SmileDirectClub, Inc.
Q2 2021 Earnings Call Transcript

Published: 9 Aug 2021

[Operator:]

Greetings, welcome to the SmileDirectClub Second Quarter 2021 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to your host, Tripp Sullivan of SCR Partners. You may begin.

[Tripp Sullivan:]

Thank you, operator. Good afternoon. Before we begin, let me remind you that this conference call includes forward-looking statements. For additional information on SmileDirectClub, please refer to the company's SEC filings, including the risk factors described therein. You should not rely on our forward-looking statements as predictions of future events. All forward-looking statements that we make on this call are based on assumptions and beliefs as of today. I refer you to our Q2 2021 earnings presentation for a description of certain forward-looking statements. We undertake no obligation to update such information, except as required by applicable law. In this conference call, we will also have a discussion of certain non-GAAP financial measures, including adjusted EBITDA and free cash flow. Information required by Regulation G of the Exchange Act with respect to such non-GAAP financial measures is included in the presentation slides for this call, which can be obtained on our website. We also refer you to this presentation for a reconciliation of certain non-GAAP financial measures to the appropriate GAAP measures. I am joined on the call today by Chief Executive Officer and Chairman, David Katzman; and Chief Financial Officer, Kyle Wailes. Let me now turn the call over to David.

[David Katzman:]

