  1193125-4-187955   ·   File #:  0-32259

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  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

11/05/04  Align Technology Inc              10-Q        9/30/04    7:569K                                   RR Donnelley/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 10-Q        For the Quarterly Period Ended September 30, 2004   HTML    363K 
 2: EX-10.13.1  Form of Option Agreement Under Align's 2001 Stock   HTML     44K 
                          Incentive Plan                                         
 3: EX-10.44    Employment Agreement Between Robert D. Mitchell     HTML     44K 
                          and Align Dated July 12, 2004                          
 4: EX-10.45    Employment Agreement Between Cecilia Claudio and    HTML     44K 
                          Align Dated September 13, 2004                         
 5: EX-10.46    Severance Agreement Between Jon Fjeld and Align     HTML     35K 
                          Dated July 14, 2004                                    
 6: EX-31.1     Section 302 CEO & CFO Certifications                HTML     19K 
 7: EX-32.1     Section 906 CEO & CFO Certifications                HTML     10K 

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

OR

For the transition period from              to             

Commission file number: 0-32259

Align Technology, Inc.

(Exact name of registrant as specified in its charter)

881 Martin Avenue

Santa Clara, California 95050

(Address of principal executive offices) (Zip Code))

(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 is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

The number of shares outstanding of the registrant’s Common Stock, $0.0001 par value, as of October 31, 2004 was 60,628,658.

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Table Of Contents

ALIGN TECHNOLOGY, INC.

INDEX

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PART I—FINANCIAL INFORMATION

ITEM 1 FINANCIAL STATEMENTS

ALIGN TECHNOLOGY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)

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

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ALIGN TECHNOLOGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

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

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ALIGN TECHNOLOGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

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

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ALIGN TECHNOLOGY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by Align Technology, Inc. (the “Company” or “Align”) in accordance with the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted in accordance with such rules and regulations. In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company as of September 30, 2004 and December 31, 2003, and its results of operations and cash flows for the three and nine months ended September 30, 2004 and 2003. These unaudited condensed consolidated financial statements should be read in conjunction with the annual audited consolidated financial statements and notes as of and for the year ended December 31, 2003 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 9, 2004.

The results of operations for the three and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004 or any other interim period, and the Company makes no representations related thereto.

The condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Certain prior period amounts have been reclassified to conform with current period presentation.

Certain risks and uncertainties

The Company’s operating results depend on, to a significant extent, the Company’s ability to market and develop its products. The life cycles of the Company’s products are difficult to estimate due in part to the effect of future product enhancements and competition. The Company’s inability to successfully develop and market its products as a result of competition or other factors would have a material adverse effect on the Company’s business, financial condition and results of operations.

Financial instruments which potentially expose the Company to concentrations of credit risk consist primarily of cash equivalents and accounts receivable. The Company invests excess cash primarily in commercial paper. The Company provides credit to customers in the normal course of business. Collateral is not required for accounts receivable, but ongoing evaluations of customers’ credit worthiness are performed. The Company maintains reserves for potential credit losses and such losses have been within management’s expectations. No individual customer accounted for 10% or more of the Company’s accounts receivable at September 30, 2004 or at December 31, 2003, or net revenues for the three and nine months ended September 30, 2004 or 2003.

The Food and Drug Administration (“FDA”) regulates the design, manufacture, distribution, preclinical and clinical study, clearance and approval of medical devices. Products developed by the Company may require approvals or clearances from the FDA or other international regulatory agencies prior to commercialized sales. There can be no assurance that the Company’s products will receive any of the required approvals or clearances. If the Company were to be denied approval or clearance or such approval were to be delayed, it may have a material adverse impact on the Company.

The Company has manufacturing operations located outside the United States of America. The Company currently relies on its manufacturing facilities in Costa Rica to create virtual treatment plans with the assistance of sophisticated software. In addition, the Company relies on a third party manufacturer in Mexico to fabricate Aligners and to ship the completed product to the Company’s customers. The Company’s reliance on international operations exposes it to related risks and uncertainties, including: difficulties in staffing and managing international operations, controlling quality of the manufacturing process, political, social and economic instability, interruptions and limitations in telecommunication services, product and/or material transportation delays or disruption, trade restrictions and changes in tariffs, import and export license requirements and restrictions, fluctuations in currency exchange rates and potential adverse tax consequences. If any of these risks materialize, the Company’s international manufacturing operations, as well as its operating results, may be harmed.

The Company receives certain of its components from sole suppliers. Additionally, the Company relies on a limited number of hardware manufacturers. The inability of any supplier or manufacturer to fulfill supply requirements of the Company could materially impact future operating results.

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2. Inventories

Inventories comprise (in thousands):

Work in process includes costs to produce the Invisalign product, including deferred costs. Finished goods primarily represent ancillary products that support the Invisalign system.

3. Net Profit (Loss) Per Share

Basic net profit (loss) per share is computed using the weighted average number of shares of common stock during the year less unvested common shares subject to repurchase. Diluted net profit per share is computed using the weighted average number of shares of common stock, adjusted for the dilutive effect of potential common stock. Potential common stock, computed using the treasury stock method, includes options and unvested shares subject to repurchase.

The following table sets forth the computation of basic and diluted net profit (loss) per share attributable to common stock (in thousands, except per share amounts):

The following table sets forth potential shares of common stock that are not included in the diluted net profit (loss) per share because to do so would be anti-dilutive for the periods indicated (in thousands):

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4. Stock-based Compensation

The Company accounts for stock-based employee compensation using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations and complies with the disclosure requirements of SFAS 148, Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123 (“SFAS 148”). The following table illustrates the effect on net profit (loss) and net profit (loss) per common share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data):

Such pro forma disclosure may not be representative of future compensation cost because options vest over several years and additional grants are anticipated to be made each year.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. The following are the weighted average assumptions:

5. Commitments and Contingencies

Short-term and Long-term Obligations

As of September 30, 2004, future minimum payments under lease obligations and financing agreements are as follows (in thousands):

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Product Warranty

The Company generally warrants its products for a specific period of time against material defects in materials and workmanship. The Company provides for the estimated future costs of warranty obligations in costs of goods sold when the related product is shipped. Accrued estimated warranty costs are primarily based on historical experience as to product failures as well as current information on replacement costs. Management periodically reviews the accrued balances and updates the historical warranty cost trends. Actual warranty costs incurred have not materially differed from those accrued.

