There are two moving parts to the fortunes of every growth company. They are the story of the company's prospects, and the results that confirm that story. In the case of 3D printing company 3D Systems (DDD), an alluring story has captivated analysts, institutional investors, and the common market participant alike. The technologies the company pioneered center around the idea of additive manufacturing, of creating an object by laying down successive layers of material and fusing them together to build something from the bottom up. When the technology was first pioneered, it promised to change manufacturing, which for centuries rested on the concept of subtraction of material to produce objects.
The benefits of the new technology are vast. The design process has benefited from much more rapid prototyping. Customized products that were once economically unthinkable can now be produced as one-off items. Tooling and machining costs that encumber traditional subtractive processes do not exist in 3D printing. Material waste is minimized because it is being added as needed rather than subtracted to create the desired object. The technology has come a long way from its infancy in the 1980s, and a continuing improvement in its precision and quality has come simultaneously as its cost has gone down. These two trends have combined to usher in the beginning of the widespread adoption of the technology, from the automotive business, to the aerospace industry, to the health sector, to the jewelry market, to architecture design, and all the way to educational institutions.
3D printing promises to democratize innovation. New low-cost personal 3D printers have even developed a following among individual early adopters; communities for sharing designs and ideas have formed. As a testament to its development, the 3D market was estimated to total $1.3 billion in 2012. Wohlers Associates estimates the industry's historical compound annual growth rate at a lofty 26.4%. In its 2012 report, it predicts that the additive manufacturing industry will reach a size of $3.7 billion worldwide, and $6.5 billion by 2019, representing a CAGR of 17%. Other surveys of the industry expect the market to reach $5.2 billion by 2020, a lower but still impressive level of growth. The story of 3D printing is, then, firmly in place.
The narrative of 3D printing has been complemented by several public companies with an exclusive focus on 3D printing, chief among them 3D Printing Systems , Stratasys (SSYS), and Organovo Holdings (ONVO.PK), as well as larger companies that are engaged in the industry such as Autodesk (ADSK), and Dassault Systemes SA (DASTY.PK). This article focuses on 3D Printing Systems. The company has experienced explosive revenue growth over the past five years, and net income has turned considerably black, as seen below. The company has time and time again surpassed analyst expectations through its results.
In short, 3D Systems' results have acted as confirmation of the 3D printing growth story. And the market has listened - since 2011, the company's stock price, as well as its trailing twelve month PE ratio, has soared. From the beginning of 2012 to today, the company is up 295%. Investor sentiment toward the company's future, as proxied by the incredible four-fold expansion in its TTM PE ratio, indicates that the market continues to expect confirmation of the company's growth story well into the future.
In all of this, one may see the most cut and dry of successful growth stories. An industry with incredible growth prospects and a company that has taken advantage of its market-leading position to grow even faster. 3D Systems' results over the years must be a clear confirmation of the story. Yet if one were to dig beneath the surface of this intoxicating narrative, a number of warnings signs begin to emerge. 3D Systems is, in fact, a company that has never delivered material free cash flows to its investors. It is a company that is heavily addicted to acquisitions that destroy, rather than create, shareholder value. In this light, the purpose of this article is to demonstrate that the story of 3D Systems is not one and the same as the story of 3D printing.
Continually Negative Free Cash Flows
In its most fundamental form, the generation of cash is the source of value companies create for their shareholders - this value can be theoretically returned in the form of dividends and stock buybacks. In the case of growth companies, shareholders expect positive free cash flows at some point in the future for their willingness to lend capital to a company today. 3D Systems, founded in 1986, had not generated any materially positive free cash flows for its investors in decades. At an on-face level, 3D Systems began to do so in 2009.
Yet the cause of this turnaround in the company's ability to create value is not centered in the growth of the 3D printing industry, which had been expanding at a heady clip for years, and whose rate of growth is actually forecast to slow down. In 2009, 3D systems began to actively augment its own strategy through an aggressive string of acquisitions. Since 2008, the company has acquired over 30 companies at a total price of $312 million.
These acquisitions have become part and parcel with 3D Systems growth strategy. In a 2012 interview with 3DPrintingIndustry, CEO Abe Reichental says of the company's acquisition binge, "Our strategy (which we have been very public about) is to build the most compelling and attractive 3D content-to-print global platform for the benefit of manufacturers and consumers. Each and every acquisition we make is carefully linked to one of our five growth initiatives and provides an important technology, presence or service building block." In its 2011 10K, the company notes that "We are working to accomplish our growth initiatives organically and, as opportunities present themselves, through selective acquisitions, including those we have already completed." With regard to the future, the 10K states, "We have made, and expect to continue to make, strategic acquisitions that may involve significant risks and uncertainties." Most recently, the company acquired Geomagic, a company that provides 3D software solutions, from a venture capital firm for an undisclosed amount on January 3.
