3D Vision Is Not Necessary To See 3D Systems Is Overvalued

Dec. 5.13 | About: 3D Systems (DDD)

The history of the stock market is littered with the ashes of glamour stocks that were in a potentially dynamic sector, or had access to an exciting new technology, but were bid up to absurd levels, ultimately causing substantial losses for market participants. 3D printing is the latest example of an industry, which similarly to the Cloud, will grow at an extremely rapid rate for a reasonable period of time into the future. Because the expectations are universally high, the industry as a whole trades at uniquely expensive valuations despite the fact that many of the companies in the industry are negligibly profitable, and the competition is about to pick up considerably. 3D Systems Corporation (NYSE:DDD) is an example of a highly promotional and acquisitive company that utilizes aggressive accounting practices and a high stock price to grow. Market participants are valuing the stock way too richly and will likely take substantial losses as things play out over the next few years.

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Source: 3D 2012 10K

At this point in time, 3D printing is largely a corporate endeavor as the scanning models have been quite sophisticated and the printers are expensive. While there is considerable innovation occurring in the types of materials that can now be printed, there are extensive limitations to the practicality of these printers on a widely used basis at this time. At the same time, I believe there is little doubt that many of these issues cannot be resolved in the ensuing decades and 3D printing will gain a great deal of manufacturing market share. There is already demand for rapid prototyping of products so there is little doubt that the industry itself will ultimately become a bastion for profitability and growth. The company has increased its offerings for the consumer but I'm less optimistic that there is a real need for 3D printing at the home, but people once said the same thing about PC's so I'm not claiming to be an oracle on the sector. At current prices and capabilities, I feel confident in saying that 3D printing isn't likely to be consumer story in the near future, as there are only so many plastic key chains and cheesy toys that the consumer can take.

The printing/razorblade business model is incredibly solid, in which the three-dimensional printers rely on consumable materials such as metals, plastics and other composites to create end products. Just like with ink, the higher margins are on the consumables instead of the hardware. 3D is expanding its retail footprint to get more points of distribution for its products. In addition, the company is trying to acquire and develop its own proprietary materials to enhance its competitive position. Proprietary materials and top of the line printers, which can manufacture a variety of different materials, are likely going to be the key ingredients to identifying the winners as this industry progresses.

3D Systems has used acquisitions to fund much of its growth and increase in offerings and materials. Most of these acquisitions were very expensive and the companies acquired had little in terms of sales or profits; luckily for 3D Systems the company was able to use its expensive stock as the acquisition currency. I don't blame the company for using its expensive stock as a currency to enhance its competitive position; if at any point the stock were to drop considerably the acquisition binge would halt, since 3D doesn't generate the cash flows necessary to organically expand at the same rate. Also a reduction in 3D's stock price would likely necessitate write-down's on its pricey acquisitions. 3D is intelligent to use its overpriced stock but what I do disagree with is how the company is being valued in the market. Between 2008-2012, 3D Systems had only invested about $280MM in R&D expenditures. Over the first 3 quarters of 2013, the company has invested about $28MM in R&D. As of 9/30/2013, the company had amassed $324MM of Goodwill, highlighting the fact that the company is using acquisitions in lieu of R&D. This is a key thesis in Jim Chanos's bearish positions in Hewlett-Packard (NYSE:HPQ) and Dell, which has led to tens of $billions in write-downs. Keep in mind that this $324MM is in excess of 1/3rd of 3D Systems book value. Don't be shocked when goodwill write-down's become a real story for 3-D, but the "good" news is that non-GAAP earnings won't reflect any issues.

On October 29th, 3D Systems reported 3rd quarter earnings results for fiscal 2013. Revenue grew 50% to $135.7MM, thanks to a 76% increase in printers and other products revenue and 30% overall organic growth. Net income in the quarter increased by 31% YoY to $17.7MM, or $0.17 per share. Non-GAAP earnings were $0.26 per share for the quarter. 3D printers and other product revenue grew to $59.8MM on a 66% increase in printer sales. Materials revenue growth rate increased to 30% and contributed $33.2MM to revenue for the quarter, while services revenue rose $11.7MM to $42.7MM. Healthcare solutions revenue grew 39% for the quarter, and contributed $16.9MM to total revenue. Consumer products revenue was $13.5MM in the quarter, primarily from printer sales. Consumer products revenue includes the Cube and CubeX printers, print materials and other cubify.com products and services.

