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Investors in 3D Systems are taking on a huge amount of risk.

We expect Hewlett-Packard and other large entities with substantial financial resources to eventually start a value-destructive pricing war in the 3D printing industry.

3D Systems registers a 5 on the Valuentum Buying Index. We prefer ideas in the Best Ideas portfolio.

Investors in 3D Systems (NYSE:DDD) are simply taking on too much risk. If the 3D printing industry manages to generate material economic profit over any duration of time, it will be competed away by the likes of Hewlett-Packard (NYSE:HPQ) or another competitor or two or three with the substantial financial resources looking for marginal growth. We're not fond of the violent stock movements of 3D Systems (as a result of this expected dynamic), and we expect the industry to be ultra-price-competitive in coming years. In any case, let's walk through a derivation of the firm's intrinsic value and apply the Valuentum style to shares.

For those that don't know us, at our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. 3D Systems posts a Valuentum Buying Index score of 5, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and neutral technicals. A score of 5 is just that -- middle of the road. Let's take a look at why 3D System's registers such a mediocre score.

3D Systems' Investment Considerations

Investment Highlights

• 3D Systems earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 36.6% during the past three years.

• 3D Systems provides 3D content-to-print solutions including 3D printers, print materials and on-demand custom parts services for professionals and consumers.

• 3D Systems has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 10.2% in coming years. Total debt-to-EBITDA was 0.2 last year, while debt-to-book capitalization stood at 2%.

• What once seemed like an unattainable pipe dream is now a very powerful means of production. 3D Systems is seeing strong demand from manufacturing customers, and the firm's consumer products are on Staples' (NASDAQ:SPLS) shelves with a positive reception from consumers.

• 3D printing is an exciting business, but competition should not be taken lightly. Hewlett-Packard plans to enter the business in a big way and to price aggressively. This is not welcome news at all. We expect the ease of entry to be a significant impediment to long-term success. Gross margins are already facing pressure, and the pressure will only get worse.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. 3D Systems' 3-year historical return on invested capital (without goodwill) is 36.6%, which is above the estimate of its cost of capital of 11.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. 3D Systems' free cash flow margin has averaged about 9.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at At 3D Systems, cash flow from operations decreased about 9% from levels registered two years ago, while capital expenditures expanded about 169% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that 3D Systems' shares are worth between $39-$81 each. This is a huge range, and it should be. For a company like 3D Systems, the only thing that investors can count on is uncertainty. Even as shares trade at $49 each at the time of this writing, we wouldn't think anything of a further 15% decline or so. Anything more than that, then we'd think the possibility of a valuation mispricing may exist, but without knowing the drivers behind the price decline, we can't say for certain that our fair value range won't change as well. Fair value estimates are not static, and only companies that fall outside of the fair value range are considered underpriced/fairly-priced.

The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $60 per share (the midpoint of the fair value range) represents a price-to-earnings (P/E) ratio of about 133.9 times last year's earnings and an implied EV/EBITDA multiple of about 50.3 times last year's EBITDA. These are just incredible multiples. Our model reflects a compound annual revenue growth rate of 27.3% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 30.6%.

Our model reflects a 5-year projected average operating margin of 24.1%, which is above 3D Systems' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 12% for the next 15 years and 3% in perpetuity. We're still building in some nice growth to arrive at the point fair value estimate of $60 per share. For 3D Systems, we use a 11.8% weighted average cost of capital to discount future free cash flows.

We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. We think investors can find much better risk-adjusted growth in a firm such as Microsoft (NASDAQ:MSFT) as an example. Our favorite companies continue to reside in the Best Ideas portfolio.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $60 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for 3D Systems. We think the firm is attractive below $39 per share (the green line), but quite expensive above $81 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate 3D Systems' fair value at this point in time to be about $60 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of 3D Systems' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $83 per share in Year 3 represents our existing fair value per share of $60 increased at an annual rate of the firm's cost of equity less its dividend yield. Importantly, this assumes our existing forecasts prove correct, and that we are not being too optimistic about profit potential. The expected equity value increase also does not consider the fair value range at that time in the future, which could be wider or smaller. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

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.

Additional disclosure: MSFT is included in the Dividend Growth portfolio.