Thanks Tripp, and good afternoon, everyone. Thank you for joining us today. Before we begin, I want to acknowledge the tragic event that occurred in our manufacturing facility last Tuesday. Unfortunately, these incidents of workplace violence are all too common in our country. Our thoughts and prayers are with our impacted team members, security personnel, and their families as they begin to recover. We are grateful for the swift actions taken by our team members, our onsite security personnel and Metro Nashville Police in responding to and quickly containing a situation that could have been much worse. Now to the events at hand, I hope you've had a chance to review our earnings release and supplemental deck. We're not going to spend time with comments on any of those documents as they speak for themselves. So we can focus our time today on some highlights of the quarter and provide some color on recent announcements. I want to also make sure that we leave this call today with the proper context and understanding of how we view the business presently, the investments we are making to drive our growth over the next several years. And our continued opportunity to leverage our telehealth platform, to execute against our mission, to democratize access a smile each and every person loves and deserves by making it affordable and convenient for everyone. On today's call, I will highlight our newly launched Challenger campaign that is targeted directly at Invisalign's customer base as we work to move upstream with our customer demographics. Other aspects of the business I will touch on will be some recent regulatory wins and what those mean for us as well as some of the unique aspects we have developed with our vertically integrated platform that are incredibly difficult to replicate. I will also provide a brief update on the cyber attack, how we've responded since then and its impact on Q2. I'd like to start by first walking through what happened in the second quarter and the reasons why we fell short in both our stated revenue targets and adjusted EBITDA goals for the quarter. This was the first quarter that we have missed our expectations since Q4 2019, where we have consistently beaten expectations over the last five quarters through Q1 2021. While we are clearly not happy with the results here in the short-term, the long-term growth and profitability potential this company is intact. And we are well positioned to continue to execute against the multi-year targets that we have previously outlined. The missing Q2 is primarily due to three main factors. I will cover each one briefly and then Kyle will provide more details in a few minutes. First, new international markets are taking longer to scale than anticipated, particularly some of our larger markets like Germany and Spain, which have felt the lingering effects of COVID. Second, top of funnel weakness has been associated with the lasting effects of COVID on our target demographics in the U.S. as well as all time, high costs per lead metrics and social platforms such as Facebook, which we believe is driven by some changes associated with Apple's new iOS update. We conducted a significant amount of internal and third-party economic research on effective COVID on our core demographic. Some of which we've highlighted in our supplemental deck and what it shows is the following. Our core demographic which has a median household income of $68,000 likely experienced outsized pressures in their capacity to spend on discretionary items, given the significant inflationary headwinds facing the non-discretionary categories like transportation, utilities and food. Additionally, as the economy emerges from a pandemic induced economic shutdown, our target consumer appears to be favoring products over services, given the pent-up demand for apparel, automobiles, home-related goods, and child-centric spending like sporting goods. Further contributing to the unfavorable condition of constraint capacity and spend on discretionary items and a general consumer preference for products over services. Joblessness remains pervasive in four of our larger states, California, New York, Texas, and Florida. Through July 10, 2021, these four states represent 40% of the nation's continuing jobless claims. In addition, we believe reduced levels of supplemental federal unemployment insurance benefits could be contributing to additional capacity headwinds. Third, broad conversion rate pressure across our customer acquisition funnel through a combination of the macro factors noted a moment ago and the residual impacts of the cyber attack in mid-April. I would note that the backlog associated with the cyber attack was 100% caught up during the second quarter, but it still had a material impact on conversion as we expected it would. Over the past six quarters, we have continued to invest in our infrastructure to execute against our controlled growth strategy, which positions us to generate average revenue growth of 20% to 30% per year for the next five years and adjusted EBITDA margins of 25% to 30% by the end of that period. Especially with the macro influences, I mentioned a moment ago, now is a critical time for us to have a singular focus on maximizing the global opportunity and achieving our longer term growth targets without the short-term focus on one quarters results. As a result, we have decided not to provide quarterly earnings guidance. We will continue to have our quarterly conference calls with commentary and Q&A but our guidance will send around annual performance and expectations. We are a relatively new company with only 20 million in revenue, a short five years ago when we launched our first Smile shop. We are learning, we are agile and we can pivot quickly to take advantage of the opportunities in front of us without the pressures of quarterly expectations. Let's talk about where the SDC brand sits in the eyes of the consumer and how well we are positioned. In customer experience, our persistent focus is paying off and we have seen continued strength and aided awareness, which remains at approximately 50%. We are also seeing our Google review ratings register at 96% positive, which remains an all-time high. Our analysis of the trends in consumer sentiment across multiple channels, including reviews, news coverage, blogs, Twitter, and other online forums continue to show significant positive trends and online consumer sentiment remains at an all-time high. For full rates also remain healthy at roughly 21%. All these efforts are positively impacting consumer perception around credibility. One of the core pillars of our brand alongside cost comfort, certainty and convenience. And our most recent independent U.S. branch record consumer survey of the general population. 68% of consumers believe our network of dentists and orthodontists provides the best possible care to customers, up from 62% in Q1 2021 and up 26% since year end 2019. Additionally, 67% of respondents surveyed noted that they view SDC as a trusted brand up 5% from Q1 2021 and up over 30% from Q2 of 2020. This is an incredible improvement in a short period of time and demonstrates our transition from disruptor to orthodontic challenger. As we make significant gains in this area, closing the gap to only a few percentage points versus Invisalign. This vast improvement in such a short period of time is largely attributable to our heightened focus on our club members and our industry-first doctor-directed telehealth platform. While we are always in pursuit of continuous improvement, we are pleased with our progress on this front, over the past few quarters. Progress in brand sentiment and credibility against Invisalign is directly correlated to our club member experience, but it's also closely associated with our recently launched challenger campaign that began a few weeks ago in July. If you haven't seen the ads, I would encourage you to check them out. The Challenger campaign is outperforming our testimonials and functional spots and cost per sale. Although, having all units in rotation is helping to raise awareness. We have the data that shows these spots are driving a higher percentage of new users to our website compared to our non-challenger campaigns. This campaign marks a shift for our brand from disruptors to challenger as we take on Invisalign and the battle to become the teeth straightening brand of choice. It asks the question, why would rumors choose to pay the three-time markup of Invisalign when SmileDirectClub offers a smarter or affordable clinically safe and effective option that is guaranteed for life and can be achieved remotely with our doctors via our telehealth platform. Reflect on that for a minute. This is the question that everyone should be asking. Why would someone pay up to $3,000 more when they can get a clinically safe and effective option that has treated over one and a half million people for up to 60% less. And the treatment plan results are guaranteed for life. That is the messaging that we will continue to reinforce. As we scale up the demographic ladder to higher income groups in both adult and teen categories. Turning to the regulatory environment, as we've noted in prior earnings calls, we are well positioned in our continued efforts to protect the access to care that consumers want and deserve. The 11th Circuit Court of Appeals recently ruled in our lawsuit pending against the Georgia Dental Board. That Dental Board do not have the right to file appeals until the conclusion of the litigation. As a result, the 11th Circuit Court of appeals has also denied the appeal filed by the Alabama Dental Board in connection with our lawsuit against that board. We are pleased that we will now be able to proceed with discovery in both of these lawsuits and believe these rulings send an important message to other dental boards who have been engaging in or considering engaging in anti-competitive conduct to preclude our growth. We continue to see more states passing teledentistry-friendly laws and refusing to pass laws that put up artificial and clinically unsupportive barriers to access to care. The trend from a legislative standpoint is very much in our favor. When it comes to legislative victories that help teledentistry, we have one in 28 states since the 2020 recession. And have successfully defended existing laws in seven other states. In addition, we continue to see growth and adoption and use of teledentistry by the dental and orthodontic industries. This is underscored even further by the expansion of our professional partnerships and well established and respected national DSOs, which is further testament to the adoption of telehealth by the dental community. Today, there are more than 1,800 dental practices participating in our partner network with many more, both in the U S and in foreign countries seeking to join in the near future. We remain confident in our long-term growth numbers because of the power and inherent value of the platform that we have built with its unique assets. Just a few short years, we achieved over 1.5 million club members across 13 countries and built the only vertically integrated medtech platform for T screening. No one has the combination of aided awareness, omni-channel presence, teledentistry platform, SmilePay financing, custom treatment planning, and manufacturing capabilities at scale that we have today. These core strengths uniquely positioned us to capture a large share of this incredible market opportunity over the long-term. As the market shifts away from analog braces to digital clear aligners as the preferred choice for T screening. Our leadership has also built on innovation, which we haven't talked much about publicly to this point. On an annual basis, we invest tens of millions into our innovation pipeline. We have dedicated teams working on AI, machine learnings, material science, and 3D printing. We have made investments into enabling the treatment of more complex cases, automated manufacturing, new types of aligners, smile scanning technologies, our proprietary telehealth platform, oral care products in a variety of other areas to continue our disruption. This investment has resulted in us securing 25 patents and dozens of patent pending in the U.S. and abroad on various technologies relating to data capture, treatment planning, monitoring, manufacturing, and consumer products. This is a very exciting part of our business, and we will update you more in future quarters as those projects come to life and are introduced into the marketplace. Of course, one of our strongest assets is the strong balance sheet that we have. We ended the quarter with $377 million of cash on the books, which will enable us to execute against our mission for many years to come. This cash ensures that we have the dry powder to focus on the long-term success for our business. And we remain more confident than ever in attaining that success. Before I close, I'd like to update you on the three growth initiatives we have previously discussed. As a reminder, they are expanding our customer acquisition channels, expanding our presence in the teen demographic and continuing our international expansion. On the first initiative, expansion of our acquisition channels, we continue to make good progress here. We have always been and remained agnostic as how customers start their journey to purchase aligners. We started with doctor-prescribed impression kits, then smile shops and now through our professional channel partnerships, corporate and insurance partnerships, mass retail locations, and pop-up events. We have expanded our reach to new segments of consumers and have strengthened our relationship with the dental community. On our corporate and insurance partnerships, we recently launched a new way for members to instantly check their coverage on our website. This is now available for six of the 10 largest U.S. dental insurers. We will be running advertising to this insurance flow and believe it could be a highly efficient lead strategy, along with being a great member experience. You can test it out by clicking on the insurance tab on sdc.com. On the retail side, our oral care products are now available at over 12,000 retail stores nationwide and serve as a highly efficient lead source and brand building opportunity. Our ancillary product portfolio is available through every retail channel, including drug stores, grocery stores, club stores, mass retailers, and through e-commerce. On the professional channel, we continue to extend our partner network and anticipate a strong cadence of additions over the ensuing weeks and months. We continue to schedule pop-up events to drive club members to our clinical partners and our network has now extended across more than 1,800 practices in the United States. One critical data point is the success that we are having with referrals into our clinical partners, for them to increase and introduce new patients for their practice. With one partner alone, we have already scheduled over 1,000 SDC patients into their practice for a free exam, which is a foundational part of our partnership. As we have highlighted before, this acquisition channel is complementary to our current offering and represents a new on-ramp for consumers who want to start their journey in a dentist chair. On the international front, the same problem that exists in North America around access, convenience, and costs also exists globally. We launched into our first country outside of North America in the second quarter of 2019 and the rest of all countries already represents 16% of our revenue Q2, which is flat to Q1 represents only a fraction of the total opportunity we're targeting and reflective of early stages of penetration. We are now in 13 markets globally with plans to launch into additional locations in Europe, Latin America, and Asia Pacific throughout this year and next. To provide some additional context on this opportunity, I would like to highlight that we are seeing higher brand awareness much earlier on in our market maturity in many of our international markets, which is evidence that the investment in marketing is paying off. To be more specific, it took us five years in the U.S. to reach the brand awareness that we are seeing in some international markets after only two years in the market. We will continue to invest heavily into brand building across these important regions to maximize our long-term share gains. And you will continue to see this reflected in our sales and marketing line item in the future. None of this will be possible without the support of our team members, club members and investors. And we thank all of you for your support as we work to capture this massively underserved market. We remain laser focused on our mission to democratize access to a smile each and every person loves and deserves, by making it affordable and convenient for everyone. And now, I'll turn the call over to Kyle, who’ll provide a detailed overview of our Q2 financial results. Kyle?

