Why Stratasys' Valuation Bubble Will Pop In 2014

| About: Stratasys, Inc. (SSYS)

3D printing equities continued their dizzying rise in 2013. Media enthusiasm magnified after President Barack Obama stated in the State of the Union that 3D printing "has the potential to revolutionize the way we make almost everything." The resulting onslaught of media coverage exposed thousands of new investors to the industry promised by the Economist as the third coming of the Industrial Revolution.

Demand for pure 3D printing plays greatly exceeds the supply of public equities. Thus, valuations have ballooned. Stratasys currently trades at over 12x enterprise-value-to-revenue. Wall Street loves that gross margins in 3D printing are typically over 40%, and last quarter Stratasys (NASDAQ:SSYS) hit 48.2%. The firm is buoyed by lucrative maintenance contracts and material sales (with margins frequently surpassing 90%) that help double the lifetime value of a printer sale.

There's one big problem: Stratasys will lose its monopoly in 2014.

Understanding Industrial vs. Desktop FDM

Stratasys has three lines of industrial printers: Objet (PolyJet), Solidscape and Fused Deposition Modeling (FDM). This article focuses on Stratasys FDM machines such as the Mojo, uPrint, Dimension and Fortus that constituted over 72% of the company's industrial system sales according to the 2013 Wohlers Report.

In June 2013, Stratasys announced the acquisition of Makerbot, the leading manufacturer of desktop 3D printers. While Stratasys' cheapest machine starts around $14k, Makerbot printers sell for under $3,000. Stratasys was caught flat-footed by the emergence of desktop 3D printing and paid dearly to catch up: $403 million in stock plus $201 million in performance-based earn-outs.

From a technical perspective, the difference between a half-million dollar Fortus and a desktop 3D printer is less than you might think. The build area of a Fortus is much larger and the printer offers a soluble support material. The Fortus is also massively more reliable, but many desktop 3D printers have a superior print resolution as measured by minimum layer height.

Yet industrial users frequently print structures with overhangs that require support material. Removing support printed in plastic by a desktop printer is an exercise in frustration often requiring the use of a knife. Additionally, efforts to print with ABS plastic in large sizes results in warping on desktop printers without a heated build area.

The two ends of the market are quickly converging as companies create more reliable desktop 3D printers and experiment with large, heated build areas. Desktop 3D printers with soluble support are next.

Litigation and the Expiration of Key Patents

Core FDM patents started expiring in 2009. This June marks a watershed moment for Stratasys: the expiration of U.S. Patent No. 5,503,785 entitled "Process of support removal for fused deposition modeling." Later this year, prosumer 3D printers will begin offering easy-to-remove support material.

Stratasys has decided on an offensive strategy starting with litigation against Afinia. The lawsuit drew ire from the Maker community reminiscent of backlash against Makerbot when the company announced that its printers would no longer be open-source. Claims of patent misuse and anti-competitive behavior risk alienating juries in trial. The current market price does not reflect the devastating outcome if Stratasys loses this lawsuit: the company will be unable to stop startups from releasing desktop machines with industrial capabilities.

New Market Entries

In addition to desktop 3D printers sufficiently improving to threaten industrial FDM sales, the entry of new companies in the US market will end the Stratasys monopoly. Meg Whitman, CEO of HP, stated that her firm will announce its industrial 3D printer by mid-year--and based on the Wired profile, the printer appears to use FDM. Rumors swirl that Tiertime, the largest 3D printing manufacturer in Asia, may enter the US market as well. Numbers provided by Wohlers Report show that Tiertime is second only to Stratasys in number of industrial FDM systems sold.

Competitive pressures will decrease Stratasys system sales and drive down gross margins. In desktop 3D printing, ABS filament is a commodity that sells for $25 per kilogram. Stratasys sells the same material in cartridges for $260. This will not last with additional industrial competition.

Stratasys Monopoly, Stock to Fall

2014 will prove to be an unforgiving year for Stratasys. 3D Systems has aggressively slashed prices of machines in response to expiring patents, much like a pharmaceutical company's response to the introduction of generic drugs. Stratasys, on the other hand, has consistently reacted slowly in changing market conditions. Its conservative management hesitates to acquire companies and resists lowering machine prices.

Stratasys relies on patents to fend off competition from aggressive, innovative and competitive upstarts. The firm's recent litigation looks poised to backfire as the media brands its efforts as anti-competitive and lawyers argue patent misuse. The purchase of Makerbot looks too-little-too-late as a dozen manufacturers of desktop 3D printers surpass 5000 units sold.

The company will survive. The valuation will not.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SSYS over 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.

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