A Forensic Accounting Report Detailing Why We Believe that 3D Systems Profitability Is Unsustainable and that Reported Organic Revenue Growth Is Overstated by an Estimated 100%
With a stock price that has more than tripled over the last 2 years, 3D Systems (DDD) has handsomely benefited from the plethora of positive media reports and bullish investor recommendations centered on the 3D printing industry. For instance, this month, Insider Monkey made the claim that DDD may be this decade's "top dog", ahead of Apple (AAPL) and Facebook (FB).
While Autodesk (ADSK) and Protolabs (PRLB) are often associated with the 3D printing industry, DDD is one of only two publicly traded 3D printer manufacturers of significant market capitalization along with Stratasys (SSYS). DDD CEO Abe Reichental appears prominently in many positive media reports, advertising his company as the public markets vehicle to play the secular growth in 3D printing products and services.
For instance, in an interview with the Financial Times in July 2012, Reichental states he expects 3D printing industry to grow bigger than the internet and expects industry sales to go from $500 million in 2012 to $35 billion in 10 years,[i] which implies a 53% revenue compound annual growth rate relative to 3D Systems inorganic sales CAGR of 7% over the previous decade. DDD has reported ~20% organic growth over the last 2 years that conforms to the narrative being told in the media.
CEO Reichental and the DDD Board of Directors have used this narrative to raise $341.7 million in equity capital to spend on acquisitions and have sold $70 million in shares over the last 2 years. However, after conducting a detailed examination of DDD's financial results, we believe that this organic growth rate is highly overstated. Below we demonstrate the following five key points.
- Organic revenue growth is overstated by an estimated 100% over the last twelve months.
- The results for the first half of 2012 are inflated by one-time sell-in to Z Corp resellers. This further overstates the repeatable organic growth rate, making us believe the business is really only growing 3% to 6% on a repeatable basis.
- DDD has not generated significant free cash flow over time, and we do not believe the Company's acquisition strategy over the last two years materially changes this business's prospects.
- Over the last several years, DDD has significantly underinvested in R&D relative to core competitors SSYS and Objet and is losing significant market share
- We believe DDD is worth $7.00-11.00 per share, or 10-15x EPS based on our expectations for a 3% to 6% repeatable organic growth rate
1. Reported last twelve month organic revenue growth of 19.3% is overstated by an estimated ~100% since the Company is including a portion of its revenue growth from recently completed acquisitions as organic revenue growth. We believe last twelve month organic revenue growth is no more than 9.6%. DDD has acquired 24 companies between the fourth quarter of 2009 and the second quarter of 2012. Through our detailed methodology we arrive at estimates for the 24 acquisitions that were completed between the fourth quarter of 2009 and the second quarter of 2012. The methodology we employ primarily relies on DDD's own SEC filings and commentary from company officials.
(click to enlarge)
Multiple members of DDD's Board of Directors were in place years before the SEC's 2003 investigation into DDD's revenue recognition practices. Deloitte & Touche LLP resigned as auditor and the Charlotte regional office of BDO USA LLP took over the DDD account in 2003. BDO Charlotte only audits one other publicly traded company, the $25 million market capitalization company Hampshire Group, and we wonder whether BDO Charlotte is up to the task of auditing the complicated accounts of DDD, which acquired 24 companies for $252.6 million from 4Q09 to 2Q12. We question why DDD excludes its reported organic growth rate from the 2011 10-K (the only audited financial report), yet advertises its organic growth rate on both 2011 and 2012 earnings calls and in 10-Q filings.
2. The results for the first half of 2012 are inflated by one-time sell-in to Z Corp resellers. This further overstates the repeatable organic growth rate, making us believe the business is really only growing 3% to 6% on a repeatable basis.
