2013 was a fantastic market for bullish speculators. Bolstered by sellside cheerleading, companies with exciting stories in new industries saw their stock prices soar despite unproven business models, liberal accounting, and high valuations. While I don't know what the broader market will do, I believe that we will see some spectacular flame-outs during 2014. My picks are based on the following:
- Valuation greater than 90x TTM earnings.
- Insider selling in past six months.
- Limited history of profitability and/or free cash flow.
- Two (VJET and ANGI) of the stocks mentioned below have had issues raised regarding accounting/misleading statements to investors raised by a credible party in the past year. This is important as it presents a potential catalyst as we move into reporting season. While quarterly results are unaudited by 3rd party accounting firms (hence the unaudited designation under the header), annual results require a thorough study from auditors.
Voxeljet (NYSE:VJET) had a spectacular run in 2013, rising +300% from its October IPO. At today's valuation, the company is selling for astounding 41x 2013 estimated revenue and over 300x earnings. Today's share cannot be justified by fundamentals - rather the share price has been chased upward by momentum investors hoping to flip the shares to somebody who imagines them going even higher. I've also seen speculation that 3D systems would buy Voxeljet. This is ridiculous. While 3D systems has been a very active acquirer in the 3D printing space, a closer look shows that the company has rarely paid more than 3-4x revenue for an acquisition. To any sober investor, it is clear that 3D systems will not pony up ~800 million to buy Voxeljet at 40+x earnings.
Voxeljet is possibly the most compelling short opportunity in the market today. Ultimately when the 3D party winds down, I expect that VJET will fetch something closer to 2.5x revenue or 16x earnings. Factoring the company's net cash position (I'm using $45 million -adjusting for Voxeljet's recent purchase of its headquarters), this gets me to a fair value of $5/share or 87% lower than today's price. In a cyclical trough (I expect this industry will prove to be quite cyclical as it sells to largely industrial manufacturers which have big swings in annual capital expenditures), shares could trade at $3-4/share.
It is worth noting that some investors, notably Citron Research, have been skeptical of Voxeljet's revenue recognition policies. These non-cash sales noted by Citron have lead the company to be a burner of cash during the first 9 months of 2013. Should Citron's assessment of Voxeljet's revenue recognition be correct, the company will face difficulties in producing its annual filings. Coupled with the likelihood of insider selling post lock-up expiry (six month expiry in the second half of April though I certainly wouldn't rule out an early secondary which could come as early as January 22 - VJET management unloaded quite a few shares at $12 at the time of the IPO), there are reasons to believe that VJET's share price could crack sooner rather than later.
Though Angie's List (NASDAQ:ANGI) had a tough second half, shares were still up nearly 27% during 2013. The company has been beset by difficulties including: 1) onslaught of competitors (EBay, Homeadvisor.com, Thumbtack.com) who are offering their services to competitors for free causing Angie's List to significantly lower its price (2) bad publicity related to the conflict of interest inherent in Angie's business model (claims to be member supported while receiving 65%+ of revenue from service provider advertising) (3) key employee resignations (4) high customer churn (23% churn) and poor customer reviews (5) recent lawsuits regarding misleading claims made to investors. While Angie's list has been around since 1995, the company has yet to report a full year profit. This should be alarming to anyone considering investing in the shares. Meanwhile insiders have lined their pockets, selling tens of millions worth of stock since the company's 2012 IPO.
Frankly I don't understand what there is to like about Angie's List shares. The company is in a disadvantaged position (due to pricing) in an increasingly competitive industry and I doubt that it will ever earn a profit (I give up at 15 years of trying). Despite all of the negative factors, Angie's list shares sell at over 3x revenue and have a market capitalization greater than $750 million. I can't see Angie's List existing in its current form. Were the company to realize it cannot compete and sell its user base (2.3 million) at $50/each (generous) to a competitor, it would fetch about $115 million (equates to 45% of revenue) or $2/share, implying 85% downside. I actually think this is an overly optimistic view - I certainly wouldn't pay $2/share if you forced me to hold the stock for two years!