Aligners are subject to the Invisalign product warranty, which covers defects in materials and workmanship, and is contingent upon proper use of the Aligners. The Invisalign product warranty is in force until the case is completed. In the event the Aligners fall within the scope of the Invisalign product warranty, the Company will replace the Aligners at its expense. If a patient chooses not to wear the Aligners, and as a result, requests additional Invisalign treatment, the dental professional pays for the additional expense. The Invisalign product warranty does not provide any assurances regarding the outcome of treatment using Invisalign.

The following table reflects the change in the Company’s warranty accrual during the nine months ended September 30, 2004 (in thousands):

Contingencies

In October 2003, the Company entered into a Loan Agreement with General Orthodontics, LLC (“GO”), whereby the Company agrees to make loan advances to GO of amounts not to exceed an aggregate principle balance of $200,000. The commitment by the Company to make advances to GO shall expire upon GO obtaining alternative financing. Interest on the loans will accrue on the unpaid principal amount of the outstanding loans at an annual rate of 5%. All loan advances and accrued interest are due and payable no later than October 2006. No advances were made by the Company to GO as of September 30, 2004.

Legal Proceedings

On January 6, 2003, Ormco Corporation (“Ormco”) filed suit against the Company in the United States District Court for the Central District, Orange County Division, asserting infringement of U.S. Patent Nos. 5,447,432, 5,683,243 and 6,244,861. The complaint seeks unspecified monetary damages and injunctive relief. On February 18, 2003, the Company answered the complaint and asserted counterclaims seeking a declaration by the Court of invalidity and non-infringement of the asserted patents. In addition, the Company counterclaimed for infringement of U.S. Patent No. 6,398,548, seeking unspecified monetary damages and injunctive relief. Ormco filed a reply to the Company’s counterclaims on March 10, 2003 and asserted counterclaims against the Company seeking a declaration by the Court of invalidity and non-infringement of U.S. Patent No. 6,398,548. The Company responded to Ormco’s counterclaims on April 2, 2003. The Company amended its counterclaim to add Allesee Orthodontic Appliances, Inc. (“AOA”), a wholly-owned subsidiary of Ormco, as a counterdefendant in regard to the Company’s counterclaim of infringement of U.S. Patent No. 6,398,548. The Court then permitted Ormco to amend its Complaint and permitted the Company to amend its counterclaim to add an additional patent each. Ormco filed a first amended complaint for infringement of U.S. Patent No. 6,616,444 on October 15, 2003. On October 27, 2003, the Company filed an answer to Ormco’s first amended complaint and a counterclaim for invalidity and non-infringement of U.S. Patent No. 6,616,444 and for infringement of U.S. Patent No. 6,554,611.

In connection with these claims, the Court granted three motions for summary judgment that we filed. First, on May 14, 2004, the Court granted the Company’s motion for summary judgment of non-infringement, finding that the Company’s Invisalign system does not infringe any of the asserted Ormco patents (5,477,432, 5,683,243, 6,244,861 and 6,616,644). Second, on July 2, 2004, the Court granted in part the Company’s motion for summary judgment of infringement, finding that Ormco and AOA infringe certain, but not all, claims of the Company’s patents Nos. 6,398,548 and 6,554,611 through the manufacture and sale of Red, White & Blue appliances. Third, on August 26, 2004, the Court granted the Company’s motion for summary judgment of invalidity of Ormco’s asserted patents claims (5,477,432, 5,683,243, 6,244,861 and 6,616,644). As noted above, the Court earlier found that the Company does not infringe these patents. In addition, the Court also denied Ormco’s motion for summary judgment seeking a finding of invalidity of the Company’s asserted patent claims (6,398,548 and 6,554,611).

The Court initially scheduled trial for October 29, 2004. At a pretrial conference held on September 10, 2004, however, the Court decided to allow the parties to file further dispositive motions. Subsequently, the Court took the trial date off calendar to permit briefing of these motions. The Company then filed a motion for summary judgment that its asserted patent claims are not invalid. The Company also filed a motion for summary judgment that its patents are not unenforceable based on Ormco’s allegations of inequitable

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conduct. Ormco filed a motion for summary judgment that it did not willfully infringe the Company’s patents. Ormco also moved to dismiss the case for alleged lack of subject matter jurisdiction. Ormco’s motion to dismiss has been denied. Each of the remaining motions, as well as various other motions filed by the parties, was heard by the Court on October 29, 2004. The Company expects the trial to be scheduled after the Court rules on such motions.

From time to time, the Company has received and may in the future receive letters from third parties drawing its attention to their patent rights. While the Company does not believe that it infringes upon any valid and enforceable rights that have been brought to its attention, there may be other more pertinent rights of which the Company is presently unaware. The defense and prosecution of intellectual property suits, interference proceedings and related legal and administrative proceedings could result in substantial expense to the Company and significant diversion of effort by its technical and management personnel. In the event the court’s decision in the Ormco litigation discussed above is overturned on appeal, or if the Company is subject to an adverse determination in a patent suit by Ormco or in any other litigation or interference proceeding to which the Company may become a party, the Company could be subject to significant liabilities. An adverse determination of this nature could also put the Company’s patents at risk of being invalidated or interpreted narrowly or require the Company to seek licenses from third parties. Licenses may not be available on commercially reasonable terms or at all, in which event, the Company’s business would be materially adversely affected.

The Company is subject to claims and assessments from time to time in the ordinary course of business. Management does not believe that any such matters, individually or in the aggregate, will have a material adverse effect on the Company’s financial condition, results of operations or cash flows.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements include, among other things, statements concerning our expectations regarding the anticipated benefit of increased collaboration between orthodontists and general practitioner dentists on our revenue growth, our expectation that the percentage of revenue generated by general practitioner dentists may, in the future, represent a larger percentage of our revenue than revenue generated by orthodontists, our expectations regarding further expansion into North American and international markets, the number of new doctors we anticipate certifying in 2004, our anticipated revenue growth for fiscal 2004, our expectation that sales and marketing expense as well as our research and development spending will increase 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 the following discussion, and in particular, the risks discussed below under the subheading “Risk Factors” and in other documents we file with the Securities and Exchange Commission. We undertake no obligation to revise or publicly release the results of any revision to 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.

