By David Sterman
While working at an investment magazine back in the 1990s, I profiled a young technology company with a very intriguing product. This company had a small sales base and struggled to make profits, but its device, which could create fully formed objects in a microwave oven-size device, was right out of Star Trek.
That company, Stratasys (NASDAQ: SSYS) was an early pioneer in the field of "rapid prototyping" -- or what's now known as 3-D printing. (Some also now call this the "additive manufacturing" market.) Stratasys, along with rivals 3D Systems (NYSE: DDD) and ExOne (NASDAQ: XONE), is no longer a well-kept secret. The first two stocks have risen more than 350% over the past two years, and XONE has doubled in value since its early 2013 IPO.
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Clearly, the market for these companies' devices is starting to take off. Stratasys boosted sales more than 30% in 2011 and 2012, its best growth rates since 2004. 3D Systems has boosted growth at an even more impressive 45% clip over the past three years. And all three are expected to boost sales at least 40% this year.
The outlook ahead is also quite bright, as new applications are emerging in the automotive, healthcare, aerospace and consumer markets. Credit Suisse estimates the industry had roughly $2 billion in sales last year and sees that figure rising to $5 billion by 2016, or a 24% compound annual growth rate. The fact that these stocks trade for at least 35 times projected 2014 profits (and 88 times in the case of XONE) might almost seem justifiable. Investors are paying up now for expected high profit levels down the road.
Yet even as investors bid these stocks ever higher, they may be missing some key speed bumps in the road ahead. It starts with competition.
Last November, GE (NYSE: GE) acquired a pair of privately held 3-D printing firms, Morris Technologies and Rapid Quality Manufacturing. Although GE hasn't made a big industry push this year in terms of contract wins, the company has been bolstering its presence at industry trade shows, leading some to expect a bigger competitive push in 2014.
Transforming powdered metal into finished metal parts is expected to be one of the biggest growth areas for the industry, and Sweden-based Arcam appears to have the industry's strongest capabilities in this niche. Arcam noted a big jump in orders and backlog when six-month results were released in August, leading to expectations of 60% to 65% revenue growth. Competition is also emerging from a handful of other privately held firms that includes EnvisionTEC, Eos and Micor.
On the consumer side, known as desktop printers, Formlabs, Printrbot, Leapfrog (not the toy company), RoBo 3D and Solidoodle are all ramping up sales efforts.
The problem with competition is that it tends to lead to more aggressive pricing strategies across the industry. And that will make it harder for 3D Systems and Stratasys to maintain gross margins above 50%, as they did in 2012.
Also, a fast-growing industry means that many of these privately held rivals may soon look to go public (investment bankers likely see them as easy deals to get done in light of the strong investor interest). Once a flurry of new companies goes public in an industry, they use their IPO funds to speed up new product development and expand marketing efforts. So Stratasys, 3D Systems and XONE may be in a golden moment -- but, from a competitive perspective, one that may not last.
Analysts at Credit Suisse are bearish on the prospects for XONE, as they believe that company has a weaker product offering and too shallow an industry presence. These analysts are more bullish on the outlook for 3D Systems, with a $62 price target that is 15% above current levels. (The neutral rating on Stratasys reflects a lush valuation for that stock.)
Yet these analysts, in a recent comprehensive industry report, failed to take note of some potential red flags that investors should be aware of regarding industry darling 3D Systems.
For starters, the company's organic growth rate is a lot less impressive than you'd imagine. Since September 2011, DDD has made 16 acquisitions, which is more than the rest of the industry combined. Fully one-third of the company's organic growth rate in the most recent quarter came from acquisitions, and analysts see organic growth slowing to 15% to 20% next year. (Deals completed thus far in 2013 explain the total projected growth rate of 24% in 2014.)
All of those acquisitions have pumped up goodwill, and 3D Systems carries just $410 million in tangible book value. That's less than the company has raised in its multiple secondary offerings over the past half-decade, meaning balance sheet value creation has been nil.
Also of concern: 3D Systems' accounts receivable spiked $18 million in the second quarter to nearly $120 million. That has raised concerns that the company is stuffing the sales channel in order to meet high quarterly sales targets that Wall Street is anticipating. Lastly, a drop in six-month cash flow (from $21 million in 2012 to $12 million in 2013) is disconcerting, especially when stated net income for the first six months of 2013 was $34 million.
Risks to Consider: As an upside risk, both SSYS and DDD have the broadest product offerings in the industry, which makes them viable acquisition candidates to a large manufacturer that wants to enter this space.
Although all three of these stocks sport very lofty valuations, 3D Systems appears to be the riskiest stock here, due to balance sheet and cash flow concerns. Fully 29% of this stock's float is held by short sellers, reflecting the mounting concerns around this seemingly impressive growth company.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.