By Damion Rallis, Senior Research Associate
While the share price at 3D Systems Corporation (DDD) continues its steady and impressive climb - up more than 200% since last November - a closer look at the company's governance profile reveals several troubling indications that 3D Systems could be due for a reversal. Not only has the 3-D printing company been involved in a public dispute over its accounting and disclosure practices, but a significant uptick in recent insider sales by key members of its board of directors would suggest that 3D Systems' overall "B" ESG rating is at risk when taken in conjunction with two of our primary assessment models, the Accounting and Governance Risk Rating (AGR®) and our Litigation Risk Model.
In the past few months, 3D Systems' relatively volatile share price has caused quite a bit of buzz in the investment community. At the end of August, the company's share price stood at about $44 but then dipped below $33 by the end of September, back up to above $45 at the beginning of November, below $38 a week before Thanksgiving, and then back over $46 just a day or two ago. So what's going on? It seems that 3D Systems is at war with a couple of analysts on Seeking Alpha. First there was an article on October 23 by Gray Wolf Research called, "3D Systems: At the Peak of Inflated Expectations," and then one by Douglas W. House on November 12 titled, "3D Systems: Has the Printer Jammed?" In short, one of Gray Wolf's main points was that the company's organic growth rate was "highly overstated" while Mr. House, referencing Gray Wolf's research, made the case that management at 3D Systems was "hiding something" as it has failed to properly disclose key financial data on several of its recent acquisitions. The "obfuscation" was a result of the company's acquisition strategy in which it incorporates its acquisitions' revenues into its own and ultimately "overstates [its] true growth rate."
At the time of Gray Wolf's article in October, 3D's share price had already been in a mini-slump since the end of August, so no story there, right? But on November 12 - the same day on which Mr. House's article fortified the arguments of Gray Wolf's research was released - 3D's share price opened at $46.19 and dipped below $37 before closing around $38 at the end of the week. As a result, these research articles led to vociferous cries from some in the investment community of "slander" and "malicious allegations." Specifically, the authors were accused of "bear raids." According to an article from Seeking Alpha, bear raids typically represent a trader or group of traders' attempt to force down the price of a stock, for gain or to cover a short position, and are done by spreading negative rumors about the target company, ultimately putting pressure on the share price. Not only were fellow investors unhinged, but so was 3D Systems. In an official press release only two days after Mr. House's article was posted, CEO Abraham Reichental of 3D Systems announced that it was "aware of certain recent articles and their materially inaccurate and misleading conclusions." It went on to say (after threatening legal action) that the articles were "malicious, irresponsible and self-serving" and that it looked forward to "discussing, fact-checking and clarifying these inaccuracies for the benefit of our shareholders, customers and partners, who we believe have been irrevocably harmed by these articles."
A mere week after Mr. House's article, 3D Systems held a conference call to "discuss, fact-check and clarify several materially inaccurate statements and conclusions made in recently published articles related to various matters including its calculation of growth, accounting methods and acquisition activities." The company dedicated 40 slides specifically to refute the allegations, going point-by-point to cast doubt on the researchers' findings. Notably absent from the conference call (despite repeated attempts to be included) were Mr. House and a representative from Gray Wolf Research. 3D's counterstrike seems, for the short term at least, to be relatively effective, its share price having spiked from $39.03 on the day of its conference call to nearly $42 at the end of the same week. While we have no interest in getting involved in their contentious game of cat-and-mouse (you can read Mr. House's rebuttal from November 26 here), our research indicates that there might be validity to the detractors' assertions.
GMI Ratings publishes Accounting and Governance Risk (AGR®) ratings on approximately 18,000 companies worldwide. These ratings reflect a broad spectrum of accounting irregularities and weaknesses in corporate governance statistically associated with an elevated risk of adverse events likely to cause precipitous contractions of equity value. Specifically, the AGR model reflects patterns and anomalies in the areas revenue recognition, expense recognition, asset-liability valuation, high-risk events and governance practice. AGR ratings have been extensively tested and validated as a predictive tool that can help market participants minimize their exposure to riskiest companies. For more information, visit the GMI Ratings web page on AGR analytics.
3D Systems' AGR Rating was "Average" as of December 2009 with an overall score of 85 (updated quarterly, the AGR score ranges from 0 - 100, with lower scores representing greater risks). Since then, the company's AGR rating has consistently dropped and, as of December 2011, fell into the "Aggressive" category. Currently, 3D Systems Corporation continues to be rated as having "Aggressive" Accounting & Governance Risk (AGR). This places them in the 26th percentile among all companies in North America, indicating higher accounting and governance risk than 74% of companies.
