Is A Downside In Store For 3D Systems? Quite Probably

Nov.19.13 | About: 3D Systems (DDD)

About a month ago, I wrote an article about how 3D Systems' (NYSE:DDD) prospects can make short sellers retreat. While my prediction seems to be coming true as the short interest in 3D Systems has declined from nearly 33% to 29% in the month of November, the reason behind this doesn't delight me. When I wrote that article, 3D Systems was trading at approximately $62, but now the share price has surged to over $82. The primary reason behind this jump is the International Business Machines (NYSE:IBM) acquisition rumor.

Investors have bid up 3D Systems on the hopes of an IBM takeover, but I think these unconfirmed rumors are baseless, thus this rumored deal will never materialize and eventually, 3D Systems will experience a pull back in its share price. Therefore, for the time being, investors should not consider buying 3D Systems.

Why the IBM acquisition is unlikely.

As it is evident, IBM's acquisition rumors are the primary reason why 3D Systems' share price has jumped nearly 29% in the past one month, but I don't think that this deal will go through, mainly because of two reasons.

1. At $90 per share, 3D Systems is too expensive for IBM to acquire.

2. Financially, the acquisition does not make sense for IBM.

Let me elaborate on these reasons. As far as reason number one is concerned, IBM will have to spend over $9.25 billion if it wishes to takeover 3D Systems at $90 per share. Despite my belief that 3D Systems has strong prospects, it is still overpriced. At present, 3D Systems has a forward P/E ratio of 64.41 and if IBM shells out $90 per share for its acquisition, its P/E ratio will rise to roughly 85.

To put into perspective, let's compare it to other big names like Apple (NASDAQ:AAPL). Apple has a forward P/E of 11.06. This means that if IBM pays $9.25 billion for the acquisition of 3D Systems, it would assume that 3D Systems' earnings will grow almost eight times faster than Apple's, and this scenario is improbable, if not impossible.

Analysts, according to Yahoo! Finance, expect 3D Systems' earnings to grow at a CAGR of 21.55% over the next five years. In comparison, Apple's earnings are expected to grow at 14.27%. Hence, paying eight times more than Apple's expected earnings growth rate doesn't make sense for IBM as 3D Systems is not expected to achieve that.

Moving on to reason number two, IBM ended the previous quarter with a cash balance of $10.2 billion and debt of $36.2 billion. In addition to that, IBM's board sanctioned yet another share buyback worth $15 billion. Now that IBM has already approved the buyback plan, it's obvious that it will have to take a loan of $9.25 billion in order to purchase 3D Systems.

So let's do the math. Under the best case scenario, this loan will have an interest rate of at least 2%, which will add approximately $180 million to its interest expenses annually. Currently, 3D Systems' EBITDA is $112.22 million, which is well short of the $180 million annual interest. Therefore, IBM's debt will keep on piling up for the next few years.

Presently, the 3D printing market is worth roughly $3 billion and analysts are expecting it to be worth $8.41 billion by 2020. Assuming that 3D Systems commands a 30% market share in 2020, it will generate nearly $2.8 billion in revenue and at present, it has a profit margin of 9.52%. If analyst estimates are spot on, based on this profit margin (which may reduce as the 3D printers become cheaper), 3D Systems will generate a profit of approximately $270 million by 2020, but by that time, the deficit in the EBITDA and interest will also increase. Therefore, even under the best case scenario, it will take IBM many years to breakeven; hence this acquisition doesn't make sense.

Conclusion

3D Systems has run up to quite some extent after the recent rumors, with its trailing P/E now at almost 180. But as we saw above, 3D Systems' acquisition by IBM is not a concrete possibility and when the rumors lose steam, 3D Systems could decline to its pre-acquisition rumor levels, making it a stock to stay away from right now.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.