Per the Z Corp and Vidar M&A call on 11/21/11, Reichental states that the $134 million acquisition "effectively doubles the number of resellers and takes us to a combined channel of some 330 resellers worldwide with complementary portfolio that allows the combined channel to sell the combined portfolio." Through our independent research interviewing participants in the Z Corp channel, we have learned that after the acquisition close date on 1/3/12, DDD held a meeting at its Rockhill, SC facility with a large group of Z Corp resellers. Our sources say that Reichental told the resellers at this meeting that DDD had just purchased Z Corp for $134 million. Z Corp independent resellers were told to buy both a Projet 1500 (sells for $10-15k) and a Project 3000 (sells for $60-90k) if they wanted to continue being a part of the reseller program. After this initial meeting in 1Q12, this message was further relayed to Z Corp resellers across the globe.
Piper Jaffray analyst Troy Jensen has apparently learned something similar through his channel checks as he writes in his 10/11/12 report:
"We believe 3D benefitted in the first half of 2012 with Zcorp channels purchasing demo printers from 3D Systems (and vise-versa), which likely overstated system sales in the 1H of the year, but the company now has a significantly larger channel selling both 3D Systems and Zcorp printers."
We believe that DDD profitability likely benefited from this reseller sell-in primarily in 1Q12 but that there may have also been some spill over into the 2Q12 quarter.
Our large point of disagreement with Piper Jaffray's Troy Jensen above is that we believe that this is an unhealthy channel that will be subject to attrition. Furthermore, while DDD free cash flow generation typically benefits from a seasonal tailwind in the second half of each year, we believe that the 1H12 sales results are inflated by this reseller sell-in and are thus unsustainable. Even with this benefit, the Company only managed to produce 1H12 free cash flow of $19.8 million, or last twelve months free cash flow of $36.9 million relative to a $2.2 billion market capitalization, implying a 1.7% free cash flow yield.
In the below table, we take the base last twelve months organic revenue rate from Point 1 above and adjust it for the one-time incremental revenue that DDD earned in 1H12 to derive a repeatable organic growth rate of 3% to 6%.
(click to enlarge)
3. DDD has not generated significant free cash flow over time, and we do not believe the Company's acquisition strategy over the last two years materially changes this business's prospects.
Below we review DDD's Cash Flow from Operations and Cash Flow from Investing since 1991 (DDD has been a publicly traded 3D printing company for more than two decades).
(click to enlarge)
Over the twenty years from 1991 to 2009, DDD produced a cumulative $72 million of Cash Flow from Operations, negative $11 million CFFO less Capex, and negative $186 million of free cash flow. This hardly sounds like a fast growing, high margin business to us.
Now let's take a look at DDD's transformation over the last ten quarters. While we see that DDD has produced $81 million of cumulative cash flow from operations, i.e. $8 million more than it had produced in its cumulative two decade history, we also see that cumulative free cash flow is nearly the same at negative $184 million from 1Q10 to 2Q12 versus negative $186 million from 1991 to 2009. What is missing from this equation is how DDD financed this spending spree: DDD raised $341.7 million of financing over the previous ten quarters, and share count increased from 45.8 million in 2009 to 59.7 million in 2Q12 once including the in the money convertible debt, or a total share count increase of 30% over ten quarters.
While it goes without saying that DDD's cash flow would be considerably lower if one excluded the 24 acquisitions for $252.6 million that DDD completed over the previous ten quarters, let's assume for a moment that we could take DDD's current free cash flow from operations less capex per share at face value and compare that to GAAP EPS. We see that cumulative GAAP EPS over this 10 quarter period is $1.34, or only 6% lower than cumulative Cash Flow from Operations less Capex metric of $1.43.