Overview

Align Technology, founded in March 1997, designs, manufactures and markets Invisalign, a proprietary method for treating malocclusion, or the misalignment of teeth. Invisalign corrects malocclusion using a series of clear, nearly invisible, removable appliances that gently move teeth to a desired final position. Because it does not rely on the use of metal or ceramic brackets and wires, Invisalign significantly reduces the aesthetic and other limitations associated with braces. Invisalign is appropriate for treating adults and teens with mature dentition. Align Technology received FDA clearance to market Invisalign in 1998.

The Invisalign product is manufactured in phases. The initial step in our manufacturing process is the creation of electronic treatment plans using ClinCheck^™, an internally developed computer-modeling program. These treatment plans are developed in our operations facility in Costa Rica and are transmitted electronically back to the U.S. ClinCheck^™ allows dental professionals to simulate treatment in three dimensions by modeling two-week stages of tooth movement. The electronic files which form the basis for ClinCheck^™, are used in conjunction with stereolithography technology to manufacture Aligner molds. These molds are then used by a third party manufacturer in Mexico to fabricate Aligners. Aligners are thin, clear plastic, removable dental appliances that are manufactured in a series to correspond to each two-week stage of the ClinCheck^™ simulation. Aligners are customized to perform the treatment prescribed for an individual patient by dental professionals using ClinCheck^™. After the Aligners are produced, the third party manufacturer ships the finished products to our customers.

Align has two customer channels: the orthodontist and the general practitioner, or GP dentist. We have historically generated a majority of our revenues from orthodontists, and we expect to continue to do so for the foreseeable future. There exists, however, a significantly greater number of GPs in North America than orthodontists. As the primary care dental provider, GPs have access to a greater number of patients than orthodontists, and possess a unique opportunity to educate these patients and introduce them to Invisalign. GPs also have the ability to refer appropriate cases to orthodontists and, in certain instances, may choose to treat less complex cases themselves. We are committed to improving the collaboration and referral relationships between orthodontists and GPs. We believe that improved collaboration is beneficial to the orthodontist and the GP and will accelerate growth in Invisalign cases and consequently increase our revenues. In addition, although we expect that orthodontists will continue to treat the majority of complex cases and continue to drive research for expanding Invisalign applications, we expect that the percentage of revenue generated by GPs will increase, largely due to the fact that there are significantly more GPs than orthodontists, and may, in the future, represent a larger percentage of our revenue than revenue generated by orthodontists. We believe this expected increase in the number of cases treated by GPs will result in an increase in the overall market for Invisalign as patients that would not have otherwise sought orthodontic treatment are introduced to Invisalign by GPs.

Our domestic orthodontist and GP dentist customers represented over 90% of our total product revenue during fiscal 2004. We expect to continue to increase our market penetration into the North American market. We will also focus our efforts towards the expansion of our international markets. We currently have patients in treatment in over 30 countries. For the remainder of fiscal 2004, we expect to increase our infrastructure and support in key countries in Europe and initiate strategic moves in Asia, more specifically in Japan, in order to take advantage of this emerging opportunity.

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Clinical education and ongoing training are critical to our customers’ success with Invisalign. We certify several thousand new doctors to use Invisalign annually, and we expect to certify approximately 4,000 newly trained doctors during fiscal 2004. Additionally, we share product enhancements, treatment tips and techniques, and clinical research data with our customers on an ongoing basis through continuing education in the form of hundreds of provider workshops, study clubs and third-party online educational centers. This information ensures that our customers understand Invisalign’s expanding applications and best uses, and that they feel confident about treating more of their patients with Invisalign.

Net revenue for the third quarter of fiscal 2004 was $45.8 million, an increase of 35% as compared to $34.0 million for the third quarter of fiscal 2003. The increase was driven primarily from increases in the number of cases submitted for both the domestic orthodontic and general practitioner channels. Net profit was $3.3 million, or $0.06 net profit per share, basic and $0.05 net profit per share, diluted, compared to a net loss of $2.1 million, or $0.04 net loss per share, basic and diluted, for the third quarter of fiscal 2003.

Results of Operations

Revenues. Invisalign product revenues by channel and other revenue, which represented training and sales of ancillary products, for the three and nine-months periods ended September 30, 2004 and 2003 are as follows:

Cost of revenues. Cost of revenues for the quarter ended September 30, 2004 was $14.9 million compared to $13.4 million for the quarter ended September 30, 2003. Cost of revenues for the nine-month period ended September 30, 2004 was $42.6 million compared to $38.6 million for the nine-month period ended September 30, 2003. Cost of revenues include the salaries for staff involved in production, the cost of materials and packaging, shipping costs, depreciation on the capital equipment used in the production process, training costs and the cost of facilities. Also included in cost of revenues are stock-based compensation expenses of $0.1 million and $0.6 million for the third quarters of fiscal 2004 and 2003, respectively, and stock-based compensation expenses of $0.9 million and $2.0 million for the nine-month periods ended September 30, 2004 and 2003, respectively. Gross profit for the quarter ended September 30, 2004 was $30.8 million or 67% of revenue, compared to a gross profit of $20.6 million or 61% of revenue for the quarter ended September 30, 2003. Gross profit for the nine-month period ended September 30, 2004 was $86.6 million or 67% of revenue, compared to a gross profit of $47.6 million or 55% of revenue for the nine-month period ended September 30, 2003. The higher gross profit in the third quarter and nine-month period ended September 30, 2004 as compared to the quarter and nine-month period ended September 30, 2003 is primarily attributable to improved fixed cost absorption related to increasing case volumes and continued manufacturing process efficiencies.

