I think that the argument, "the stock price is too high relative to earnings, therefore it's a bad investment can be faulty." All too often, we give ourselves a pat on the back for setting up a system of criteria, screen to find stocks that match that criteria, and buy those stocks.
All too often, people say they want a stock that has high growth prospects and is also extremely cheap. But all too often, I almost never find those kinds of investments. Plus, in the rare instance that something does, in fact, show up on a screen, there's usually a caveat, a high-risk, for a very high reward. Sometimes the business is heavily cyclical, or in other cases, the growth rate was inflated due to an asset sale or some favorable tax treatment.
In other words, I have found that in many instances, a criteria-driven investment model, where a high valuation translates into the stock being a bad investment, can be ineffective. But I guess the latest victim of high valuation equals bad investment is Stratasys (NASDAQ:SSYS).
High P/E, therefore it's bad?
Stone Fox Capital basically summarizes:
After about six months from that original call, investors shouldn't rush back into the stocks with valuations now back to rather expensive levels. Does one really think Hewlett-Packard is going to purchase 3D Systems for upwards of $8 billion using a 20% premium to current prices? Based on normal PS or PE multiples, any deal would be difficult to turn accretive even using a high level of cash and low interest debt.
However, I'm dubious, at best, that the stock is way too overvalued, because even if earnings growth has been less than sales growth, it's because margins typically don't expand until the business model scales without any additional investment into headcount. Unlike other businesses, Stratasys is a hybrid of service, tech, and manufacturing. Really weird combination, but to debunk the idea that Stratasys is somehow being bid up to higher levels when compared to other companies, I'm going to drag in a company from a different sector that has awfully similar characteristics.
Stratasys has both a CAPEX and R&D component, but gross margins are extremely high. I guess this kind of financial statement reminds me of Intel (NASDAQ:INTC). Anyone who analyzes semiconductors knows that PP&E and ongoing R&D are essential. Since the two companies have a very similar cost structure that optimizes financial resources in similar ways, I feel that it's okay to make the comparison.
Also, I'm not using a peer comparison analysis of Stratasys versus 3D Systems (NYSE:DDD), because I'm trying to prove that whether the stock belongs into a hot sector or not, if a stock with similar financial characteristics were to grow at just as high of a rate, chances are it would trade at similar valuations.
(Source: Compiled from 10K, created by AlexLeAnders)
So, as we can tell, Intel and Stratasys both have very similar cost structures. Both have high gross margins, albeit Intel has a slightly higher one at 60%, versus Stratasys at 50% (previous fiscal year). Currently, the Non-GAAP gross margin of Stratasys is around 60%. But both essentially invest heavily into R&D and CAPEX. Given that the companies use financial resources in a similar way, I believe that this can be a representative case study.
Stratasys has a financial plan that's very specific
Why the lack of profitability in the case of Stratasys? Furthermore, why does the company raise capital through share offerings to pay for CAPEX?
When it comes to plant, property, and equipment, you depreciate the asset and expense it over a couple years. You also reap the tax benefit by expensing the property and equipment gradually on your income tax. If you earn profit, you pay taxes and then you get to buy your machinery and equipment. But if you want to avoid doing that, you technically have an alternative choice. You spend all your money on operating costs and cost of revenue. You earn zero income, and then you use shareholder capital or debt to pay for your plant property and equipment. This limits the tax rate to near nothing, and you might even get a tax refund on the depreciation expense in future accounting/tax periods.
Very simply, a business is encouraged to spend as much money as possible on line items that are pre-tax dollars, and is encouraged to borrow or raise capital for line items that are paid with taxed earnings. Companies that successfully do this are maximizing financial resources.
But not too surprisingly, on a conventional metric system that tries to narrowly define what is good or not good, key performance indicators and tax strategies hardly ever show up.
Plus, let's use some common sense. If you can grow sales with pre-tax cash, why bother giving any portion of it to the government? If the stock price fetches a high valuation, you can raise capital at a reasonable cost; companies do not pay taxes on a capital raise, whether it is through stock or debt. So the natural answer is to use someone else's money to pay for real estate, and use the revenue generated from sales to grow the front-end work force.