[Kyle Wailes:]

Thank you, David. I would also like to offer my heartfelt sympathy to our team members affected by last week's events and my thanks to our security team, team members and the first responders for their quick decisive actions. Now let me jump right to our results for the quarter. Please be sure to review our supplemental materials posted to our investor website, which provides additional details and everything that we'll cover. Additionally, as a result of several conversations we have had with investors, we have attempted to include additional information in the supplemental materials, including a detailed breakdown of U.S. and Canada versus rest of world. Revenue for the quarter was $174 million, which is a decline of 13% sequentially, and up 63% on a year-over-year basis. This was driven primarily by 90,000 initial aligner shipments at an ASP of 1,885, which is at 1.3% sequentially and up 3.7% year-over-year. The Q2 results are primarily due to three main factors that David mentioned earlier. I will walk through a bridge from our initial growth target in Q2 to our actual revenue and outline how much each of these areas impacted our results. As a starting point, let's use 6% sequential growth off Q1, which was the midpoint of our 5%, 7%, sequential target or $211 million pre-cyber-attack. First, the new international markets are taking longer to scale than anticipated, particularly some of our larger markets like Germany and Spain, which have felt the lingering effects of COVID. These markets combined contributed to a miss of approximately $2.5 million in revenue in the second quarter. We will be relaunching in these two countries with an over-investment in the second half of the year to drive more penetration. Past results from other markets such as the UK and Australia are good examples of scaling and penetration that we expect to see in these two markets as we relaunched them. Given that, over the next 36 months, we would expect them to get to similar levels of aligner penetration as a percentage of the addressable population. Second, the macro factors David outlined, in which we have highlighted with supporting economic data in our earnings supplemental deck contributed to approximately $25 million of the miss. This includes a combination of top-of-funnel weakness and middle-of-funnel conversion. We call the top-of-funnel means everything prior to requesting a kit or scan and middle-of-funnel means requesting a kit or scan to returning the kit or showing up for the scan. I won't restate all the data behind those factors, but I do want to highlight that we experienced all-time high cost-per-lead metrics on social platforms, such as Facebook, which we believe is driven by the changes associated with Apple's iOS update. To put this into perspective, our cost-per-lead metrics were up over 100% on a quarter-over-quarter basis and we have seen a continue to rise in the Q3. Lastly, we saw broad conversion rate pressure once the member return their kit, or complete with their scan. All of which we believe is associated with the residual impacts of the cyber attack in mid April, and the delays it caused and delivery of our treatment plans. This attributed to approximately $9 million of the miss. On our first quarter earnings call, we estimated the initial impact could be 7,000 to 10,000 initial shipments in the quarter. The final was approximately 6,100 shipments slightly ahead of the initial forecast from May. It's important to note that the backlog of the cyber attack was fully caught up in the month of June, and we don't expect ongoing issues really to the attack. Providing some details on the other revenue items. Implicit price concessions were 7% of gross aligner revenue, consistent with the first quarter. Similar to the first quarter, although our total reserves related to revenue were consistent with prior trends, we maintain separate reserves for IPC and cancellations. We analyze and rebalance those reserves on a regular basis. The net effect in the current quarter was a lower IPC reserve offset by higher cancellation reserve. Reserves and other adjustments, which includes impression kit revenue, refunds and sales tax came in at 10% of gross aligner revenue. Financing revenue, which has interest associated with our Smile Pay program came in at approximately $12 million, which is flat to Q1. Other revenue and adjustments, which includes net revenue related to retainers, whitening and to other ancillary products came in at $20 million driven by another good quarter from our oral care products. Now turning to Smile Pay. In Q2 2021, Smile Pay purchases came in at 61% of initial aligner purchases, this is flat to Q1 and slightly below historical levels. However, overall, Smile Pay has continued to perform well and our delinquency rates in Q2 and to date in Q3 were flat to prior quarters. Because we keep a credit card on file, and have a low monthly payment, we expect Smile Pay to continue to perform well. Credit card authorizations continue to perform well, and we remain focused on improving operations and collection strategies. Turning to results on the cost side of the business. Gross margin for the quarter was 74%, representing a 200 basis point sequential decline and an almost 2,000 basis point improvement versus Q2 2020. The sequential performance is entirely attributed to the revenue decline. On a more positive note, the continued focus on streamlining our manufacturing facilities is paying off. Our second-generation automation machines are now producing approximately 85% of aligners up from 70% at the end of Q1, 2021. We expect that percentage to grow to approximately 90% by the end of the third quarter. While still early, we are seeing the investment in streamlining our manufacturing generate very positive trends in our turnaround time, higher productivity per team member, reduction in scrap, and most importantly, a more consistent and superior product for our club members. Marketing and selling came in at $96 million or 55% of net revenue in the quarter, compared to 49% of net revenue in Q1 2021. The sequential increase as a percentage of revenue was attributed to the decline in revenue. You'll recall that in Q1 2020, sales and marketing was 72% of net revenue. So we have made great progress over the past five quarters. On smile shops, recall that they functioned primarily as fulfillment centers, instead of sources for demand generation. We had 135 permanent locations as of quarter end and held 153 pop-up events over the course of the quarter, for a total of 288 location sites. That total was up from 282 at the end of Q1 and 218 at the end of Q4. These pop-up events are a critical component to supporting our demand, function in the same capacity as a permanent smile shop and enable us to fully leverage our smile shop resources to fulfill demand that is coming through aided awareness, referrals, and marketing. We also have approximately 500 partner network locations that are active or pending training in an active pipeline of approximately 1,000 locations. While still early, we are seeing positive trends and have outlined a case study in our supplemental materials to demonstrate the impact that we’re having on our partner locations. As referenced earlier, our marketing and selling expenses in the quarter reflects significant investment in brand building to support our long-term growth in international markets and this quarter's results bear out that emphasis. Sales and marketing as a percentage of revenue was 67% in rest of world markets, compared to 53% in the U.S. and Canada. We believe this was the right time to invest overseas, where we see 75% of the total market opportunity and where the competitive landscape is highly fragmented. That said, our long-term sales and marketing targets of 40% to 45% of revenue remain intact. General and administrative expenses were $85 million in Q2, compared to $81 million in Q1 2021. The sequential increase was primarily driven by a one-time reclass from selling to G&A labor of $1.4 million and the additional $1.4 million associated with the reclass that was not in the comparable period. Adjusting for this, G&A expenses were up $1.2 million driven by a one-time increase in medical benefits expense during the quarter and increased investments in key teams. We plan to continue to stay vigilant with cost control throughout the remainder of the year and beyond and you should expect to see continued leverage from this line item. Other expenses include interest expense of $1.9 million of which $1 million was deferred loan costs associated with the convert we issued earlier in the year. $500,000 was associated with long-term lease accounting and $400,000 was associated with capital leases. Additionally, other expense of $700,000 primarily related to one-time store closure costs of our Texas facility and retail locations. All of the above produces adjust EBIDTA of negative $22 million in the quarter with an all-in net loss of $55 million. Breaking it out regionally, adjusted EBITDA came in at negative $9 million for the U.S. and Canada and negative $13 million for rest of world, where we will continue to overinvest in sales and marketing. Moving to the balance sheet, we ended the second quarter with $377 million in cash and cash equivalents. Cash from operations for the fourth quarter was negative $31 million. Cash spent on investing for the fourth quarter was $22 million, mainly associated with leasehold improvements, capitalized labor and software, and building our manufacturing automation. Free cash flow for the second quarter defined as cash from operations was cash for investing was negative $53 million. Before closing, I would like to highlight a few key points on how we are allocating our dollars on revenue growth. As consumers are considering straightening their teeth, they do three things as part of the research on which provider they should choose. One, they search online; two, they ask their dentist; and three, they ask their friend or family member. We continue to make significant investments across these three areas to organically become the leader in teeth treatment. Online, we're making significant investments in brand credibility driven by the Challenger Campaign, which drives home our compelling value proposition and evidence by our consumer sentiment and brand credibility is working. With GPs, the partner network is off to a good start and we will be making significant investments in the channel in the coming quarters. And lastly on friends and family, our customer experience continues to improve, and we expect that to pay off of higher referrals in the coming quarters. Additionally, it is important to remind you that 75% of our opportunity is in international markets. In order to capture this opportunity and drive long-term revenue growth, we will continue our over-investment in these regions, particularly with the relaunch in the second half of this year in Germany and Spain. Lastly, on liquidity, we're well positioned with approximately $377 million of cash in our balance sheet. This gives us ample liquidity to support all of the growth initiatives while also investing in R&D and innovation. Echoing David's earlier comment, we are clearly not happy with the results here in the short-term. However, the long-term growth and profitability potential of this company is intact, and we're well positioned to continue to execute against the multi-year targets that we have previously outlined. We remain laser focused on providing the best club member experience, and our mantra remains to drive control and profitable growth. The changes we have made and are continuing to make and customer service are working. This is evidenced by the strengthening of our brand perception and credibility, which is now within a few percentage points versus Invisalign. We look forward to continuing to update you on progress in the days and weeks to come. Thank you to everyone for joining today. With that, I'll turn the call back over to the operator for Q&A.