Similarly, GMI Ratings' Litigation Risk model - a projection of the probability of shareholder class action litigation - shows that 3D Systems' litigation risk continues to increase, having dropped from 46 in June 2010 to its current score of 4, meaning "High Risk" and placing them in the 4th percentile of all companies in North America, indicating higher shareholder class action litigation risk than 96% of all rated companies in this region.
It is our AGR Rating, however, where the true intrigue lies. One area of concern is the company's aggressive acquisition strategy. Since the quarter ending in June 2010, 3D Systems has acquired four companies per fiscal quarter compared to an industry mean of about one acquisition per fiscal quarter. Comparably large numbers of mergers and acquisitions is a red flag for corporate governance issues. In other words, an acquisitive nature is a characteristic of some companies' strategies, and is inherently risky. Acquisitive companies sometimes buy non-viable companies in order to boost short-term revenues. Another area of concern regarding the company's sagging AGR rating is revenue recognition, where 3D Systems has been red flagged for Operating Revenue/Operating Expense. Large operating revenues are the critical ratio of potential revenue recognition issues. Because of the potential impact that Operating Revenue has on earnings, this line item is susceptible to potential earnings management. Since the three-month period ending in September 2010, 3D System's ratio of total revenue to total operating expenses has been consistently above the industry median.
3D Systems' governance profile includes other examples of practices that not only fail to benefit its shareholders but also serve to reflect our worsening view of the company's long-term sustainability risk. As an example of our concern, the company's board of eight directors includes two company executives and four directors who have served for at least 13 years, including the chairs of two of the board's four standing committees. While we see the value in experience, it is increasingly difficult to consider directors independent after so many years of service. Long-tenured board members can often form relationships that may compromise their independence from management and therefore hinder their ability to provide effective oversight.
A key area of concern is the company's Executive Committee, which includes the CEO and long-tenured directors Chairman Walter G. Loewenbaum and Kevin S. Moore. The Committee, whose principal responsibility is to function on behalf of the board when it is not in sessions to guide the company's strategic planning, met nine times in 2011, the same amount of meetings as the full board. This runs counter to the intended nature of an independent board of directors. As a means of comparison, the average Russell 3000 Executive Committee meets only 1.6 times per year, an indication that 3D System's Executive Committee holds considerable power. As an aside, the majority of Russell 3000 companies holding more than nine Executive Committee meetings are companies from the banking and financial sectors.
Furthermore, two long-tenured directors (including Chairman Walter G. Loewenbaum) serve together on the board of Luminex Corporation, raising additional concerns about intra-board relationships that can compromise non-executive directors' ability to act individually and independently. Also, Audit Committee and Compensation Committee member Daniel S. Van Riper has been flagged for his service on the board of DOV Pharmaceutical, Inc., which was delisted due to a violation of exchange regulations. In addition, the company utilizes a plurality director election standard without a resignation policy which means that in uncontested elections directors could theoretically be elected with only one vote. Overall, these features call into question the board's ability to act as an effective counterbalance to management.
A board composition of this nature may contribute to policies which can further damage shareholder interests. 3D Systems' executive compensation practices reflect this possibility. CEO Abraham Reichental received fiscal 2011 total summary compensation ($2,728,038) worth well over three times the median total summary compensation ($742,625) for the other named executive officers (NEOs). This raises concerns about internal pay equity. In addition, a significant portion (45%) of NEOs' annual incentive awards consists of the Compensation Committee's subjective evaluation of personal objectives. While certain objectives may be quantifiable in nature, discretionary elements can undermine the credibility and effectiveness of a well-structured incentive plan. In fact, despite failing to achieve both of the company's annual financial targets, the CEO was still able to receive a discretionary cash bonus of $450,000 for such unquantifiable achievements as "the attention that he brought" to completing acquisitions. Discretionary incentive bonuses of this nature undermine the integrity of a pay-for-performance compensation philosophy. Furthermore, the CEO's equity award valued at nearly $1.7 million consisted merely of restricted stock awards that vest simply over time without performance-contingent criteria. Equity awards should have performance-vesting features in order to assure proper alignment with company performance.
Finally, the company's insider trading activity raises several red flags. Most notably, no 3D Systems insider has purchased stock since September 2010. Since then, however, insiders have dumped nearly 2.3 million shares valued at over $82 million. In fact, the CEO has sold 321,353 shares valued at $13,832,418 since the beginning of September while Chairman Loewenbaum has unloaded nearly 200,000 shares valued at nearly $8.6 million since the beginning of August. Once again, while we are loath to make assumptions based on a high amount of stock trades - there are any number of factors that could force an individual to liquidate his stockholdings - there is evidence that could suggest that insiders know something that we don't know, despite their loud protestations.