In this case, Stratasys is just maximizing the effectiveness of its financial resources. Any company that operates in technology and is in the early growth stage shouldn't boast about how it has high net profit margins, especially if the money can be reinvested into the business to retain a durable advantage against peers in its space.
Intel is a more mature business, on the other hand
Anyhow, what Intel is, is a more mature form of Stratasys. Intel, unlike Stratasys, can no longer grow sales as easily, because the market is pretty much saturated. Intel depends heavily on economic growth, whereas Stratasys is in the stage of ramping sales into markets that have yet to even be developed. Unique use cases for the technology continue to emerge, whereas Intel is tied to an established ecosystem that continues to market and sell product in hopes that an expanding middle class in foreign markets, paired with higher discretionary spending will drive demand.
The two companies are essentially the same in terms of financial performance, but operate at two different points along the product life cycle.
So let's go ahead and examine a historical chart of Intel's P/S ratio.
As you can tell, over the course of the roaring 90s, the company's price multiple continued to increase quite drastically. Let's begin from the period 1995 to 2000; the stock went from a 3 P/S ratio to an astronomical 16.25 P/S ratio.
If someone invested into Intel in January of 1995, they would have bought the stock at a price of $2.97 (adjusted); the cumulative ROI would be 948% (based on today's price). However, had the same investor bought the stock on January of 2000, they would have bought in at $30.88 (adjusted), and would have earned zero dollars over the course of a decade, unless you were to factor back in dividends. The stock price remained essentially flat for ten years, because net income never actually grew over the period.
So what deflated the P/S multiple had more to do with contracting earnings. It wasn't just the mania of the 2000s that contributed to the peak valuation; what really kept Intel from returning investors any money had more to do with the lack of earnings growth between 2000 and 2014. Net income remained essentially flat, and only on an EPS basis have things improved, as a result of share buybacks. This indicates that perhaps even Intel is undervalued or is fairly valued.
But this article isn't here to address the historical financial performance of Intel. I'm trying to using it as a benchmark of financial performance in relation to Stratasys.
(Data compiled from YCharts, created by AlexLeAnders)
Using data from the past five years, I was able to find that a lower price-to-sales ratio corresponded to lower sales growth. Whereas higher sales growth corresponded to a higher price-to-sales ratio, and the trend line confirms the correlation.
And not everything along the line is clear-cut. The data correlates, but not in every instance is a stock going to price itself at a higher valuation, even after exhibiting a phenomenal year in terms of growth. Maybe guidance indicated that earnings weren't going to be as good in the following year, and the price ended up correcting. In other words, the data is meant to give us a basic idea, but it doesn't indicate that in all instances this will always be the case.
I programmed Excel so that it extrapolates the trend line further, but basically given the data inputs, assuming Intel had a price-to-sales ratio of 10, the company would have generated year-over-year sales growth of around 30%.
Therefore, when comparing the behavior of investors with regards to Intel in comparison to the outward expectation built into Stratasys, what's interesting is that investors would essentially behave the same, assuming both companies had similar growth rates.
Between fiscal year 2013 and 2014, Stratasys estimates that sales will grow by 38%. When referring back to the trend line analysis on Intel, had Intel had a 38% growth rate in terms of sales, the price-to-sales ratio would have been 12 to 14.
The bottom line
Currently, Stratasys has a price-to-sales ratio of 10.7. I think the company is fairly valued (maybe slightly undervalued), as investors would be willing to pay a similar amount per unit of sales growth for Intel. Also, I'm not exactly making an apples and oranges comparison here. Both companies have gross margins in the 50%-60% range, both invest similar amounts into similar areas. However, Intel generates profit and Stratasys doesn't; but as I have mentioned earlier, the low profitability saves money on taxes. Whereas Intel is a more mature business, therefore the company has to return earnings to shareholders and use a portion of net income on capital expenditure. The two companies are somewhat different in that aspect, but overall, I think I have been able to make as many variables as constant as possible in the analysis, and have come away with a conclusion that closely corresponds to how investors are currently behaving.
Right now, the high ratio is a fair ratio, because if another company with similar performance characteristics were to grow at the same rate, the multiple on sales would probably be the same.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.