[Operator:]

And at this time, we will be conducting a question-and-answer session. And our first question is from Jon Block with Stifel. Please proceed with your question.

[Jon Block:]

Thanks guys. I'll try to give it tied to one and one follow-up. I guess the first one, Kyle, just on miss relative to, I think it was the May 10 guidance when you had maybe almost four weeks of visibility seems rather stark. So can you just discuss, that in more detail? I would have thought you had better visibility called into early June or around that timeframe. And then I'll go ahead and ask a follow-up.

[Kyle Wailes:]

Yes. Thanks, Jon. Look, I think looking back on it and if you kind of look at Q2 overall, and even prior to that starting with March. March was one of the best months that we've ever had, right, and sort of looking back that did coincide with stimulus payments and also other factors as well from an execution perspective, but given the performance that we saw within March, as we entered into April and Q2, we certainly weren't thinking about it in macro headwind across the business there. And then as we talked about on the last earnings call, April and May were obviously impacted by the cyber attack and the associated backlog associated with that. So we weren't really sure of the magnitude on that until we could really catch up the backlog and that really didn't happen until we got into June. I think the other thing that sort of happened as well within late April was the iOS change and the adoption of that really ramped up over a few months. So if you look at how that ramped, it really took towards the end of June, even into July for that to continue to ramp up. And so it took time to understand the impact associated with that on our leads and also the costs associated with that change as well. So I think just kind of looking back on it, given the strengths that we saw within March, we certainly weren't thinking about a macro factor on Q2. And as we've talked a lot about in the past from a month-to-month perspective, the business can be lumpy just given the complexity of the acquisition funnel, which is why you sort of have to look at it more on a rolling quarterly basis to understand trends there. So I think it was just the magnitude of those changes that are happening over a short period of time, it didn't give us great insight looking back on it at the time in May.

[Jon Block:]

Okay. That's helpful. And I apologize in advance for some of the bluntness of the next question. But the call track with no real DTC competitor, is that just a bit misleading? Do you guys really believe your results are indicative of the DTC market? And I asked because, it seems like your U.S. results – and you guys gave a lot of details, so U.S. and Canada aligner results were down 16% sequentially, there is a competitor where you can do enough raw math, that seems like they were up 15% sequentially, they're all U.S.-based. So can you talk about the competitive landscape and why were they not seeing some of the same macro headwinds that you guys called out specific to the most recent quarter? Thanks.

