By Daniel Holland
The outlook for the 3-D printing industry remains upbeat, but the market's optimism continues to grow just as much, resulting in peak performance expectations and little margin for error. Both 3D Systems (DDD) and Stratasys (SSYS) are trading well ahead of our fair value estimates, making us hesitant to recommend the names to new long-term investors. While our summer travels to trade shows and discussions with industry participants have done little to alter our opinion, some emerging developments in the industry may shape the growth trajectory and moat prospects for companies in this sector.
Old Things Made New
Overlooked in the excitement surrounding 3-D printing is that the technology underlying many of the 3-D printers sold is already quite mature (between 20 and 30 years old). Patent expirations have helped bring the industry to prominence because they result in lower machine prices and greater number of manufacturers, but these factors act contrary to building a sustainable moat.
The core Stratasys patent on its fused deposition model printer has already expired, giving rise to many competitors, including MakerBot, which was recently acquired by Stratasys. ExOne (XONE) purchased its underlying licenses for the binder jetting process from the Massachusetts Institute of Technology, and those have already begun rolling off. As a result, we expect machine prices to continue to come down, though existing manufacturers should still have room for differentiation on a couple of important fronts, namely material compatibility and machine quality. Whereas 3D Systems enjoys a significant buffer, its principal patents expire at varying times through 2027.
While the machine patents are beginning to expire, the key ingredient for a printer and the manufacturer's moat prospects is the consumable material used inside the printer. We continue to believe that the research and development focus of printers remains on the material side. This is evidenced by ExOne's material lab, ExMAL, which is aimed at expanding compatible metals, and Stratasys' and 3D Systems' growing breadth of available colors. Building a formidable portfolio of materials also enhances a firm's attractiveness to potential customers because the material determines potential end uses for any printed product.
Each company is subject to patent risk, but we think 3D Systems has insulated itself the most by diversifying its revenue sources. In particular, 3D Systems has expanded its reach to software development, creating a more integrated system. While any one individual patent may roll off, exposing some element of the company's underlying technology, it would be much harder for a company to replicate the end-to-end solutions that 3D Systems has the capacity to offer. Conversely, both Stratasys and ExOne are betting more on individual machine patents, with Stratasys only recently finding additional niches with the acquisition of Objet in late 2012.
Curious Fascination With Service Bureaus
Major 3-D printer manufacturers operate print-for-hire shops where customers can send 3-D files and receive a printed product. These service bureaus are akin to contract manufacturers, with the key distinction being that the order size at a service bureau can be as small as one unit and the item still can be reasonably affordable.
The primary reason manufacturers operate service bureaus is that they lead to equipment sales. Service bureaus act as slack capacity for customers already using 3-D printing. A bureau owned by a manufacturer is a preferred destination because it is more likely that the service bureaus will have the equipment to handle higher volume and more-specialized jobs. To that degree, the service bureaus help build customer relationships and increase the likelihood that the next printer a customer orders comes from that manufacturer.
We see some merit in this approach, but we still believe overall price competition in the contract manufacturing markets will intensify as the price of printers comes down and the installed base continues to build. During our visits to recent 3-D printing trade shows, we came across several service bureaus and met numerous other entrepreneurs with business models aimed at lowering the costs in using outsourced 3-D printing. The current slack capacity rationale will be short-lived, in our opinion, as more firms enter the market. Often the businesses against which the original-equipment manufacturers are competing in the service bureau market may also be purchasers of equipment. We foresee an environment ripe for price competition for contract manufacturing.
Stratasys and 3D Systems have roughly the same amount of revenue coming from printers and related materials over the past 12 months. The difference is 3D Systems' greater exposure to service bureau revenue. Projecting into 2014, we expect Stratasys' printer and other product revenue to outpace that of 3D Systems, driven by a full year of Objet and MakerBot revenue in the base. Additionally, 3D Systems continues to expand its service bureau business by acquisition. As such, we think a greater percentage of Stratasys' future revenue profile will be attached to more moat-worthy businesses (namely, selling consumable material), helping the company sustain current levels of profitability.
