3D Systems (NYSE:DDD) published its Q1 report on Tuesday, and investors reacted negatively, sending the shares down 10% on the day of the release. I believe that the report shows far more positive than negative developments, and I think that we may see limited downside in 3D Systems' share price going forward. In fact, the stock may have bottomed on the day of the earnings report. The company is focusing on capturing market share and exploiting the rapid developments in the 3D printing space, and is sacrificing short-term profitability to boost investments into R&D and sales and marketing. Operational leverage should return in the second half of 2015 as these investments start to pay dividends to 3D Systems investors.
Negatives - margin compression, 2014 guidance, and moderating growth in the U.S. and initial market reaction to earnings
The focus of the negative reaction was margin compression, moderating growth in the U.S. and the lack of upside guidance for 2014. Gross profit margin declined 130 basis points over Q1 2013 due to a continued unfavorable product mix and the rising costs of manufacturing expansion. The company continues to invest aggressively, as R&D spending rose 165% Y/Y and as the company continues to increase sales, marketing and infrastructure spending. A 510-basis point compression in printers and other products' gross profit margin outweighed the 200-basis point expansion of materials gross profit margin and a 140-basis point expansion in services gross profit margin. Management expects continued margin pressure in the next couple of quarters and a return of operational leverage in the second half of 2015. We should see strong margin expansion and rapidly rising profits in the second half of 2015, with a full return of operational leverage in 2016. That is the time when investors should focus on profitability, not now. Top line growth is the name of the game right now, and the investments the company is making now should pay dividends in the future.
Management stated in the Q1 conference call that revenue in the United States increased 19% Y/Y. When asked about the issue, 3D Systems CEO, Avi Reichental said that he does not see it as moderating growth: "We had somewhat of a tough comparison in the U.S. quarter-over-quarter, but more importantly we don't see any slowdown in the U.S. We don't consider a single quarter to be a trend." He also stated that he expects higher growth in the U.S. in subsequent quarters. This will be an important metric to follow in the following quarters, and leaves room for doubt about continued momentum in the U.S.
My largest disappointment was the lack of upward guidance revision. Management reiterated its prior guidance for 2014 revenue between $680 and $720 million. This was disappointing, because the company made acquisitions that should have translated into higher guidance. And a "beat-and-raise" nature of a fast-growing company is usually responsible for higher stock prices. However, there are several clues that point to potential revenue upside and upward guidance revisions in the following quarters. Management expects that growth will accelerate in the second half of the year because of several factors: the company has launched 24 new products over the last year, which should ensure higher materials growth rates. Management also indicated that it will take another look at 2014 guidance once it concludes the Robtec acquisition. So, we might see an update on 2014 guidance in Q2 or Q3, and I expect revenue at the high end of the current guidance, or even above $720 million, based on stronger momentum in the second half of the year and a possible upward revision due to recent acquisitions. Analysts might have caught this too, as the 2014 revenue consensus moved up to $706.6 million from $699 million.
Positives - accelerating services and materials growth, demand in the direct metal segment, strong growth in Asia-Pacific and Europe, expansion in Latin America
The trends in the materials and services units are encouraging. Services revenue rose 38% to $46.6 million, primarily driven by Quickparts. Materials revenue growth rate accelerated to 41%. Materials gross margin expanded 200 basis points to 74.7%, while the services gross margin expanded 140 basis points. The growth in the services and materials business should continue to accelerate in the rest of 2014 and beyond as the demand for the newly-sold printers picks up and as the company continues to expand its materials offerings.
Direct Metal 3D printer sales have outstripped 3D Systems' manufacturing capacity during Q1, even though the company continued to add capacity. Management plans to quadruple Direct Metal printer sales over the next 12 to 18 months. The company also plans to market a larger-format and higher-speed Direct Metal printer, most likely at the end of 2014. The increased demand in the Direct Metal business should provide additional upside to future expectations.
The company is also expanding in Asia-Pacific and Europe, and plans to expand more rapidly in Latin America. Revenue from Asia-Pacific and Europe rose 97% and 66%, respectively, and these markets present a large base for future growth. The acquisition of Robtec, the largest Latin American additive manufacturing service bureau and the leading 3D printing and scanning product distributor in the region, should create a strategic sales and service platform in the region. The expansion in Latin America is another factor in my expectations for higher-than-expected revenue growth in 2014.
I believe that 3D Systems' Q1 report is encouraging, despite the margin compression and the lack of upward guidance revision. The company should continue to deliver robust revenue growth rates in the future, and we should see the return of operational leverage in the second half of 2015. The accelerating growth in the materials and services business is particularly encouraging, and it will contribute to higher margins going forward. A look at a P/S ratio chart reveals that 3D Systems is near the bottom of its 18-month valuation range and it may have bottomed. Additional downside should be limited, since the growth potential and future expectations are changing for the better and there are no signs of slowing growth and declining business momentum, which would push the share price and the valuation range lower.
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.