For the first nine months, revenue grew 42% to $358.6MM and gross profit margin expanded 120 basis points to 52.3%. Over the same time period, net income has grown by 17% to $32.9MM, or $0.34 per share. On a non-GAAP basis, the company earned 4.66 per share for the first nine months of 2013. 3D uses extremely aggressive accounting where the non-GAAP results exclude the tax affected impact of amortization of intangibles, noncash interest expense, nonrecurring acquisition, integration, and severance expenses, including gain or loss on acquisitions, the impact of litigation settlements, stock based compensation, and noncash loss on conversion of convertible debt. While this accounting might be reflective of cash flow, it does not provide accurate metrics towards the value creation or destruction of the business. Stock based compensation is a significant expense and certainly shouldn't be disregarded, and when a company is as acquisitive as 3D how non-recurring are these charges? No other industry outside of technology uses this type of accounting and I've yet to see why it would ever be appropriate, and when management teams focus on silly metrics, I proceed with caution.

For example, non-GAAP net income was positively impacted by adding back $6.2MM of amortization expense, $0.7MM of acquisition and integration expenses, $3.1MM of stock based compensation, a $2MM loss on conversion of convertible notes, and $0.1MM of noncash interest expenses, which were partially offset by a $4MM tax impact related to the items just discussed. For the 3rd quarter, non-GAAP operating expenses amounted to a whopping $33MM, or 24% of revenue. For the first 9 months, non-GAAP operating expenses amounted to $95.9MM, or 27% of revenue. These are huge numbers for a very small earnings base and management's focus on this type of data allows them to pay rich prices for acquisitions that spur revenue growth, without highlighting the negative aspects of these decisions. Management is only partly responsible as the analyst community and the investor base are guilty of allowing management to get away with this chicanery, by upgrading the company and assigning an absurd valuation.

3D's market capitalization is approximately $8 billion at prices around $78 per share. This is about 17 times trailing twelve months sales, which is rich for any industry. The company has reported GAAP earnings of $44MM over that same time period or $0.65 per diluted share, so the company is trading at about 180 times earnings. This is still a small industry and the barriers to entry aren't that difficult that a well-capitalized competitor such as a Hewlett-Packard or International Business Machines (NYSE:IBM) couldn't encroach, and at the least impact margins dramatically. Below is a table that shows what 3D Systems net income would look like assuming 10%, 15%, 25% and 35% growth rates over the next five years. Even in the most optimistic scenario, net income would be just less than $200MM in year 5. This means that assuming 35% net income growth for five years, 3D Systems is currently trading at 40 times year 5 net income. That is utterly absurd and it doesn't even take into account that 3D lacks the cash or cash flow to attain this growth organically, therefore I would juxtapose that the actual EPS growth numbers would be far inferior, implying a much higher P/E ratio.

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The question that needs to be asked is "could a sophisticated company take say $5-7 billion to replicate 3D Systems' business?" I believe the answer is yes that they very likely could, as there is still a great deal of innovation necessary for 3D printing to become more practical for a greater number of products, so what is proprietary today, might not necessarily be highly relevant three years from now. Better capitalized competitors can pay rich prices to acquire their way into growth like 3D Systems has, while still investing much more into R&D to develop their own printers and materials. If Hewlett-Packard or Lenovo were to invest $500M-$1 billion into this area, I believe that both companies' could potentially become very viable threats to 3D Systems. 3D only has around $1 billion in total assets and most of these comprise of goodwill and intangibles, which were acquired at rich prices, so $5 billion or so in investment could likely lead to a far superior business than what 3D currently offers, especially when you consider HPQ and Lenovo's experience in traditional printing. Because the market capitalization is not high enough that a silly acquisition couldn't be made, I'd be wary shorting 3D, but I surely wouldn't invest in this business anywhere near current prices. I've been looking to sell calls way out of the money, but the bid/ask spreads are quite wide so I've yet to establish a position. If the company is acquired, shorting the stock of the acquirer might not be a bad proposition if the price paid is even close to current levels.

Disclosure: I am short DDD. 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.

Additional disclosure: I am long HPQ