While much of the hype of the industry has surrounded lower-end, consumer-oriented printers, in our opinion the real boon to the industry has been GE's (GE) vocal support and active use of the high end: additive manufacturing. The initial pitch for a traditional manufacturer to use 3-D printing is to cut down on scrap materials, or reduce inventory levels associated with spare and rare parts, but GE's motivation is different. Because additive manufacturing essentially builds objects at a very fine level as opposed to cutting from a larger surface, a printed object can take on shapes that traditional manufacturing will not allow because of physical limitations. As a result, engineers have more design freedom. GE's aviation division is the leading adopter, but other divisions in the firm are also using this method, including the energy business (oil and gas and power generation) and healthcare. Even though this is a small part of GE's operating structure, management continues to point to additive manufacturing as a key strategy for cost-cutting and innovation.
A key trend we have seen at GE of late has been the firm's desire to own and integrate more of its supply chain. This is evident in the 2012 joint venture with Parker Hannifin (PH) for exclusive development of fuel nozzles as well as the recently closed acquisition of aerospace supplier Avio. In November 2012, GE acquired its supplier of 3-D printed parts, service bureau Morris Technologies. This move has created several ripples in the 3-D printing world. Other industrial firms that were using Morris for production-grade materials have had to find other qualified vendors and in many instances are also bringing that work in-house.
While this is not a new problem for supply chain management for industrial firms, this shift in the industry will be important to monitor for printer manufacturers and service bureaus. On one hand, large industrial firms once reliant on service bureaus may opt to copy GE and bring manufacturing in-house to protect intellectual property and ensure a stable supply for future production by acquiring an existing bureau. Manufacturers also could build their own service bureau by buying a number of 3-D printers to serve internal demand. Based on recent commentary from ExOne and our own discussions with large manufacturing firms, the latter path is preferred at the moment, given relatively low system costs and rather high business valuations related to 3-D printing bureaus.
We think the future of the high-end printer market resembles that of other industrial machine builders. In particular, the existing printing and identification businesses Videojet (a Danaher (DHR) subsidiary), Markem-Imaje (a Dover (DOV) subsidiary) and Domino Printing Sciences provide insights. Each firm is a critical part of the manufacturing line that offers a distinct advantage to manufacturing customers: being able to print distinct codes at high volume. These firms have successfully locked up the high-margin aftermarket opportunities by limiting the types of ink used in printers and reducing product cycle lengths, securing a larger share of economic profits. Gross margins at Domino, the only pure play of the group, average just under 50%, slightly under current levels of Stratasys and 3D Systems, with roughly the same annualized sales as the leading 3-D printers. Domino is currently valued around 20 times forward earnings, compared with more than 40 times for the 3-D printers.
Bridging the Education Gap: Software as the Key Link
While the professional market simply needs to see a financial or design reason to invest in 3-D printing technology, the more nascent consumer market needs both a reason and a proper education in design to get a meaningful benefit from the technology. The 3-D community boasts a number of forums that make 3-D designs available for users, but consumer printers will be at the mercy of the true designers unless the end user invests a meaningful amount of time learning how to design objects in 3-D. This hurdle is not insurmountable, but it is worth consideration when comparing 3-D printer adoption rates with personal printers, DVD players, iPods or other easier-to-learn consumer oriented devices.
Over the past year or so, the software community has adapted to the education level of consumers with a variety of free design solutions, generally available online and in some cases on smartphones and tablets. For example, Autodesk's (ADSK) 123D apps allow users to create 3-D files from photos for free, and it allows users to design objects on the fly. Additional pay options offer access to premium models, educational tools and discounts on 3-D printers. This is being cross-promoted with MakerBot's Replicator consumer printer.
Given the high degree of competition among 3-D printer manufacturers in consumer-oriented markets, we do not foresee strong economic profits for manufacturers. The opportunity here will be for software firms that facilitate the ability to create and use printers to the best of their capabilities.
3D Systems has been the most active in developing its own software capabilities with the early 2013 acquisition of Geomagic and several subsequent acquisitions. The company's vision is to be relevant in all phases of the printing process, including idea conceptualization, manipulation and ultimately fabrication. To this end, 3D Systems is developing a holistic solution. This strategy will enable the firm to integrate technologies and offer a variety of customer entry points across the printing landscape. As a result, we expect the company to continue to develop additional joint ventures and acquire other 3-D oriented software vendors.