[David Katzman:]

Yes, I can take that on Jon. First of all, I don't think any of our miss is attributable to these other DTC competitors. And I think specifically, you're probably talking about Byte as part of densify now. I heard a lot of rumblings and noise about this, I went through the transcript to earnings call myself. There was no published numbers about Byte. There was lot of inference and speculation about what the number was. I can tell you that without all the infrastructure that we've built over the last six years in custom treatment planning, automated manufacturing, we do brand studies all the time every quarter, they're aided awareness is low as single-digits, that out the 50% they don't spend much on multi-channel marketing like we do, there is no TV, they don't have smile shops, they don't have 100% proof financing like we do. I just think, there is a lot of numbers being thrown around there and I think it's all speculation. So we don't see it, we don't hear it, we don't see it in our brand trackers, both Candid and Byte, which are the two that are mentioned quite a bit. But just that they don't have the entire platform, vertical integration, custom treatment planning, automated manufacturing at scale that – like we do. So we don't really see them as a real threat, they're not international, they're not all the things that we're doing and all the innovation that we're doing as well. So for now, I think we have a real headstart and we spent 100s of millions of dollars in these initiatives that I just mentioned. And so, until they do that, improve themselves and we start to hear real numbers out there. I – they are not a huge concern of ours right now, we're focused on Invisalign, moving upstream on our demographics, as I mentioned. We think there is a real opportunity, I don't think it would have been there two or three years for us – two or three years ago for us. We weren't ready. We're ready now, our Smart Sculpt, Comfort Sense, treatment planning, all proprietary that we're constantly iterating on, we're moving into more complex cases. We feel the mild to moderate adult teeth straightening and teens teeth straightening, we could start capturing share from those lines, that's what we're going after.

[Jon Block:]

Okay. Thanks for the details.

[Operator:]

Our next question is from Robbie Marcus with JPMorgan. Please proceed with your question.

[Unidentified Analyst:]

Hi, this is actually Lily on for Robbie. Thanks for taking the question. So can you talk a bit about why a step up in fourth quarter over third quarter is a prudent assumption right now, just given the headwinds that you called out, how much confidence you have in a ramp over the course of the year at this point? Thanks.

[Kyle Wailes:]

Yes. Thanks, Lily. I can take that one. So, yes, I think if you look historically, if you look at Q4 from a seasonality perspective, it's been better than Q3 historically. And so, if you look at the guidance that we've outlined $750 million to $800 million and we've put a lot of details in our supplemental deck as well around this. But on the $750 million effectively, what we're assuming there is that we do see a little bit of a pickup from that seasonality that I mentioned a minute ago in the fourth quarter. And then really just a small ramp in Germany and Spain as well. Germany we're relaunching right now; Spain, we're sort of relaunching this fall as well. But we are assuming in that $750 million, a continuation of the macro headwinds that we saw within the latter part of Q2 and also into Q3 as well. When you look at the $800 million – and I don't think it's all of these that really need to occur, but at some combination thereof, certainly the macro environment going back to a more normal state would be a tailwind for us within our demographics or some combination of success within our Challenger Campaign, which we've talked a lot about and really just launched within TV in July as well, we're pushing a lot more into TV versus Facebook, given the iOS impact there. Germany and Spain, continuing to ramp, we've got a very material spend occurring in the second half of this year in both of those markets. And we also have a lot of investments that we're making into the partner network as in the GP channel. So I think when you look at all of that, then sort of outlines what gets us to the $750 million versus the $800 million here in the back half of the year.

[Unidentified Analyst:]

Okay, great. Thank you. Just a quick follow-up. With the delays to the international ramp, how does this change your strategy of focusing on international growth over the U.S., just considering it sounded like that was going to be the main driver in the near-to-midterm? Thanks.

[Kyle Wailes:]

Yes, I don't think it changes the strategy necessarily there. I mean, those were more sort of isolated incidents in both of those markets as a result of sort of stop – certain stops associated with COVID. And so over the course of the past year, we'd start to launch both of those markets and we'd have shutdowns regionally depending on where we were. So we never had a real opportunity to start to get those markets off the ground. And as we looked at starting to make some investment here in the second quarter and start to get more locations open, it really just got pushed out here in Q3, in the case of Germany and more closer to Q4 in the case of Spain. So it doesn't change anything from a long-term perspective. If you look at our opportunity the 75% of the global market is outside of the U.S., we still think it is a massive opportunity that we're going after, and we still believe it's the right time for us to build our footprint there to really help drive and support the long-term growth that we've outlined.

[Operator:]

As there are no more questions from Robbie's line, our next question is from Kevin Caliendo with UBS. Please proceed with your question.

[Kevin Caliendo:]

Thanks. So just to – kind of the same question on international. But what do you think the model is now in terms of ramping the profitability, has it changed in any way? I mean, you've been in the UK, maybe the longest. Can we use that as a proxy to think about what the proper investment is, is it country-by-country? We're all just sort of struggling about how to think about you hitting some of your longer-term margin targets.

[David Neumann:]

Yes, I think –

[Kyle Wailes:]

Yes, go ahead, David. And then I’ll jump in.

[David Neumann:]

No, I was going to just talk about the over investments that we made in Australia and UK and Canada when we first launched. And that's what we talked about here today about, more of an over-investment on the marketing side to get the awareness levels up and that requires a multi-channel marketing spend along with TV. So look it – I mean, we very quickly as we start to ramp up or start to open up our international markets in February of 20, COVID hit, that's when we started Germany and some other countries, Netherlands, Austria. So we have to pull back, we weren't going to make those kinds of investments, not understanding really how the market was going to respond. But coming back out of it, we have a playbook that we get these shops launched, we had our clinical lease partners and partner networks launched. We got our marketing set for the first 60 days or so, and then we start to spend, and that's what we're doing now in Germany. TV has launched in Germany in August here and same is going to happen with Spain. And so, for roughly six months to nine months, we overspend and excuse me, and we see how the market goes, it takes about two years for a country to mature. We are seeing – as Kyle mentioned, we are seeing these markets such as the UK and Australia get to aided awareness – higher rated awareness faster than we saw in the U.S., so that's encouraging. But about a two year overspend, and then we see it's a profitability. Kyle, you want to add anything to that?