Sales and marketing. Sales and marketing expenses for the quarter ended September 30, 2004 were $13.9 million compared to $10.5 million for the quarter ended September 30, 2003. Sales and marketing expenses for the nine-month period ended September 30, 2004 were $40.6 million compared to $32.6 million for the nine-month period ended September 30, 2003. Sales and marketing expenses include sales force compensation (combined with travel related costs and expenses for professional marketing programs), conducting workshops and market surveys, advertising and dental professional trade show attendance. Sales and marketing expenses include stock-based compensation expenses of $0.1 million and $0.5 million in the third quarters of fiscal 2004 and 2003, respectively, and stock-based compensation expenses of $0.6 million and $1.8 million for the nine-month periods ended September

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30, 2004 and 2003, respectively. The increase in sales and marketing expense of $3.4 million for the third quarter of fiscal 2004 as compared to the third quarter of fiscal 2003 resulted primarily from an increase in spending of $1.6 million related to incremental headcount in our North American sales and marketing work force, $0.8 million related to our international sales and marketing workforce and consulting services, and $1.4 million related to increases in media, advertising costs and marketing promotions. The increase in spending was partially offset by the decrease of $0.4 million in stock-based compensation expense. The increase in sales and marketing expense of $8.0 million for the nine-month period ended September 30, 2004 as compared to the nine-month period ended September 30, 2003 resulted primarily from an increase in spending of $3.4 million related to incremental headcount in our North American sales and marketing work force, $0.8 million related to North America sales force training, $2.6 million related to our international workforce and consulting services, and $2.3 million related to increases in media, advertising costs and marketing promotions. The increase in spending was partially offset by the decrease of $1.1 million in stock-based compensation expense. The increases during fiscal 2004 have been consistent with our marketing and sales initiatives and we expect these initiatives to continue in the remainder of fiscal 2004. Accordingly, we expect sales and marketing expense to increase during the fourth quarter of fiscal 2004 as we continue to invest in sales force staffing, clinical education, direct-to-consumer advertising and related consumer programs.

General and administrative. General and administrative expenses for the quarter ended September 30, 2004 were $8.3 million compared to $8.7 million for the quarter ended September 30, 2003. General and administrative expenses for the nine-month period ended September 30, 2004 were $25.2 million compared to $25.6 million for the nine-month period ended September 30, 2003. General and administrative expenses included salaries for administrative personnel, outside consulting services, legal expenses and general corporate expenses. General and administrative expenses include stock-based compensation expenses of $0.5 million and $1.6 million for the third quarters of fiscal 2004 and 2003, respectively, and stock-based compensation expenses of $2.6 million and $5.7 million for the nine-month periods ended September 30, 2004 and 2003, respectively. The decrease in general and administrative expense of $0.4 million for the quarter ended September 30, 2004 as compared to the quarter ended September 30, 2003 was primarily due to decreases in stock-based compensation expense of $1.1 million and general corporate expenses of $0.5 million. Partially offsetting the decreases were $1.2 million in incremental payroll expenses from additional headcount expense for the third quarter of fiscal 2004 as compared the third quarter of fiscal 2003. The $0.4 million decrease in general and administrative expenses for the nine-month period ended September 30, 2004 as compared to the nine-month period ended September 30, 2003 was primarily due to the decrease in stock-based compensation expense of $3.1 million and the sales tax charge of $1.4 million incurred during the second quarter of fiscal 2003. The decreased expenses in the nine-month period ended September 30, 2004 as compared to the nine-month period ended September 30, 2003 was partially offset by increases of $2.8 million in payroll expenses and $1.3 million in general corporate expenses.

Research and development. Research and development expenses for the quarter ended September 30, 2004 were $4.8 million and $3.1 million for the quarter ended September 30, 2003. Research and development expenses for the nine-month period ended September 30, 2004 were $11.8 million and $9.8 million for the nine-month period ended September 30, 2003. Research and development expenses include the costs associated with software engineering, the cost of designing, developing and testing our products and conducting clinical and post-marketing trials. We expense our research and development costs as they are incurred. Research and development expenses included $0.9 million and $0.6 million of stock-based compensation for the third quarters of fiscal 2004 and 2003, receptively, and $1.6 million and $2.5 million of stock-based compensation for the nine-month periods ended September 30, 2004 and 2003, respectively. The increase in research and development expense of $1.7 million for the quarter ended September 30, 2004 as compared to the quarter ended September 30, 2003 resulted primarily from a $1.1 million severance charge related to the departure of Align’s vice president of engineering and increased spending of $0.6 million for product improvement initiatives. For the nine-month period ended September 30, 2004 as compared to September 30, 2003, the increase of $2.0 million resulted from the $1.1 million severance charge and increased spending of $1.8 million for product improvement initiatives, partially offset by a $0.9 million decrease in stock-based compensation expense. For the remainder of fiscal 2004, we expect to increase research and development spending for clinical research and product improvement initiatives.

Interest and other income (expense), net. Interest and other expense was ($0.2) million for the quarter ended September 30, 2004 as compared to ($0.4) million for the quarter ended September 30, 2003. Interest and other expense was ($0.6) million for the nine-month period ended September 30, 2004 as compared to ($0.1) million for the nine-month period ended September 30, 2003. Interest and other income (expense), net, includes interest income earned on cash balances, interest expense on debt, foreign currency translation gains and losses for the dollar against other currencies related to international businesses and other miscellaneous charges. For the quarter ended September 30, 2004 as compared to the quarter ended September 30, 2003, other expenses increased by $0.2 million for the quarter ended September 30, 2004 as compared to the quarter ended September 30, 2003. For the nine-month period ended September 30, 2004 as compared to the nine-month period ended September 30, 2003, other expenses decreased by $0.2 million, and foreign currency translation loss was reduced by $0.3 million for the nine-month period ended September 30, 2004 compared to the nine-month period ended September 30, 2003.

Income tax provision. Income tax provision was $0.3 million and $0.8 million for the quarter and nine-month periods ended September 30, 2004, respectively, and was as a result of taxable income during fiscal 2004. Income tax provision for the quarter and nine-month periods ended September 30, 2003 was $38,000 primarily related to the net loss during fiscal 2003. We expect tax expense for fiscal year 2004 to be at an effective tax rate of approximately 10%.

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Stock-based compensation. In connection with the grant of stock options to employees and non-employees prior to 2001, we recorded deferred stock-based compensation as a component of stockholders’ equity. Deferred stock-based compensation for options granted to employees is the difference between the fair value of our common stock on the date such options were granted and their exercise price. For stock options granted to non-employees, the fair value of the options, estimated using the Black-Scholes valuation model, is initially recorded on the date of grant. As the non-employee options vest, we remeasure the remaining unvested options, with the change in fair value from period to period represented as a change in deferred compensation. This stock-based compensation is amortized as charges to operations over the vesting periods of the options. For the quarters ended September 30, 2004 and 2003, we recorded amortization of deferred compensation of $1.0 million and $3.1 million, respectively. For the nine-month periods ended September 30, 2004 and 2003, we recorded amortization of deferred compensation of $4.7 million and $10.2 million, respectively.

