At the start of March, last year, I gave 3D Systems (NYSE:DDD) a price target of $47 per share when the stock was trading close to $30 per share. However, the stock gained value faster than expected, and it more than tripled in value before coming down to around $70. Year-to-date, the stock is down more than 20%, and the market participants believe that the stock might come down further.
As my regular readers know, I do not recommend short-term trades, and I have always advocated the long-term investment approach. In case of the 3-D printing industry, we all know that the industry is in the early stages, and the companies are going through a hyper-growth period. As a result, volatility in price will be high as investors continue to bet on the long-term growth prospects of these stocks. Due to the elevated levels of volatility, I believe the short-term trading should be left to expert traders.
After the company announced its full-year results, I decided to update the model and increase its scope. Previously, my model projected revenue and earnings till 2022. However, now I have extended the period to 2026. Furthermore, I have updated the revenue and cost assumptions as well as expectations according to the new data available to us. I will discuss the model and its results in the following paragraphs.
Model and Assumptions
First of all, let's talk about the model and the assumptions. I have used a discounted free cash flow approach in order to determine the fair value of the stock.
- The first step that I have taken is the calculation of pro-forma earnings. For the first-year revenue growth, I have taken the figures from the company's outlook for 2014 (3D Systems expects to have revenue between $680-720 million during the current year). I have taken a value close to the mid-point of the expected revenue figure for the year. For the next year, the company expects to reach $1 billion in sales. Again, I have used the expected revenue figure for 2015, as I believe the company will be able to reach that figure through organic as well as non-organic growth. In the following years, growth has been gradually falling before settling on terminal growth rate of 3%. It is important to note that in my previous model, the assumed terminal growth rate was 4%.
- The gross margin for the company will show slight improvement over the next two years. I have assumed cost of sales declining to 40% in 2018 as the long-term gross margin of the company is expected to be around 60%. Furthermore, operating expenses are expected to rise over the next two years, as the company tries to increase its market share through different marketing activities and expansion of sales channels. As a result, I have increased the operating expenses by 1% in each of the following year or two years. However, in the long-term, I believe the operating expenses will settle at close to 28% of the total revenues.
- The next item is the tax rate. 3D Systems' effective tax rate for the last year was close to 31%, up from 10% during 2012. The company still has some deferred taxes, which might complicate the calculation of the tax obligation. As a result, I have assumed a constant tax rate of 30%. Please note that the tax rate in my previous model was variable, with the highest rate for any single year not going over 25%. So I have increased the tax rate by at least 5% from even the highest point in the previous model. In some years, tax rate has been increased by as much as 18%.
Pro-forma earnings shown above have been calculated using the above-mentioned assumptions. According to my calculations, 3D Systems should be able to maintain solid operating and net profit margins even after the hyper-growth period.
For valuation, I have used a 10% discount rate, which I believe is appropriate for the company, as it has increased its footprint in the global 3-D printing industry. The discount rate is a unique component, which can differ for each investor. However, I feel a discount rate around 10% is appropriate; you can of course use your own discount rate if you deem my discount rate to be on the higher/ lower side. The below table shows the calculation of free cash flows and fair value of the company.
For the free cash flow calculation, I have taken net income as the starting point. All of these net income figures represent projected net income based on above-mentioned assumptions. To reach at free cash flows, I have made adjustments regarding, depreciation, amortization, interest expense and other non-cash items, such as restructuring expenses/gains, gains/losses on equipment sale and taxes. Furthermore, investment in fixed and working capital has also been taken into account.
Free cash flows beyond 2026 have been projected at a constant growth rate of 3% and discounted at the discount rate of 10% (adjusted for growth rate) to calculate terminal-year free cash flows. After calculating free cash flows for each year, I have discounted those free cash flows at 10% to reach at the present value, and added them to achieve $8.9 billion in discounted free cash flows. According to my free cash flow model, 3D Systems' stock should be trading at around $86 per share. At the moment, the stock is trading close to $71 per share. The current stock price shows that the upside potential in 3D Systems is close to 21%.
I remain bullish on the 3-D printing industry as a whole and 3D Systems in particular. I think the stock will be trading above $86 per share in about a year's time. I am giving it a one-year price target of $86 per share. The companies in the 3-D printing industry are working very hard to increase the market share; there are new partnerships and acquisitions announced on regular basis, which may result in the stock price going above my price target sooner than expected. However, I believe one year is a reasonable time frame for the stock to move towards its fair value.
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.