[Kyle Wailes:]

Yes. The only thing I would add is that, I think a good way to look at it is, if you could look at the UK in particular, we – if you look at it from aligner orders as a percentage of the population within that country, after about 24 months to 36 months, we have – and we've done that both in the UK and in Australia, we get the similar levels of penetration that we see within the U.S. from aligners as a percentage of the population. So that's always been our model, that's been the ramp plan. That's still the goal as we enter into these new markets, as well as start with the population means tested for affordability, and then create a plan to ramp to a line of orders as a percentage of that population over a course of 24 to 36 months. And as David said, we overinvest significantly, you can see that in sales and marketing as a percentage of revenue. We're in newer markets, we could spend 80% or 100% of revenue for nine to 12 months as we ramp up those markets to support that longer-term growth. But the plan is still in all of those markets to be profitable after about 24 months.

[Kevin Caliendo:]

And a quick follow-up. This is a tougher one maybe to answer directly, but the stock is at/or below where management had bought in the open market previously. Is there any reason structurally, fundamentally, strategically why management wouldn't be willing to step in again at this price here and now or in the near future?

[David Neumann:]

Kevin, the stock on any given day can fluctuate 10% to 20%, it's highly volatile, there is relatively large short position. I haven't looked at it, I haven't looked at it today, I don't look at it on a daily or weekly basis. We know where we're going, the company sound – I'll have to look at, where the stock is at any given point in time, if we want to make further investments. But – the three largest holders, the two founders and myself own more than 70% of the company. So we're all in, we're all invested, we're all working our butts off to make this thing happen. And so, you have our commitment, whether we buy another $10 million, $20 million, $30 million on the stock, it's not going to make a difference as to how we're going to work or how much we believe in this company.

[Kevin Caliendo:]

Fair enough. Thank you.

[Operator:]

Our next question is from Dylan Carden with William Blair. Please proceed with your question.

[Dylan Carden:]

Thank you very much. Just to circle back, I think the revenue guidance question was more if I kind of take the midpoint of your guidance here and give you the average – the seasonal waiting on the fourth quarter, I'm kind of getting the 9% to 11% sequential growth between the third quarter and fourth quarter, and that's obviously above your longer-term targets, I guess, is that a function of higher marketing spend. Just – is there enough conservatism, I guess in kind of the outlook as it stands now? And then I just have one follow-up. Thanks.

[Kyle Wailes:]

Yes. I mean, we're certainly, if you look at the demand that we're staffed for today from a manufacturing perspective and treatment planning perspective, we're certainly – have built a base to be able to support growth metrics in and around that range, or potentially even higher as you look at Q4. And so from a demand perspective, that's always something that we've been a little hesitant to do, just given the historical impact that we've had around the customer care. But I think if you look at the business today, if you look at manufacturing, the changes that we've made in brand credibility and consumer sentiment online, we feel very good about that from where we stand at this point in time and look at the back half of the year. I think if you look at sort of what would make that happen, it's everything I had talked about before. And again, it's not all of this that would need to happen, but certainly if there is a change in the macroenvironment for our core demographic in particular, that could be a tailwind as you look at the back half of the year here. Certainly the Challenger Campaign, as I talked about, we're investing significantly into that and really just launched it on TV in July. I think pushing a lot more into TV versus Facebook again, Germany and Spain, I think there is 80 million people in Germany alone, it's a massive market, Spain and Iberia broadly is the third largest market for clear aligners globally. So these are our big markets that we're ramping into here in the back half of the year. And then certainly, partner network adoption. If you look at the brand credibility statistics that we've published within the deck, I think we're making good traction there with GPs. And that's another area that we're going to continue to invest heavily here in the back half of the year. So all of those are really core levers that could help us get to the growth members or even beyond that, that you've outlined there.

[Dylan Carden:]

Awesome. And you set up my next question perfectly there. On the 1,800 partners, I think you mentioned sort of 500 are active or about to be trained. Can you kind of disaggregate the about to be trained component? And when does this channel really start kicking in as far as sort of when you get to all those partners up and running and start seeing them maybe contribute more to the model?

[Kyle Wailes:]

Yes. So the 1,800 would include, so for example, if we have a large DSO that we've signed and let's say it's got 500 practices, but 250 of those have committed, the 250 would be included within the 500. The 250 that have not committed are part of that 1,800. And so, we have 1,800 as part of a broader network of DSOs and GPOs and other partners, where – their companies have agreed to be part of the network. We've got 500 locations that we already agreed to sign on and start submitting cases. So the majority of those are live today. We have a few week pipeline of training that we have where we have to go in and train the practice, and so some of those are still in that training phase. And then we've also got a very robust pipeline as well, as we mentioned, we've got about 1,000 locations today that are in the pipeline at some phase or another in the sales process. And that's both domestically and internationally as well, we've got robust pipelines, if you look at our international markets as well.

[Dylan Carden:]

And would you expect of the 1,800 balance – sorry the 1,200 balance, 1,300 balance that's low hanging fruit as far as sort of getting adoption across other partners, or is it more just signing on larger DSOs and kind of taking some percentage of those businesses?

[Kyle Wailes:]

Yes, it's all the above. So certainly as we're in a large DSO and some of those practices are live. We obviously have great data and we've actually put some of that data in a supplemental deck as well as show the impact that we're having on these practices. So use smile brands as an example that we've outlined in the deck, we've already referred about 1,000 patients into their practices for pre-exams. The lifetime value of that is approximately $3 million to $5 million. And so we're in a pretty short period of time. We're having a material impact here. And as I think as other practices see that better within the network, that certainly makes the sale process easier to launch into those practices. So that's not the exclusive focus. It's also continuing to bring on new practices, both from a DSO perspective, but also just independent GPs as well.

[Dylan Carden:]

Excellent. Thank you very much.

[Operator:]

And our next question is from Chris Cooley with Stephens Incorporated. Please proceed with your question.

[Chris Cooley:]

Good afternoon, appreciate you taking the questions. I just wanted to shift a little bit, just kind of talked about the quarterly progression here a little bit, but maybe just a little bit more a change in maybe sentiment in the sense that I think in prior commentary the company has really not viewed Invisalign as a true primary competitor. We've kind of talked about this as a much larger clear aligner opportunity and different segmentation that we think about the marketplace. And just, I guess still a little bit curious here about the impetus behind the shift to the Challenger program and that incremental expenditure and the headwinds that you're seeing as a result of that orientation of competition and why now that is a much greater bearing on the company's operations. Thank you.