We recorded expenses of $0.1 million and $0.3 million for the quarters ended September 30, 2004 and 2003, respectively, related to options granted to non-employees after 2001. We recorded expenses of $0.4 million and $0.9 million for the nine-month periods ended September 30, 2004 and 2003, respectively, related to options granted to non-employees after 2001.

Historically, we have accelerated the vesting of options to several employees in connection with severance packages. This acceleration was accounted for as a charge to the condensed consolidated statements of operations. We recorded $0.7 million for the quarter and nine-months ended September 30, 2004 related to the departure of Align’s vice president of engineering. We recorded no such charge for the quarter ended September 30, 2003 and $0.8 million for the nine-months ended September 30, 2003 related to severance packages for several employees. This charge is equal to the intrinsic value of the options which was calculated as the difference between the exercise price of the accelerated options and the fair value of the common stock on the date of acceleration.

Liquidity and Capital Resources

We have funded our operations with the proceeds from the sale of our common and preferred stock, an equipment-based term loan, bridge loans and cash provided from operations. We have incurred operating losses from inception through the third quarter of 2003.

As of September 30, 2004, we had $63.2 million of cash and cash equivalents, $0.3 million of restricted cash and $0.5 million of marketable securities. We had an accumulated deficit of $292.9 million as of September 30, 2004.

Net cash provided by operating activities totaled $17.5 million and $4.9 million for the nine-month periods ended September 30, 2004 and 2003, respectively. Net cash provided by operating activities for the nine-month period ended September 30, 2004 resulted primarily from operating profit and increases in current liabilities. For the nine-month period ended September 30, 2003, net cash provided by operating activities resulted primarily from increases in accrued liabilities and deferred revenue, partially offset by operating losses.

Net cash used in investing activities totaled $4.8 million for the nine-month period ended September 30, 2004 and $3.9 million for the nine-month period ended September 30, 2003. For the nine-month period ended September 30, 2004, net cash used in investing activities resulted primarily from the purchase of property and equipment for capacity expansion and manufacturing improvements, partially offset by proceeds from the sale of equipment and maturities of marketable securities. For the nine-month period ended September 30, 2003, net cash used in investing activities resulted primarily from the purchase of property and equipment for capacity expansion and manufacturing improvements and purchases of marketable securities, partially offset by maturities of marketable securities.

Net cash provided by financing activities was $5.6 million and $0.8 million for the nine-month periods ended September 30, 2004 and 2003, respectively. For the nine-month period ended September 30, 2004, net cash provided by financing activities consisted of proceeds from the issuance of common stock, primarily from exercises of employee stock options, partially offset by payments on debt obligations related to the equipment-based term loan and capital lease obligations. For the nine-month periods ended September 30, 2003, net cash provided by financing activities consisted of proceeds from the issuance of common stock, primarily from exercises of employee stock options, and proceeds from payment on stockholders’ notes receivable, partially offset by payments on debt obligations related to the equipment-based term loan and capital lease obligations.

Contractual Obligations. There have been no material changes to our contractual obligations outside the ordinary course of business from those disclosed in our annual report on Form 10-K for the fiscal year ended December 31, 2003.

In December 2003, we increased our accounts receivable-based revolving line of credit from $10.0 million to $15.0 million, and negotiated more favorable terms. Accessing the revolving line of credit is restricted based on qualifying accounts receivable and

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compliance with certain loan covenants. As of September 30, 2004, we had not utilized the revolving line of credit. In December 2002, we secured an equipment-based term loan of $5.0 million, which was fully drawn down in December 2002. As of September 30, 2004, the equipment-based term loan had an outstanding balance of $2.1 million.

We expect that the increase in our operating expenses will be commensurate with an overall increase in the level of our business activity, including increased sales and the related costs of products sold, our consumer advertising campaign and dental professional marketing efforts, continuing efforts to automate our manufacturing processes, increases in the size of our sales force and dental professional training staff, continued international sales and marketing efforts, and development and improvements to our product. In addition, we may use cash to fund acquisitions of complementary businesses or technologies. Our capital requirements depend on market acceptance of our products and our ability to market, sell and support our products on a worldwide basis.

We believe that our current cash and cash equivalents will be sufficient to fund our operations for at least the next 12 months. If we are unable to generate adequate operating cash flows, we may need to 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 could be required to delay establishing a national brand, building manufacturing infrastructure and developing our product and process technology, or to reduce our expenditures in general. 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.

Critical Accounting Policies

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 financial statements requires our management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenue 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, accounts receivable, legal contingencies 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 affect our more significant judgments and estimates used in the preparation of our condensed consolidated financial statements.

Revenue Recognition

We recognize revenue in accordance with SEC Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, and EITF 00-21. SAB No. 104 requires that four basic criteria must be met before revenue can be recognized: persuasive evidence of an arrangement exists; shipments have occurred; the fee is fixed and determinable; and collectibility is reasonably assured. Determination of whether persuasive evidence of an arrangement exists and whether delivery has occurred or services have been rendered involve management’s judgments based on whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. EITF 00-21 addresses the issue of accounting for arrangements that involve the delivery of multiple products or services. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.

Revenue from the sale of Invisalign and ancillary products is recognized upon product shipment, provided that no significant obligations remain, transfer of title has occurred and collection of the receivable is deemed probable. The costs of producing the ClinCheck^™ treatment plan, which are incurred prior to the production of Aligners, are deferred and recognized as related revenues are earned, i.e. upon shipment of the Aligners.

In certain instances, adjustments to a patient’s teeth are made in the final stages of orthodontic treatment. To make these final adjustments and move a patient’s teeth to the final desired position, dental professionals may elect to use Invisalign as a finishing treatment tool and order newly manufactured Aligners. These newly manufactured Aligners, or “case refinement”, are not provided with the Aligners produced as part of the initial treatment plan and are manufactured only upon the request of the dental professional if final adjustments are desired.

From June 2001 through April 2003, we offered our dental professionals the opportunity, at the time of the creation of the initial treatment plan, to purchase at a discount a one-time, non-refundable case refinement. Revenue, in the amount of the stand-alone sales price of the undelivered element, is deferred until the earlier of shipment of the case refinement or, if case refinement is never requested, the point in time when the case is deemed completed, or “case expiration”. In cases where the dental professional did not purchase case refinement in advance, case refinement revenues, if any, are recognized when the new Aligners are shipped.