The central question that must be asked when forecasting 3D Systems' ability to create value in the future is what part of its revenue and earnings are generated through organic growth of the company and what part comes from its acquisitive behavior. A number of articles have attempted to ferret out the company's intrinsic growth rate by backing out the revenue the company has taken in from the businesses of companies it has acquired. Yet this form of analysis asks the wrong question. It is impossible to accurately back out revenue of acquired companies because the combined entity does not act equivalently as the two separate companies would. Synergies exist from the acquisition itself that render the comparison rather useless. Products are integrated, redundant employees laid off, sales channels and administrative functions are leveraged. In addition, 3D Systems discloses revenue figures for the businesses it has acquired only when they are deemed "significant" according to GAAP, which leaves more than 25 of their acquisitions with no revenue or income numbers whatsoever. The company began to break down what it terms organic revenue growth from its overall revenue growth in 2011. For instance, in the company's Q3 presentation, it states that whereas total revenue growth for the first nine months of 2012 was 57%, organic revenue growth was 24%.
The company's interpretation of what "organic revenue growth" represents is nebulous, but it states that acquired companies are treated as acquired revenue for the first 12 months. Subsequent to the one-year period, only growth on top of that original revenue is included as organic revenue growth. This framework contains a critical flaw. The acquisitions 3D Systems has made have inflated its own organic growth rate above what it would be absent acquisitions. The acquisitions have expanded the company's geographic reach and sales channels for its own products. For instance, in its investor presentation regarding its $35 million acquisition of Rapidform, the company lists these two synergies as reasons for the acquisition.
And in its press release regarding the 2012 acquisition of Z Corporation and Vidar Systems for $135 million, it notes that the acquisition "doubles its reseller coverage globally." The acquisitions 3D Systems has made over the past five years have benefited sales of its own products - the growth in sales of these products are categorized as organic growth, even though the numbers are higher than they would be had the company not acquired clients and sales channels through its acquisitions for its own products. This is not a problem in and of itself - it merely points to the fact that even the company's own breakdown of total revenue growth versus organic revenue growth is not entirely useful to its investors because it is not a true reflection of the company's growth rate had it not completed acquisitions. It also points to the notion that if 3D Systems is expected to grow at its current rate into the future, it must also be expected to make further acquisitions.
If neither backing out revenue from acquisitions, as some analysts have attempted, nor the company's own breakdown of revenue figures can illuminate 3D System's true performance, what can? Due to the regular and ongoing nature of 3D Systems' acquisitions, they should be understood as capital expenditures and subtracted from free cash flow calculations. Acquisitions are seen as an extraordinary event and receive accounting treatment as such under GAAP; yet for 3D Systems, acquisitions are an ordinary part of business. Currently, the company categorizes acquisition costs in the Statement of Cash Flows as an Investing Activity labeled "Cash paid for acquisitions, net of cash assumed." When the company makes an acquisition, it assigns assets and liabilities of the acquired company to various of its own balance sheet items, such as "Property and Equipment" and "Intangible Assets." Any excess amount of the acquisition price over the balance between assets and liabilities acquired is categorized on the balance sheet as "Goodwill." For instance, of the fair price paid for acquisitions in 2009, it allocated assets and liabilities as follows, with the excess of assets - liabilities labeled goodwill.
The problem with this method is that it distorts the reality of the company's financials. As a case study, one can look to 3D System's largest acquisition to date, the combined purchase of Z Corporation and Vidar Systems for $135 million. In its Q1 2012 10Q, the company listed the entire acquisition amount in its Statement of Cash Flows, under Investing Activities, further under "Cash paid for acquisitions." And, it began to include the entirety of revenue generated by the acquired companies on its Income Statement (the acquired companies had revenue of over $56 million in 2011, which is the only proxy for their revenue in 2012 that is public). Yet, the costs of the acquisition barely affected operating expenses. When the company breaks out acquisition expenses in its 2011 10K, it notes that only $3.6 million in acquisition and severance expenses made their way to the Income Statement.
Another $3 million has been expensed for all acquisitions in the first nine months of 2012, but acquisition costs for the time period totaled $282 million. And although the company amortizes intangible assets it has acquired such as patents, it does not amortize the goodwill it has on its balance sheet from acquisitions, which now totals over $220 million. The company instead checks for impairment using its own future projections, and has never impaired goodwill and recognized expense for it. This runs contrary to common sense, given that, for instance, it discontinued products of Z Corporation such as the Zbuilder printer after it acquired the company. The acquired company's revenue has fallen post-acquisition yet goodwill from the acquisition has not been impaired. All of this points to the fact that the way that 3D Systems currently accounts for its acquisitions stilts its revenue and income figures. Whereas the company immediately realizes all the beneficial effects of each acquisition (revenue and net income) into its own top line, it only recognizes a fraction of the total cost of the acquisitions as expenses and amortizes only a part of the total assets acquired over a 15-year time frame. If the company had used its own research and development to develop the technologies and patents it gained from acquisitions, they would have been expensed the year they were incurred. If the company used its own sales force to expand its client base, the costs would have been immediately expensed as Selling, General and Administrative. Instead, they had already been expensed by the acquired companies and did not affect 3D Systems' Income Statement.
