Malocclusion is a fancy term for misaligned teeth. Align Technology (NASDAQ: ALGN), the maker of Invisalign, says between 60% and 75% of the world’s population have malocclusion. SmileDirectClub (NASDAQ: SDC) places that estimate even higher at 85%. I haven’t personally counted to see which company is right, but it’s probably safe to say there are a lot of people worldwide who would benefit from having their teeth straightened.
Since both Align Technology and SmileDirectClub treat malocclusion with transparent retainers, most assume these two companies are cut-throat competitors. But in reality, they have enjoyed a friendly business relationship for years. However, a key agreement between the two companies is set to expire at the end of the year, setting up a confrontational 2020 and beyond.
Image source: Getty Images.
In July 2016, Align Technology purchased a stake in then two-year-old SmileDirectClub. At the time, it was a 17% equity interest in the company. A year later, Align Technology purchased an additional 2%.
The two companies also entered a supply agreement in 2016. Align Technology became SmileDirectClub’s exclusive third-party provider of transparent retainers. To be clear, SmileDirectClub manufactured the majority of its retainers itself, but it did purchase retainers from Align Technology totaling almost $28 million in 2018. Additionally, SmileDirectClub uses Align’s technology to make oral images used for retainer manufacturing.
Part of the supply agreement included a non-compete clause. This clause had provisions that stipulated SmileDirectClub cannot solicit Align employees specifically in Costa Rica, where SDC has its main call center. SDC also agreed not to solicit any Align employees worldwide.
This all changed in Feb. 2018, when SmileDirectClub alleged that Align Technology broke the agreement. The problem was that Align began opening Invisalign stores in 2017 as part of a pilot program. In 2018, it expanded the program to 12 stores in major cities in an attempt to grow a direct-to-consumer segment of the business. But it was also done to better compete with companies like SmileDirectClub. The concept is a lot like SDC’s SmileShop.
The two companies sought legal arbitration over the issue. In March, Align Technology announced that it had basically lost the case to SmileDirectClub. Align was required to close all 12 of its Invisalign stores and had to relinquish its equity stake in SDC, which was required to buy back Align’s stake for its 2017 value — the time when Align broke the non-compete provisions. The two companies are still debating what the value should be.
The supply agreement with its non-compete clauses was set to expire at the end of this year, and indeed, the supply agreement does expire on Dec. 31. Align Technology has made it clear that the business relationship is over. It will let its contract with SmileDirectClub expire. However, the arbitrator extended the non-compete provisions until August 2022. That makes 2020 a transitional year for these two companies, one in which we could see jockeying for position before a more heated face-off in 2022.
The arbitrator gave SmileDirectClub a gift by extending the non-compete clauses until 2022. Since opening for business in 2014, SDC has grown its SmileShop footprint to over 300 locations as of September, when it went public. Going forward, the company has an agreement with CVS to open up to 1,500 SmileShops inside the pharmacies over the next five years. It also has an agreement with Walgreens for “any number” of SmileShops. SDC is well capitalized for a massive rollout like this, with $548 million in cash on the balance sheet.
Align Technology also has a sizable war chest with $490 million on its balance sheet. And it really liked the direct-to-consumer model of its Invisalign stores. It wouldn’t be surprising if Align’s management had a countdown ticker set up somewhere, ticking down the days until Aug. 2022 when it can resume opening these brick-and-mortar locations. Once the non-compete clause expires, it’s game on.
Rarely is business a zero-sum game. There can be multiple winners in any single business opportunity. And if the malocclusion market is really as big as the companies say it is, there’s room for both players.
Yet in a business battle, I prefer the long-term prospects of Align Technology. SmileDirectClub isn’t facing a battle only with Align. It’s also under attack from the American Association of Orthodontists (granted, not exactly an unbiased party) and state legislatures. Align, on the other hand, has a healthy network of over 63,000 trained Invisalign doctors worldwide. Additionally, Align Technology makes oral scanners, such as the iTero, which SDC relies on for taking 3D pictures of teeth to make its retainers. Having control over that factor is a competitive advantage for Align, and sustainable competitive advantages are something to look for, especially when evaluating growth stocks.
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Jon Quast has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Align Technology. The Motley Fool recommends CVS Health. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.