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We updated our domestic and international pricing policies in May 2003 and January 2004, respectively, to include the future delivery of one case refinement in the price of each case and to offer additional case refinements at a price of $125 each and at a comparable price internationally, which we believe represents its fair value based on competitive product offerings. Revenue deferrals associated with future case refinement after May 1, 2003 are $125 per case and a comparable price internationally after January 2004. This revenue deferral amount represents the fair value of a case refinement as determined in accordance with EITF 00-21, which addresses the issue of accounting for arrangements that involve the delivery of multiple products or services. These revenue deferrals will be recognized when the case refinement has been shipped or upon case expiration, whichever is earliest.

Service revenues earned for training of dental professionals and staff for Invisalign are recorded as the services are performed. Service revenues earned under agreements with third parties are based on negotiated rates, which are intended to approximate a mark-up on our anticipated costs.

We estimate and record a provision for amounts of estimated losses on sales, if any, in the period such sales occur. Provisions for discounts and rebates to customers are provided for in the same period that the related product sales are recorded based upon historical discounts and rebates.

Warranty Expense

Aligners are subject to the Invisalign product warranty, which covers defects in materials and workmanship. Our materials and workmanship warranty is in force until the Invisalign case in completed. In the event the Aligners fall within the scope of the Invisalign product warranty, we will replace the Aligners at our expense. Our warranty is contingent upon proper use of the Aligners for the purposes for which they are intended. If a patient chooses not to wear the Aligners, and as a result, requests additional Invisalign treatment, the dental professional pays for the additional expense. The Invisalign product warranty does not provide any assurances regarding the outcome of treatment using Invisalign.

The Company generally warrants its products for a specific period of time against material defects. We accrue for estimated warranty costs upon shipment of products. The Company provides for the estimated future costs of warranty obligations in costs of goods sold when the related revenue is recognized. The accrued warranty costs represent the best estimate at the time of sale of the total costs that the Company expects to incur to repair or replace product which fails while still under warranty. The amount of accrued estimated warranty costs are primarily based on historical experience as to product failures as well as current information on repair costs. Actual warranty costs could differ from the estimate amounts. The Company regularly reviews the accrued balances and updates the historical warranty cost trends. Actual warranty costs incurred have not materially differed from those accrued. If we were to experience higher rates of warranty events, we would be required to accrue additional warranty costs, which would negatively affect our operating results.

Allowance for Doubtful Accounts

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make payments. We periodically review these estimated allowances, including an analysis of the customers’ payment history and information regarding the customers’ creditworthiness. If the financial condition of any of our customers were to deteriorate, resulting in their inability to make payments, an additional allowance may be required and would negatively impact our operating results.

Accounting for long-lived assets

We assess the impairment of long-lived assets periodically in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors that could trigger an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a significant decline in the stock price for a sustained period and the market capitalization relative to net book value. If these factors or their related assumptions change in the future, we may be required to record impairment charges which would negatively impact operating results.

Legal contingencies

We are currently involved in certain legal proceedings as discussed in Note 5 to our condensed consolidated financial statements. Because of uncertainties related to both the potential amount and range of loss from pending litigation, management is unable to make a reasonable estimate of the liability that could result if there is an unfavorable outcome in these legal proceedings. As additional information becomes available, we will assess the potential liability related to this pending litigation and revise our estimates accordingly. Revisions of our estimates of such potential liability could materially impact our results of operations and financial condition.

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Deferred Tax Valuation Allowance

Pursuant to the guidance provided in the Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS No. 109), we anticipate that we will again provide a full valuation allowance against our net deferred income tax assets at the end of 2004. This conclusion is based upon the belief that it is more likely than not that these assets will not be realized.

The principal business condition necessary to realize the benefits of these assets is the generation of significant future profits. Although we anticipate that profits will result from our future operations, historical data is insufficient develop the trend data that is necessary to reasonably predict future profits.

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RISK FACTORS

We have only recently experienced significant revenue growth and achieved profitability. If we fail to sustain or increase profitability or revenue growth in future periods, the market price of our common stock may decline.

You should consider our business and prospects in light of the risks, expenses and difficulties encountered by a company in an early stage of operations. Since inception, we incurred significant operating losses and we have only achieved profitability since the fourth quarter of fiscal 2003. From inception through July 2000, we spent significant funds on organizational and start-up activities, recruiting key managers and employees, developing Invisalign and developing our manufacturing and customer support resources. We also spent significant funds on clinical trials and training programs to train dental professionals in the use of Invisalign.

We continue to incur significant operating expenses to:

As noted above, we have only recently achieved profitability, as a result, to sustain or increase profitability in future periods, we will need to continue to increase our revenue, while controlling our expenses. We generated positive operating cash flow for the first time during fiscal year 2003, and we cannot be certain that we will be able to sustain or increase such positive cash flow from operations, from period to period, in the future. In addition, we have recently experienced significant revenue growth. Because our business is evolving it is difficult to predict our future operating results or levels of growth and we may not be able to sustain such growth levels in future periods. If we do not sustain or increase profitability or revenue growth or otherwise meet the expectations of securities analysts or investors, the market price of our common stock will likely decline.

We have a limited operating history and expect our future financial results to fluctuate which may cause volatility in our stock price.

We were incorporated in April 1997 and began sales of Invisalign in July 1999. Thus, we have a limited operating history, which makes it difficult to evaluate our future prospects and your investment in our stock. In addition, we expect our future quarterly and annual operating results to fluctuate as we increase our commercial sales. These fluctuations could cause our stock price to decline. Some of the factors that could cause our operating results to fluctuate include:

To respond to these and other factors, we may need to make business decisions that could adversely affect our operating results. Most of our expenses, such as employee compensation and lease payment obligations, are relatively fixed in the short term. Moreover, our expense levels are based, in part, on our expectations regarding future revenue levels. As a result, if our revenue for a particular period falls below our expectations, we may be unable to adjust spending quickly enough to offset any unexpected shortfall in revenue growth or any decrease in revenue levels.

Due to these and other factors, we believe that quarter-to-quarter comparisons of our operating results may not be meaningful. You should not rely on our results for any one quarter as an indication of our future performance.

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Our information technology systems are critical to our business. System integration and implementation issues and system security risks could disrupt our operations, which could have a material adverse impact on our operations, sales and operating results.

We rely on the efficient and uninterrupted operation of complex information technology systems. All information technology systems are vulnerable to damage or interruption from a variety of sources. For instance, as our business has grown in size and complexity, the growth has placed, and will continue to place, significant demands on our information technology systems. To effectively manage this growth, we will need to continually upgrade and enhance our information systems to more effectively manage our operations.