The Evolution of the "Pro-Sumer" Highlights a Key Weakness for Stratasys
During Stratasys' call with investors to discuss the acquisition of MakerBot, management identified a new market of pro-sumers - professionals using consumer-oriented 3-D printers (for example, the MakerBot Replicator). While Stratasys views this group of customers as a rich population to which it can upsell higher-end units, we think the strategy has a flaw that could erode the profitability of the core Stratasys and Objet printer lines.
Roughly 80% of MakerBot's printer sales are to professional customers, which we see as problematic. Before the MakerBot acquisition, virtually all of Stratasys' sales were made to these customers. One of the challenges printer manufacturers have had to face has been determining how many features to include in cheap printers. An important metric for printer quality is the micron count, or printing layer thickness (100 microns is an industry benchmark for acceptable prototyping). MakerBot's Replicator 2X can produce items at 11 microns, more than meeting the standard, albeit with very long print times. To the extent that a user is willing to let a print job run overnight, a $3,000 printer may suffice where he or she previously would have had to purchase a faster $45,000 unit for equivalent quality. While we recognize that there are certain material limitations and related issues that may make the cheaper unit unrealistic, we think there is a meaningful addressable market that can be served by the inexpensive MakerBot.
As a result, we think Stratasys' acquisition of MakerBot was defensive in nature, with the biggest opportunity being the ability to stop third-party materials from being used in the MakerBot printers. Recognizing that traditional 3-D printer customers were opting for lower price points, Stratasys purchased MakerBot to extend its reach down the curve. The level of technology available and price point in the next iteration will be important in assessing the company's overall strategy, in our opinion. Stratasys now has far more control over what the next-generation MakerBot will provide, which we think will affect the economics of not only the lower end of the printer spectrum but also the long-term viability of the mid-tier ($20,000-$90,000) printers. We reiterate our concern about the MakerBot transaction, which Stratasys expects to dilute both earnings and cash flow for 2013 and 2014.
That said, building the pro-sumer market not only affects Stratasys, but also other industry participants. The release of MakerBot's desktop scanner, the MakerBot Digitizer 3D Scanner, should also help consumers put machines to work. As opposed to having to deal with software design, a user places an object he/she wants to replicate on the scanner, and the machine creates a 3-D file. MakerBot's Digitizer is priced at $1,400, so replicating existing physical objects is now more affordable and poses a threat to professional instrumentation providers like Faro Technologies (FARO). While 3-D scanning firms like Faro have been the supplier of scanners in traditional engineering applications, these devices are typically too expensive for consumers to afford. Additionally, similar to the preceding 3-D printing argument, we think industrial customers that were forced to buy more expensive scanning technology will soon have viable, less costly options. Because the Digitizer integrates with existing software platforms, allowing users to enhance scanned object designs, we think the impact on software providers will be neutral to positive.
3-D Printing Stocks Overvalued
We have been reluctant to follow the market's lead in valuing the 3-D printing sector. In our opinion, overly optimistic growth expectations that ignore dilutive business strategies underscore the market's current optimism. Our industry growth forecast hinges on accelerated adoption of printers, using the number of printers per design engineer as a key driver of adoption. Currently there are roughly 85 3-D printers per 3-D computer-aided design license, with roughly 40% of engineers using 3D CAD software. As more engineers shift from 2D CAD development to 3D CAD, printing in 3-D should be more accessible to a larger population. Our hesitance to recommend stocks in the sector rests with the market's overestimation of these firms' ability to execute in the future. For example, Stratasys is currently trading at 40 times its consensus 2014 earnings estimates. While this valuation requires a healthy growth expectation, the stock is even more expensive because consensus earnings are based on non-GAAP projections, which include what we consider ongoing operating items.
When including recurring expenditures for stock-based compensation and amortization expense for past acquisitions, we estimate that the consensus metric overstates the true earnings power of 3D Systems and Stratasys. Even though amortization expenses will generally disappear, firms that continuously acquire other businesses will have a persistent amortization expense. Because both Stratasys and 3D Systems have shown over the past couple of years that acquisitions are an integral part of the growth strategy, we think these items should remain in the normal earnings projection. New owners of the stock are effectively paying more than 85 times 2014 earnings and nearly 60 times projected 2014 free cash flow for Stratasys. We think the mispricing is driven largely by new equity investors not fully accounting for the amount of share dilution caused by the acquisition of Objet and MakerBot, while overestimating the cash flow benefit from these acquisitions.