To gain an accurate understanding of the true free cash flows that the company generates, all acquisition costs should be treated as capital expenditures, and amortized over their useful lifetime as intangible assets. Most broadly defined, capital expenditures are expenditures that create future economic benefits. When 3D Systems acquires companies, it acquires their technologies, products, patents, employee talent, facilities, sales channels, and customer relationships. Each of these are assets that will create future value for 3D Systems. Therefore, each of them should be treated as a capital expenditure, and not just an investing cash flow. Once this adjustment is made to the free cash flows of 3D Systems, it becomes apparent that it has never generated positive free cash flows for investors; rather, it has consistently generated growingly negative free cash flow, as seen below. Using the company's own forecasts for the 2012 year and an extrapolation of the remaining blanks from the first nine months of 2012, the company produced negative cash flow of $131 million. In 2011, it generated negative cash flow of $60 million. A view of 3D Systems' inability to generate positive cash flow provides a more accurate view of the value the company has created for shareholders than simply its reported revenue and net income figures.
3D Systems' Acquisitions Destroy Value
The rationale behind acquisitions is that they will create value by harnessing synergies between the merged companies. 3D Systems' management espouses this view. In press releases regarding its acquisitions, it notes that acquisitions have allowed it to harness revenue and cost synergies, augment its product portfolio, and expand its sales channels. Most importantly, it traces its competitive advantage to being able to "offer a comprehensive toolbox... we sell our customers the right tool for the job." Its acquisitions have expanded its portfolio of product offerings, which include computer-aided design software, 3D printers across all price points, materials for printers, and 3Dproparts, a service which insources 3D production for customers. Yet for all the promise of synergy, the majority of empirical studies have found that acquisitions tend to destroy value rather than create it. Although 3D System's acquisitions have generated significant revenue growth, they have not been accretive to value. In order to finance its more than $300 million in acquisitions, the company has used a number of equity share offerings and convertible debt issuances, specifically designated for acquisitions. As seen below, cash flows generated from financing activities have been the primary source of acquisition activity (cash flows from investing), not cash flows from operations.
When assessing the success of an acquisition strategy, it is not enough to simply look at revenue and income growth. The real question that must be asked is whether the cost of capital used to finance acquisitions is higher or lower than the return on capital used. The point is simply illustrated by the following scenario: if one were to borrow from a bank at 10% to invest in a new business that has a rate of return of 5%, the individual would be destroying value. The rate of return on capital invested, therefore, must be higher than the cost of the capital used. The following data is used to calculate 3D Systems' annual return on invested capital and weighted average cost of capital:
Since 3D Systems began its acquisition strategy in 2009, its return on invested capital has declined considerably - the return it generates on its investments has fallen as its rate of acquisitions has increased. All of this makes sense given that acquisitions face severe difficulties that are amplified as more acquisitions are made. Incorporating more and more acquisitions into a company becomes more and more difficult logistically and culturally. Return on invested capital is a conservative proxy of the company's return on acquisitions made given the assumption that the company runs its core businesses better than new acquisitions. This holds for 3D Systems, which has seen revenue and net income declines for acquisitions like Z Corporation, one of the only acquired companies for which it breaks out previous and current data. Weighted average cost of capital represents the return expected by investors in both its equity and debt, derived from the expected return on equity of DDD stock and its own convertible debt issuances.
As seen in the graph above, since 3D Systems began to utilize acquisitions to generate growth, its return on invested capital has been lower than the cost of capital it has used to finance its acquisitions. The gap between the two lines represents the value the company has destroyed since it began its acquisitions, or roughly $6.5 million. Although these acquisitions have buoyed the company's revenue and income figures, they have not created any real value for investors. The allure of the 3D printing story has led investors to value 3D Systems at a price-to-sales ratio of 10.69. By contrast, the price to sales ratio the company has paid for its disclosed acquisitions has ranged from 0.90 for Quickparts to a high of 5.90 for Renshape and Digitalis. It amounts to an arbitrage of price-to-sales ratios in which 3D Systems uses its own inflated valuation to issue equity to acquire private companies at more reasonable market values, thus delivering outsized revenue growth.
Every growth stock depends on both a story and results that confirm that story. In a myopic sense, 3D Systems' impressive revenue and income growth have confirmed the tantalizing 3D printing story. Yet it would be Quixotic to believe that a logical cause and effect exists between the promise of the 3D printing industry and 3D Systems' own exaggerated growth. In the case of DDD, a company that has operated for more than 20 years saw its fortunes change only when it began an aggressive acquisition strategy in 2008. As it has delivered results through this strategy, investors have sent its stock soaring higher, enabling it to continue to make more acquisitions by issuing equity at inflated prices. Yet the strategy is not one that a sustainable growth model is made of. 3D Systems has spent the last five years picking higher and higher fruit from the acquisition tree, and in the near future it will no longer be able to pick any further or deliver revenue growth that exceeds the lofty expectations it has created for itself. Inevitably the market will realize the disconnect between the company and its story, and the company's value will tumble abruptly to a much more realistic level.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.