[David Katzman:]

Yes, I can take that one. So, when we first started this business, we really went after the underserved market and it was really incremental. These are people who absolutely could not afford $5,000 for braces or clear aligners. A heavy demographic here today is at $68,000 per year household income. And we do get – we skew up and down the income range, but that is clearly the majority of our customer base. I think when we started, we didn't have the manufacturing. We didn't have some of the technology that we have today like I mentioned, our Smart Sculpt, Comfort Sense technology, we've got a proprietary way that we make our aligners that we think the Invisalign customer is going to enjoy with no buttons or attachments or IPR. We have the manufacturing, the laser cutting that we're doing and the scale, our treatment planning – custom treatment planning software team is doing a tremendous job, getting more complex cases. We're doing more staging, more arch expansion. So the timing is right. And by the way, this isn't something we just started because of the macro effects that are 68,000 of your customers facing. We started talking about this as the company progressed and got more mature and we have more capabilities. It's happens to coincide with our launch in July was always going to be that to go from disruptor to challenger and go after that higher income customer. Because really when you look at it, I mean, Invisalign is a terrific engineered product, their manufacturer wholesaler selling to the doctor, that's it. It’s not a closed end system like we have where our doctors are part of our network. They're not marking up the product. So really, the Invisalign is selling to the GP ortho at the same – roughly the same price, a little bit less, and what we're selling to the direct-to- consumer. That's what this intermediary does. It takes out cost in the equation. We didn't have the product. We didn't have the service. We didn't have in our 24/7 contact center that now has a robust dental team to answer questions. We actually think it's a superior platform for the consumer. It's more convenient. They don't have to go to in-person visits on a monthly basis or regular basis to get their new aligners, to have access to dental professionals 24/7. So we're super excited. We think we're going to educate the consumer, let them know, there's clear plastic aligners, straightening teeth. There's two ways to go. You can go to your doctor, you can pay the markup a three-time markup, or you can go direct as our campaign saying, encourage you to go watch some of the commercials. Those are just the tip of what we're doing to educate customers on this opportunity. So hope that answers your question about the timing of it. And it just happens to be coincidentally as our customer right now is facing more challenges during this macro impact. We're primed and ready to go at this launch.

[Chris Cooley:]

Thank you.

[Operator:]

And our next question is from Alex Nowak with Craig-Hallum Capital Group. Please proceed with your question.

[Alex Nowak:]

Good afternoon, everyone. Can you expand on the playbook of how you go from marketing for brand awareness to marketing, to close the sale? In the U.S., you have really good brand awareness, but it seems the company is still searching for that optimized ways to market to close that sale. So maybe expand on the different marketing tactics you're taking and how does this apply also to the international side, too?

[David Katzman:]

Yes. So even though, we have 50% aided awareness, we still – we used to go on our unaided awareness. Unaided awareness is always tough. We want to be as a consideration set, whenever a person thinks about T screening, whether they see our ads or not. TV is a better high funnel branding play. So we're shifting a lot of what we're doing with Facebook into a TV, also within Facebook, rather than using it as a conversion tool. We are because of the iOS issues. We are shifting more of that until we call a reach and visitor play, getting more people introduced to the brand, especially at the higher income levels. That's another thing that we're doing. And so we have a really robust CRM platform. If you've ever come into the SDC community, giving your email address or your mobile phone, you'll see SMS and emails and communications. We do IVR, outbound reach, all kinds of things. And that's really the closer. So we do a lot of lead gen through our smile assessment, through our insurance lander, which I encourage everyone on the call to go take a look at. We're really excited about it, instant eligibility, as far as we know, we're the only ones in the world that have that we spent well over a year, putting that together with our technology team to be able to – as soon as you enter your information, you will know what your coverage is, how much your out-of-pockets going to be. If you want to use SmilePay, what it's going to cost you. So those are all legions for us that we then use our contact center and our CRM platforms to convert. So that's the difference between more of a branding that we're doing and more of a conversion tool through CRM.

[Alex Nowak:]

All right. Appreciate that. And then could you briefly go over the legal announcements in the quarter and then just what's the current state of play across California, Georgia and Alabama?

[David Katzman:]

Yes. Kyle, go ahead. Go ahead.

[Kyle Wailes:]

Yes. I was going to say just from a regulatory perspective and you've seen some big wins there, Chris, I think we're in or Alex, right. We're a very good position from where we've been historically, so there's recent news both in Alabama and Georgia about some recent wins there and moving into discovery. I think when you take a step back and look at it all across all the cases that we're in. The trend from a legislative perspective is very much in our favor. And so when it comes to legislative victories that helped teledentistry broadly, we won in 28 states since the 2020 session and we've successfully defendant laws in seven other states as well. So I think that's sort of the core takeaway there. Very good spots are better than we've ever been in from a regulatory perspective and similar on the litigation side as well.

[Alex Nowak:]

All right. Appreciate it. Thank you.

[Operator:]

And our next question is from Michael Ryskin with Bank of America. Please proceed with your question.

[Michael Ryskin:]

Hey, thanks for taking the question, guys. I got a bit of a long one, so I'll use both of my questions to ask just the one. I appreciate all the clarity you provided in the – in some of the appendix of the slide deck regarding the macro issues and how that – how you think that that impacted 2Q and some of the outlook going forward. But I'm just hoping to get a little more detail. I mean, from my perspective COVID and some of the macroeconomic pressures, it's been around for some time, we saw it in 3Q, 4Q last year. It was around in 1Q. So I'm just curious what it is specifically that's changed now and why you think that won't – that we'll have some carry over going forward, but not as much, is it, is it really tied to the stimulus, the government package you talked about? Is there anything else that you're seeing that changed from sort of 1Q to 2Q or from 4Q to 1Q, 2Q and then sort of my follow on immediately is do you see some risk in your mind and 4Q of those factors persist, particularly if we've got Delta Varian coming back, COVID, hasn't really gone away. So we see some downsides of the 750 million number?