In October 2004, we implemented a new version of our enterprise resource planning system and new software for our manufacturing execution system. During the remainder of fiscal 2004 and throughout 2005 we will integrate additional functionality into our manufacturing execution system, which will more efficiently integrate this system with our other system applications, such as customer facing and manufacturing tools. System upgrades and enhancements require significant capital expenditures and allocation of valuable employee resources. Delays in integration or disruptions to our business from implementation of these new or upgraded systems could have a material adverse impact on our financial condition and operating results.

In addition, experienced computer programmers and hackers may be able to penetrate our network security and misappropriate our confidential information or that of third parties, create system disruptions or cause shutdowns. Furthermore, sophisticated hardware and operating system software and applications that we either internally produce or procure from third parties may contain defects in design and manufacture, including “bugs” and other problems that can unexpectedly interfere with the operation of the system. The costs to eliminate or alleviate security problems, viruses and bugs could be significant, and the efforts to address these problems could result in interruptions that may have a material adverse impact on our operations, sales and operating results.

If we fail to maintain the adequacy of our internal controls, our ability to provide accurate financial reports could be impaired, and any failure to maintain our internal controls and provide accurate financial reports would cause our market price to decrease substantially.

Effective internal controls are necessary for us to provide reliable financial reports and help prevent fraud. We are continuously evaluating and working to improve our internal controls. Our evaluation may conclude that enhancements, modifications or changes to our internal controls are necessary to satisfy the requirements of the Sarbanes-Oxley Act of 2002. We cannot be certain that the measures we implement will ensure that we maintain adequate controls over our financial processes and reporting in the future. Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our financial reporting obligations. Any failure to maintain the adequacy of our internal controls and provide accurate financial reports could subject us to costly litigation, could make it difficult to attract and retain quality management personnel and could have a negative effect on the market price of our stock.

We have limited product offerings, and if demand for Invisalign declines or fails to develop as we expect or if dental professionals or consumers do not adopt Invisalign in sufficient numbers or as rapidly as we anticipate, or if orthodontists and GP dentists do not collaborate as we expect, our revenue will decline.

We expect that revenue from the sale of Invisalign will continue to account for a substantial portion of our total revenue. Continued and widespread market acceptance of Invisalign by both dental professionals and consumers is critical to our future success. If orthodontists and dentists experience a reduction in consumer demand for orthodontic services or consumers prove unwilling to adopt Invisalign as rapidly as we anticipate or in the volume that we anticipate, or if orthodontists and GP dentists do not collaborate as we expect, our operating results could be harmed. Factors that could cause Invisalign not achieve market acceptance at the rate at which we expect, or at all are described more fully below.

Our success depends upon increasing acceptance of Invisalign by dental professionals. Invisalign requires dental professionals and their staff to undergo special training and learn to interact with patients in new ways. In addition, because Invisalign has only been in clinical testing since July 1997 and commercially available only since July 1999, dental professionals may be reluctant to adopt it until more historical clinical results are available. Also, increasing adoption and cumulative use by dental professionals will depend on factors such as the capability, safety, efficacy, ease of use, price, quality and reliability of our products and our provision of effective sales support, training and service. In the future, unanticipated poor clinical performance of Invisalign could result in significant adverse publicity and, consequently, reduced acceptance by dental professionals. If Invisalign does not achieve growing acceptance in the orthodontic and dental communities, our operating results will be harmed.

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Our success depends upon the acceptance of Invisalign by a substantially larger number of dental professionals as well as potential patients to whom we are now actively marketing. Invisalign represents a significant change from traditional orthodontic treatment, and patients may be reluctant to accept it or may not find it preferable to conventional treatment. In addition, patients may not comply with recommended treatment guidelines for Invisalign, which could compromise the effectiveness of their treatment. We have generally received positive feedback from both dental professionals and patients regarding Invisalign as both an alternative to braces and as a clinical method for treatment of malocclusion, but a number of dental professionals believe that Invisalign is appropriate for only a limited percentage of their patients. Market acceptance will depend in part upon the recommendations of dental professionals, as well as other factors including effectiveness, safety, reliability, improved treatment aesthetics and greater comfort and hygiene compared to conventional orthodontic products. Furthermore, consumers may not respond to our direct marketing campaigns or we may be unsuccessful in reaching our target audience. Adoption by consumers may also be impacted by general macroeconomic conditions, including the economic downturn and increased unemployment levels in the United States of America, levels of consumer confidence and consumer spending, all of which fluctuate and could be affected by unstable global economic, political or other conditions.

Our success depends in part upon improving the collaboration and referral relationships between orthodontists and GP dentists. Although orthodontists have historically generated a majority of our revenues, there exists a significantly greater number of general practitioners in North America than orthodontists. As the primary care dental provider, GPs have access to a greater number of patients than orthodontists, possess a unique opportunity to educate these patients and introduce them to Invisalign, have the ability to refer appropriate cases to orthodontists and, in certain instances, may chose to treat less complex cases themselves. We are committed to improving the collaboration and referral relationships between orthodontists and GPs. We believe that improved collaboration is beneficial to the orthodontist and the GP and will accelerate growth in Invisalign cases and consequently increase our revenues. If, however, this improved collaboration and increase in referrals does not occur or occurs more slowly than we anticipate, our operating results could be harmed.

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

Currently, two of our key production steps are performed in operations located outside of the U.S. At our facility in Costa Rica, technicians use a sophisticated, internally developed computer-modeling program to prepare electronic treatment plans, which are transmitted electronically back to the U.S. These electronic files form the basis of our ClinCheck^™ product and are used to manufacture Aligner molds. A third party manufacturer in Mexico fabricates Aligners and ships the completed products to our customers. Our costs associated with these operations are denominated in Costa Rican colons, Mexican pesos and U.S. dollars.

Our reliance on international operations exposes us to risks and uncertainties that may affect our business or results of operation, including:

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If any of these risks materialize in the future, our operating results may be harmed.

Our success depends in part on our proprietary technology and if we are unable to successfully enforce our intellectual property rights, our competitive position may be harmed.

Our success will depend in part on our ability to maintain existing intellectual property and to obtain and maintain further intellectual property protection for our products, both in the U.S. and in other countries. Our inability to do so could harm our competitive position. We believe our intellectual property position represents a substantial business advantage. As of September 30, 2004, we had 56 issued U.S. patents, 82 pending U.S. patent applications, and numerous foreign issued patents, as well as pending foreign patent applications.

