Align Technologies (NASDAQ:ALGN) is a market leader in the orthodontic and restorative treatment market, manufacturing the Invisalign system, the most advanced clear aligner system in the world. Gone are the days when patients with crooked teeth had to fit on a pair of unsightly looking metal braces. Align's solutions offer a custom-made solution for patients that are molded to fit their jaws, along with a patented material and design that are unobtrusive.

The company just reported another stellar set of Q3 earnings, with total net revenues up 20.2% year-over-year and Invisalign case shipments up 20.7% year-over-year. Worldwide Invisalign case shipments continued to rise and hit a new high of 384,000 cases, of which around 66% (255,800 cases) were to adults and the remainder to children. Year-over-year, the increase in the number of cases to adults and children was 15.8% and 31.6% respectively.

Photo of woman with a clear teeth aligner

Image Source: Getty Images

These numbers point to the steady increase in Align's business as it has established itself as a leading player in orthodontics. However, as the company grows and expands rapidly across the globe, there has been a trend of falling operating margins. This troubling aspect, if not properly addressed and checked, may wipe the smile off investors' faces. Here are two factors that are driving this phenomenon.

Higher marketing expenses 

Align has been spending aggressively on marketing and promotional activities in order to attract more customers to use its products. During the quarter, the company launched a new advertising campaign for North America seeking to reach over 140 million customers. In addition, Align has announced marketing relationships with professional sports teams such as the Toronto Raptors and Carolina Hurricanes. Such endorsements don't come cheap, as SG&A expenses increased by over 20% year-over-year to $277.5 million.

chart of Align Technologies Operating Margins

Source: Align Technologies' Q3 2019 Condensed Financials, Author's Compilation; *Q1 2019 margin adjusted for closure of Invisalign stores. Originally reported as 16%; **Q2 2019 margin adjusted for one-off litigation settlement with SmileDirectClub Inc (NASDAQ: SDC). Originally reported as 29.4%

Operating margins for Q3 2019 hit 20.9%, its lowest operating margin in the last ten quarters. Though Q1 2019's margin seemed much lower at 16%, the numbers were impacted by a one-off expenses. After making adjustments, the operating margin for the quarter ended up being higher than Q3 2019's. It's important for investors to adjust for such one-off items in order to observe the true state of the business. 

To be fair, advertising is a necessary part of Align's strategy in order to create awareness and to showcase the attractiveness of its product. Investors need to track the revenue numbers in future quarters to judge if there is any positive flow through from this spending.

Average selling price (ASP)

The ASP of Align's key product is a good indicator of the level of pricing power the company has. If there is strong demand for Align's products and many patients are requesting them from their dentists, then Align should be able to charge higher prices for its products, which then flows through to higher ASP per case for Align.

Chart of Align Technologies Average Selling Prices

Source: Align Technologies Q3 2019 Presentation Slides, author's compilation

It appears that ASP for both Worldwide and International divisions is on a downward trend, with just a slight uptick in Q3 2019. Q3 2017's Worldwide ASP was $1,310, but this fell to as low as $1,230 in Q2 2019, only to rebound slightly to $1,260 in Q3 2019. Align's CFO John Morici mentioned in the earnings conference call that the uptick was due to a change in product mix, and the company expects Q4 2019's ASP to be "closer to $1,245" (for Worldwide). With SmileDirectClub's (NASDAQ:SDC)recent listing, there's more competition in the market now and this is driving down overall ASP.

The problem with falling ASP is that Align will have to rely solely on volume growth in order to grow its revenue. While this has not been a problem for the company thus far, if ASP does fall more sharply over the next few quarters, it may start to have a negative impact on revenue growth, which in turn feeds into the problem of declining operating margin.

Align's growth prospects remain bright

Despite the above red flags, Align's growth prospects remain bright. Management's Q4 2019 outlook expects case volume to grow by approximately 20% to 22% year-over-year while operating margin is expected to be in the range of 22% to 22.7%, higher than Q3 2019's level. If Align manages to reverse the trend of falling operating margins and ASP, investors will have good reason to smile broadly again.