[Kyle Wailes:]

Yes. I think if you look at what's changed and as you pointed out, Michael, I think we try to outline some of this in the deck as well, but it really goes back to our core demographic. So our core demographic is $68,000 household income at the median. And if you look at things that's happened to them on Q2 in particular, inflation is a good example. So the increased cost of non-discretionary goods and services is we think limiting their ability to spend on discretionary goods and services. And if you look at that income demographic in particular, they experienced in a quarter of 5.8% increase in the weighted average cost of their non-discretionary basket. That was actually higher than where it was last year and higher than relative to all income demographics within the quarter as well. So if you think about the impact of that, and just use an example, the cost of gas within the quarter was up more than 50% in the second quarter of 2021. Within that target demographic of income, that's about 4% of their spending on gas. Whereas if you're making over 200,000, it's only 2%, so there's an outsized impact that we've seen on our sort of poor customer. And a lot of that was isolated to events that started to happen in within Q2. Similar on spending preferences as well, right, as consumers were within that sort of demographic replenishing goods, they were doing some more on the good side, less on the services side. So when things like apparels or sporting goods or e-sports or cars or home-related goods as examples, I think joblessness is another one. If you look across our four big states, our top four states of Texas, California, Florida, and New York, they accounted for about 40% of the nation's unemployment claims through July 10. That's actually up to 42%, if you look at the most recent surveys, so that trend has continued there, and then certainly the iOS update as well, which as we've talked about the changes there limited, ad tracking, and if you look at the ramp and adoption associated with that, it took time. It was over the course of the quarter for adoption there to fully occur. So I think it's all of those together from a macro perspective, Michael, that we're isolated within the quarter in comparison to other time periods. And then look, I think, as you look at is there risk associated with the 750 to 800, certainly look we've assumed within the 750, obviously, like we talked about before that Q4 is higher than Q3 driven by seasonality. But we've also assumed that the macro environment that we're in today remains the same. And so if the macro environment gets worse from a consumer spending perspective of our demographic and none of the other levers that we've talked about like the Challenger campaign or Germany or Spain, or the partner network adoption start to kick in, there could potentially be risk in that, but certainly that's obviously difficult for us to predict and say whether or not the macro environment is going to get worse or not. And generally what we saw when last year, certainly as the COVID was sort of at its peak. From a dollars perspective, there was government support and stimulus packages that support it that, so we actually did better in that environment when COVID was peaking than obviously we did here in Q2.

[Michael Ryskin:]

Thanks so much.

[Operator:]

And our next question is from Nathan Rich with Goldman Sachs. Please proceed with your question.

[Nathan Rich:]

Great. Thanks. Good afternoon. Kyle, I guess I'm trying to put the commentary together from today. And I guess, it seems like you're shifting away a bit from the controlled growth strategy that you've had the past couple of quarters and maybe investing more to drive future growth. How would you maybe characterize the strategy from here and kind of what went into the decision to reaffirm the long-term guidance in light of both the macro environment, as well as some of the investments you're making in the business?

[Kyle Wailes:]

Yes. From a controlled growth perspective, nothing has really changed there. I mean, the 20% to 30% focus is still our focus. The 5% to 7% sequential targets, we're always – sort of a methodology or an approach to get to that 20% or 30%, but the 20% or 30% was always the ultimate goal there. That's a compound annual growth rate over a five-year period. And I think when you look at the long-term opportunity for this business, starting with just the sheer market opportunity, the brand awareness and position being the number two player we think within this market. We think we're very well positioned to achieve those targets that we've outlined. And I think when you look at sort of what's happened here in the short-term, there's nothing that we see that is systemic, right. What we see around the missing Q2 is associated with the macro environment that we've talked about. We don't believe that that macro environment is permanent. It's associated with international markets taking longer to ramp. None of those are permanent and it's associated with the cyber attack, which again is impermanent. So I don't think there's anything that happened within the quarter that changes our view on the long-term prospects of where this business can go.

[Nathan Rich:]

Okay. Makes sense. And then could you maybe just talk about your expectations around free cash flow for the rest of the year on the new kind of revenue and EBITDA guidance that you've been talking about? Thank you.

[Kyle Wailes:]

Yes. So we've got about $375 million in cash as a quarter end. I think that gives us all the liquidity we need to both manage certainly any downsides in the event of a tougher COVID environment, more of a growth mode as well. If you look at our ARR as well, we've got 200 million of ARR on the balance sheet and we've got nothing against that. So we certainly have the opportunity to continue to factor and securitize that at some point in the future as well. If you look at what we've guided to historically, it's been about 10 million to 15 million per month in quarterly burn so on the high end – in monthly burn, sorry. So on the high end that would be about 45 million over the course of the quarter. We came in just higher than that in Q2 in the low 50s. And I still think the high end of that range is a good place to be, as we look at the back half of the year here. So 45 million to 50 million in burn as we think about the back half of the year and if you look at that against our – cash balance, it puts us in a good position there from liquidity perspective to continue to execute against the longer term targets that we’ve outlined.

[Operator:]

It appears that our final question comes from Laura Champine with Loop Capital Markets. Please proceed with your question.

[Laura Champine:]

Thanks for taking my question. I think it'll be a fairly quick one. So the way I read the guide for G&A is just that it increases sequentially, so not a ton of granularity there. Can you be more specific on what we should expect for international G&A increases as you launched those countries more or at least a couple of them?

[Kyle Wailes:]

Yes, so that's right. I think if you look at the G&A overall, we've tried to be very vigilant over the past several quarters. And we're continuing to do that as we look at the back half of the year here. As you look at the growth targets that we've outlined, we're expecting small increases just as a result of the revenue drivers or the revenue being at a higher amount. So things like the contact center, as an example, and being able to support that demand or payment fees as an example so as revenue grows, we have more payment fees that would hit the G&A. I think both of those are fairly small in the context of our total G&A, but certainly a little bit of increases there on a quarter-over-quarter basis as we hit those growth targets. And then certainly as we launch into international markets as well, there's a lead time and a ramp that's associated with that. I think you can see that in G&A as a percentage of revenue being about 65% of total revenue here in Q2. For rest of world, about 55% on a year-to-date basis so that trend will continue as we launch into new markets here in the back half of the year for the markets that we're already in today, the 13 countries that we're in globally, we're not expecting additional G&A that we're going to be pushing into those markets. It's really going to be about more new markets that we're expanding into. And then also, as I said before, supporting the growth within the business.

[Laura Champine:]

Got it. Thank you.

[Operator:]

And we have reached the end of the question-and-answer session. I’ll now turn the call over to David Katzman for closing remarks.

[David Katzman:]

I just want to thank everyone for joining us, a really good group of questions. And we look forward to speaking with you over the next months and quarters to come. Thank you very much.

[Operator:]

This concludes today's conference. And you may disconnect your lines at this time. Thank you for your participation.