We intend to rely on our portfolio of issued and pending patent applications in the U.S. and in other countries to protect a large part of our intellectual property and our competitive position. However, our currently pending or future patent filings may not issue as patents. Additionally, any patents issued to us may be challenged, invalidated, held unenforceable, circumvented, or may not be sufficiently broad to prevent third parties from producing competing products similar in design to our products. In addition, any protection afforded by foreign patents may be more limited than that provided under U.S. patents and intellectual property laws. We also rely on protection of our copyrights, trade secrets, know-how and proprietary information. We generally enter into confidentiality agreements with our employees, consultants and our collaborative partners upon commencement of a relationship with us. However, these agreements may not provide meaningful protection against the unauthorized use or disclosure of our trade secrets or other confidential information, and adequate remedies may not exist if unauthorized use or disclosure were to occur. Our inability to maintain the proprietary nature of our technology through patents, copyrights or trade secrets would impair our competitive advantages and could have a material adverse effect on our operating results, financial condition and future growth prospects. In particular, a failure of our proprietary rights might allow competitors to copy our technology, which could adversely affect pricing and market share.

If we infringe the patents or proprietary rights of other parties or are subject to a patent infringement claim, our ability to grow our business will be severely limited.

Extensive litigation over patents and other intellectual property rights is common in the medical device industry. We have been sued for infringement of third party’s patents in the past and, while these actions have been dismissed, we may be the subject of patent or other litigation in the future.

From time to time, we have received and may in the future receive letters from third parties drawing our attention to their patent rights. While we do not believe that we infringe upon any valid and enforceable rights that have been brought to our attention, there may be other more pertinent rights of which we are presently unaware. The defense and prosecution of intellectual property suits, interference proceedings and related legal and administrative proceedings could result in substantial expense to us and significant diversion of effort by our technical and management personnel. An adverse determination of any litigation or interference proceeding to which we may become a party could subject us to significant liabilities. An adverse determination of this nature could also put our patents at risk of being invalidated or interpreted narrowly or require us to seek licenses from third parties. Licenses may not be available on commercially reasonable terms or at all, in which event, our business would be materially adversely affected.

See Part II Item 1 of this Form 10-Q for a summary of our material pending legal proceedings.

Pending or future litigation could have a material adverse impact on our results of operation and financial condition.

We are currently a party to various legal proceedings and claims. Management does not believe that the ultimate outcome of these legal proceedings and claims will have a material adverse effect on our financial position or results of operations. However, there is no assurance that the court’s decision in the Ormco litigation will not be overturned on appeal. In addition, litigation is subject to inherent uncertainties and unfavorable rulings could occur. An unfavorable ruling could include monetary damages or, in cases where injunctive relief is sought, an injunction prohibiting us from selling our products. If an unfavorable ruling were to occur in any specific period, there exists the possibility of a material adverse impact on the results of operations of that period or future periods.

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See Part II Item 1 of this Form 10-Q for a summary of our material pending legal proceedings.

We currently rely on third parties to provide key inputs to our manufacturing process, and if our access to these inputs is diminished, our business may be harmed.

We currently outsource key portions of our manufacturing process. We rely on a third party manufacturer in Mexico to fabricate Aligners and to ship the completed product to customers. As a result, if this third party manufacturer fails to deliver its components or if we lose its services, we may be unable to deliver our products in a timely manner and our business may be harmed. Any difficulties encountered by the third party manufacturer with respect to hiring personnel, and maintaining acceptable manufacturing standards, controls, procedures and policies could disrupt our ability to deliver our products in a timely manner. Finding a substitute manufacturer may be expensive, time-consuming or impossible.

In addition, we are highly dependent on manufacturers of specialized scanning equipment, rapid prototyping machines, resin and other advanced materials. We maintain single supply relationships for many of these machines and materials technologies. Our growth may exceed the capacity of one or more of these manufacturers to produce the needed equipment and materials in sufficient quantities to support our growth. In the event of delivery delays or shortages of these items, our business and growth prospects may be harmed.

We have experienced rapid growth, and our failure to manage this growth could harm our business.

We have expanded rapidly since we commenced commercial sales in 1999. Our headcount increased from approximately 50 employees as of September 30, 1999 to approximately 932 employees as of September 30, 2004. This expansion will continue to place significant demands on our management and other resources and will require us to continue to develop and improve our operational, financial and other internal controls, both in the U.S. and internationally. In particular, rapid growth increases the challenges involved in a number of areas, including recruiting and retaining sufficient skilled personnel, providing adequate training and supervision to maintain our high quality standards, and preserving our culture and values. Our inability to effectively manage this level of growth could harm our business.

If we lose our key personnel or are unable to attract and retain key personnel, we may be unable to pursue business opportunities or develop our products.

We are highly dependent on the key employees in our clinical engineering, technology development and management teams. The loss of the services of those individuals may significantly delay or prevent the achievement of our product development and other business objectives and could harm our business. Our future success will also depend on our ability to identify, recruit, train and retain additional qualified personnel. In addition, few orthodontists are accustomed to working in a manufacturing environment since they are generally trained to work in private practices, universities and other research institutions. Thus, we may be unable to attract and retain personnel with the advanced qualifications necessary for the further development of our business. Furthermore, we may not be successful in retaining our key personnel or their services. If we are unable to attract and retain key personnel, our business could be materially harmed.

We experience competition from manufacturers of traditional braces and expect aggressive competition in the future.

Currently, our Invisalign product competes directly against a product called Red, White and Blue, which is manufactured and distributed by Ormco, a subsidiary of Sybron Dental Specialties. In addition, manufacturers of traditional braces, such as 3M Company, Sybron Dental Specialties and Dentsply International have substantially greater financial resources and manufacturing and marketing experience than we do and may, in the future, attempt to develop an orthodontic system similar to ours. Large consumer product companies may also enter the orthodontic supply market. Furthermore, we may 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 our competitors, our business could be harmed.

Complying with regulations enforced by the Food and Drug Administration (FDA) and other regulatory authorities is an expensive and time-consuming process, and any failure to comply could result in substantial penalties.

Our products are medical devices and are subject to extensive regulation in the U.S. and internationally. FDA regulations are wide ranging and govern, among other things:

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