Recent investor lawsuits (there are a number of them) allege that Angie's List management has failed to make material disclosures in public filings. Angie's auditors are no doubt aware of these allegations and I suspect they will be more closely scrutinizing the company's figures and commentary as the company readies its year end filings. Any delay or restatement would be yet another red flag to investors and this could serve as a near term catalyst for sending the shares lower.
Lastly, I think 3D Systems (NYSE:DDD) shares are ripe for a significant decline after rocketing +160% during 2013. There are few things which have captured the market's attention like 3D printing. DDD Systems is believed to be the 800 lb. gorilla of the 3D printing industry. With $510 million in revenue expected for 2013, 3D systems trades at 19x revenue and nearly 100x operating profit. Multiples like this imply: 1) sustained period of super-normal growth for at least a decade (2) maintaining and/or increasing operating margins for the foreseeable future (3) a business with a strong moat/stable competitive environment. I have concerns regarding all three of these points. Firstly, as I noted above, 3D printing will prove to be a highly cyclical industry given the industry given that it sells mainly to industrial companies with highly variable capital expenditure budgets. Growth can slow for industry or company specific reasons including increased competition and new technologies super-ceding capabilities of existing players like 3D systems. Further, I think the company's roll-up strategy will end up leading to many key employees from acquired companies leaving to start their own new 3D printing companies leading to new competitors with strong industry knowledge and customer relationships.
Let's explore these concerns. While I don't see any impropriety in the company's accounting methodology, R&D understated. In 2012, 3D systems spent just $23.5 million or 6.6% of revenue on R&D (just over 10% looking at R&D divided by printer + consumable sales). This certainly doesn't sound like an insurmountable obstacle for competitors. However, 3D Systems has made several acquisitions, acquiring technology in the process. However, this isn't captured in the income statement (though it does siphon off cash flow, the only thing that really matters in the valuation of a business - 3D systems spent over $300 million on acquisitions between 2010-2012 vs. less than $50 million in expensed R&D). Through these acquisitions, the economic reality is that 3D systems has really just shifted a part of it's R&D onto the cash flow statement, flattering the income statement. As investors typically pay more attention to the income statement, this gives 3D systems the appearance of being a higher margin business than it actually is. Given that 3D printing is supposedly a very technologically advanced field which is experiencing rapid innovation, I suspect that the true R&D burden for an industry leader like 3D systems is 15+% of revenue. Adjusting the income statement to reflect this lowers adjusted operating margins by ~500 basis points (using 15% of product/consumable sales). The recent acquisition of Xerox's R&D group (bringing on 100 engineers which I estimate will cost an additional $15 million+ per year) provides support for my thesis.
My second major concern regarding profitability is the service business (35% of 2012 revenue) whereby 3D systems owns 3D printers and does 3D printing on behalf of its customers. This is a much more commoditized business which is seeing a large inflow of capital which will ultimately lead to: lower utilization, lower pricing, and lower margins/returns on capital. To some extent, the market is already realizing this as pure-play service company ProtoLabs (NYSE:PRLB) has significantly underperformed the industry.
Lastly, I will note that downcycle margins are likely to be materially lower than today's level. Coupled with increasing competition, ultimately I think that leading players in the industry will earn cross-cycle operating margins of 12-15%, similar to the copier industry. This is the materially lower than the 23% adjusted operating margins the company has recently reported.
On a $800 million revenue base (2015 estimate) with 15% operating margins, $120 million in operating profit. Capitalizing this at 12x and adding in $300 million in cash on the balance sheet gets me to $1.75 billion in equity value or 82% lower than today's price. In a downcycle, I wouldn't be surprised to see shares trading below $10.
While brokers/investment banks rate all of these stocks positively, this is just a product of their incentives. Brokers and investment banks are tens of millions of dollars in IPO, secondary, convertible, and M&A fees from the aforementioned companies. Rating them anything but 'Buy' would be suicide. There is a reason why lawmakers have mandated that such conflicts of interest be disclosed to investors and why there is a 3-5 page fine print disclosure at the end of all broker reports. I believe investors with a longer term time horizon would be handsomely rewarded by going against the crowd and selling/shorting the aforementioned securities.