4. Over the last several years, DDD has significantly underinvested in R&D relative to core competitors SSYS and Objet and is losing significant market share
Reichental views DDD's print technologies as a competitive advantage in the 3D printing space, stating in an article for Forbes that:
"We do have excellent competitors, yet there are key differences between our products and business model and theirs. First, all the competitors that you mentioned are single print engine pure plays-a single technology offered in different sizes and formats. Contrast that with our seven print engines…"
Let's take a look at DDD's seven print technologies below. "Principle print engines" per the 2011 10-K include all of the following except for 3DP, which was acquired in the Z Corp acquisition:
We believe that MJM technology will be DDD's primary sales driver on a forward basis and the stiff competition that DDD faces in this sub segment from the combined Stratysis-Objet entity (the two companies agreed to merge in 2012). We believe that the financial histories of DDD, SSYS, and Objet paint a compelling picture. Clearly Objet and SSYS have been gaining significant market share from DDD. Below for simplicity, we do not strip out inorganic growth for DDD in 2010 and 2011. What is more instructive is the divergence in the growth rates over the last decade, a period in which DDD revenue has been effectively flat excluding acquisitions and SSYS and Objet have gained significant share of the 3D printing industry:
What is fascinating from the above chart is that even including DDD's massive inorganic growth in 2010 and 2011, the Company only grew at a 7.0% 11-year CAGR relative to SSYS, which completed very few acquisitions and grew at a 14.4% CAGR, over twice the rate of DDD. We only have 5 years of historical financials for Objet going back to 2007, and since then Objet grew at a 15.9% CAGR, nearly entirely organically, relative to DDD's 10.2% inorganic revenue CAGR since 2007.
In the early 2000s, DDD was teetering on the brink of bankruptcy due to its negative cash flow generation. The 2003 10-K Risk Factors warned that:
"[i]f the Company's financial condition worsens and it is unable to attract additional equity or debt financing or other strategic transactions, the Company may become insolvent or be forced to declare bankruptcy… In connection with its cost containment efforts, the Company has reduced the number of employees engaged in research and development efforts. The Company did not introduce any significant product advances in its SLA® and SLS® systems in 2001, 2002 or 2003. These factors may have negatively affected the Company's ability to compete effectively… The Company believes that sales of its SLA® and SLS® systems have declined in part because the Company has not introduced any significant advances in these products during the past three years."
What we find so interesting is that while DDD was forced to cut R&D during this difficult period from 2001 to 2003, both R&D spending as a percent of sales and R&D per print engine technology have declined significantly from this bare bones period. R&D as a percent of sales and R&D per print engine for DDD were roughly flat from 2004-2006, but have declined precipitously over the last 5 years from 2007 to 2011, particularly in relation to its chief competitors, SSYS and Objet. In our view, this lack of R&D investment explains in large part why DDD has lost so much market share to SSYS and Objet over the last decade.
5. We believe DDD is worth $7.00-11.00 per share, or 10-15x EPS based on our expectations for a 3% to 6% repeatable organic growth rate
DDD claims an organic growth rate far above what it is actually generating based on our detailed assessment of DDD's acquired revenue. We believe that repeatable organic growth over the last twelve months has been 3% to 6% and see no reason to believe that organic growth will accelerate on a forward basis beyond this level given competitive pressure in DDD's core 3D printing business. 10-15x EPS is an appropriate valuation multiple for a business growing revenue organically at 3-6% on a forward basis, which implies a share price of $7.00 to $11.00, or 70% to 80% downside from the current share price based on 2012 Street GAAP EPS. This valuation is in line with DDD's historical stock price history prior to the introduction of the roll up acquisition strategy in 2010. We believe the GAAP metric is closer to an estimate of repeatable free cash flow that the market should capitalize, but even applying the Non-GAAP metric we arrive at a price target 54-69% below the current share price assuming a 10-15x EPS multiple.
Disclaimer: As of the publication date, the author of this report has a short position in the company covered herein and stands to realize gains in the event that the price of the stock declines. The author does not use options to establish positions prior to a report’s publication. The author does not discuss unpublished reports, or provide any advanced warning of future reports to others. Following publication, the author may transact in the securities of the company, and may be long, short, or neutral at any time hereafter regardless of our initial opinion. The author of this report has obtained all information herein from sources believed to be accurate and reliable. The author of this report makes no representations, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. All expressions of opinion are subject to change without notice and the author does not undertake to update or supplement this report or any of the information contained herein. This is not an offer to buy any security, nor shall any security be offered or sold to any person, in any jurisdiction in which such offer would be unlawful under the securities laws of such jurisdiction.
Disclosure: I am short DDD.