- 3D Systems will report Q1 next Tuesday: we feel pretty comfortable at the top-line level but believe that earnings are once again at risk.
- Gross margins could head south as rising competition and consumer products put pressure on ASPs.
- The operating margin could suffer from increased R&D and marketing spending vs. Q4 (when the company started stepping up investments).
- The stock’s valuation has become more reasonable but another miss would probably drive down the price close to our $26 bear-case valuation (50% downside).
- While a beat would spark a 10-20% rally. The risk/reward remains unattractive.
We have been aggressive sellers of 3D Systems (NYSE:DDD) since January and our article "Competition to heat up as key patents expire, earnings risk on the downside," lead a fellow SA author to give us the nickname "the $26 bears."
But, believe it or not, we thought about calling the stock a trading buy in recent weeks. Indeed, the stock price collapse made the valuation much more reasonable and the stock started to trade below the mid-point ($54.5) of our bull-bear valuation analysis ($83-$26, for more details please read our February article "$83 or $26? Pick your scenario).
Finally, we did not make the call. Why?
Momentum is broken and earnings risk is still on the downside
We believe that 3-D printing names are momentum stocks. And obviously, the positive momentum is now broken with a flurry of profit-warnings in recent months from the likes of 3D Systems, Stratasys (NASDAQ:SSYS), ExOne (NASDAQ:XONE)… and with stock prices down close to 40% from their peak.
3-D printing stocks have even entered a vicious circle: stock prices are going down, fear is rising and putting additional pressure on stock prices and so on…and we do not identify any catalyst that would reverse this trend.
Indeed, we believe that the earnings risk is still on the downside. We said in January that the expiry of key patents between 2014 and 2017 would spark increased competition and pricing pressures across the industry as open-source hardware printers would be able to integrate laser sintering. Since then, increased competition has become a reality, with HP (NYSE:HPQ) claiming to have a breakthrough 3-D printing technology (a release date has yet to be announced) and with low-cost Asian printer makers (such as Taiwan's New Kimpo or Singapore's Pirate3D) entering the all-important consumer market with aggressive prices (see this article in the Nikkei Asian Review). And the arrival of low-cost Chinese printers could make things worse.
In all, we reiterate our view that the ASP of printers is likely to fall sharply in coming quarters, suggesting significant pressure on gross margins going ahead: prices go down, but costs remain high due to continued marketing and R&D efforts (both 3D Systems and Stratasys warned in January due to increased R&D and marketing spending).
That said, we believe the risk will be high heading into 3D Systems' Q1 earnings release (next Tuesday).
What to expect from the Q1 earnings release?
We feel pretty comfortable at the top-line level and believe that the company should do well in view of easy comps (22% organic growth in Q1 13 vs. 29% over FY13) and of the revenue traction seen in Q4. But investors' attention is likely to focus on gross and operating margins if you remember that investors punished the stock in January despite a strong FY14 revenue guidance as the margin guidance was well below expectations.
Gross margin trends in the last quarters have been worrying: the margin was sharply up in Q1 last year (up more than 200bps) and gradually deteriorated to end the year flat in Q4. Due to rising competition and to the rising weight of consumer products, we would not be surprised to see a slightly down gross margin in Q1 and this could be a source of concern for investors.
At the operating margin level, 3D Systems started to step up investments in Q4, suggesting that the impact of increased R&D and marketing spending could potentially be higher in Q1 and importantly higher than expected by the Street.
In all, we would expect 3D Systems to deliver rather good revenue growth, but uninspiring margins and earnings.
If we're wrong (3D Systems posts a strong beat), the stock will probably rerate by 10-20%. But if we're right, we consider that a second consecutive miss or warning could be lethal for the investment case and drive the stock close to our $26 bear-case valuation, suggesting a 50% downside. Once again, we've got to say that the risk/reward is not attractive.