Truth be told, Morgan Stanley’s recent downgrade of Align Technology, Inc. (NASDAQ:ALGN) makes some sense…at least on the surface. ALGN stock is trading at a frothy trailing P/E of 87.3, and the forward-looking P/E of 43.7 is still uncomfortably rich. And, though earnings and sales are growing at a strong double-digit pace, nothing inspires competition to enter the fray like a proven profit opportunity.
Might this be a situation, however, where market leadership, a strong, recognizable brand name and reliable growth mean an investor has to “pay up” for quality? Maybe, or maybe not.
Certainly, interested parties are considering stepping into ALGN stock a little sooner than they normally might in such a situation. Align stock may continue moving lower for a little while longer, though, following through on the post-downgrade plunge we saw last week as more reality sets in.
ALGN Stock Downgraded
You know the company, even if you don’t think you know it. Align Technology is the name behind Invisalign dental braces, which can straighten teeth using clear plastic molds, rather than wire. There are other brand names of clear aligners, though the fact that most people can’t name one of those other providers speaks volumes about how much market share Align Technology enjoys.
It’s not just about its prowess, though. Align continues to enjoy more than its fair share of the market’s ongoing growth. Sales are projected to grow 26% this year, spurring earnings per share of ALGN stock from last year’s $3.89 to an expected $4.52 this year to a projected $5.65 next year.
Not every observer thinks the future is going to look as impressive as the recent past has, however. Morgan Stanley analyst Steve Beuchaw is one of those doubters, recently downgrading the company from “Overweight” to “Equal-weight” on concerns the stock had simply become too expensive right as its growth pace was about to decelerate.
His point was well taken, if the 10% pullback ALGN stock has suffered in the meantime is any indication.
Align stock had been flying high, but when forced to look back and see the 100% gain mustered over the course of the prior year, it didn’t take a lot of convincing to make the bulls understand they’d come too far, too fast.
There may still be more downside in store, however.
A Perfect Storm
In many regards, it’s a proverbial perfect storm Beuchaw sees on the horizon.
Align Technology is the market leader; of that, there can be little doubt. Its alliance with the similarly recognizable name SmileDirectClub has helped make it so. That partnership isn’t necessarily rock-solid, though. Invisalign is mulling the establishment of storefronts that SmileDirectClub argues violates a non-compete clause. The disagreement may ultimately prod SmileDirectClub to find another supplier; Align doesn’t appear to be backing down.
In a bigger sense, the rising tide of stronger consumerism may be about to reach a plateau. That is to say, while rising incomes, falling unemployment and more confidence about the future has pushed more people into purchasing optional dental care, that addressable market may be on the verge of being “maxed out.”
Though there will still be fresh demand, Beuchaw believes that the total addressable market will be the same size in the foreseeable future that it’s been in the recent past. In the meantime, competitors will have found more ways to chip away at Align Technology’s dominance.
In other words, there’s still a whole heap of uncertainty here.
Earnings on Tap
Beuchaw conceded that Align Technology was a “world class” company in terms of execution… a big part of the reason it was able to become the dominant name in its market. The Morgan Stanley analyst stresses that the downgrade is more about ALGN stock (and unrealistic expectations from investors) than it is about the company itself.
Even with that being the case, though, ALGN stock is valued at about twice the market’s average forward-looking P/E right now. It’s priced for growth that may simply not be in the cards.
That’s why all eyes are going to be scrutinizing the first-quarter numbers it will post after the market closes this Wednesday.
Analysts are looking for revenue growth of 31%, and are expecting per-share profits to rise from 85 cents to 98 cents. Any shortcoming on either front could look and feel magnified to already-nervous investors. What the market’s really going to be looking for, however, is a hint that Beuchaw is wrong to worry.
Investors probably won’t get that hint.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can follow him on Twitter, at @jbrumley.