By Daniel Holland
We think the additive manufacturing industry is ripe for further growth as the cost of hardware declines and manufacturing and design companies look to be more efficient with product-development spending. Though both stocks are ahead of our fair value estimates, we think 3D Systems (NYSE:DDD) still offers significant earnings growth potential as the firm benefits from secular growth trends and improving margins. Stratasys' (NASDAQ:SSYS) upcoming merger with Objet should create a dominant force in the rapid prototyping segment, which we think is the most compelling growth market for 3D Systems and Stratasys.
What Is 3D Printing and Why Does It Matter?
Three-dimensional printing, also called additive manufacturing, is the process of building objects from a 3D computer design by layering thin strips of material on top of each other. Typically the material, be it plastic, composite, or metal, is extruded wet and dries quickly before the next layer is applied, although some printers use ultraviolet curing between printer head passes. Even though the technology and concept have received a lot of buzz, the foundational principles behind additive manufacturing have been around for decades. The industry has risen to prominence largely because lower unit costs have created new markets for the technology, particularly in the professional and hobbyist markets.
Given that traditional manufacturing techniques essentially start with a block of metal that is machined down to the appropriate fit and shape, a scrapless manufacturing process has the potential to reduce raw material costs considerably. While many have considered this to be the holy grail of manufacturing, the scalability of the technology is in doubt by major industrial manufacturers that we have talked with and limits the potential of the technology. These printers specialize in short-run, customized jobs, with the only requirements for production being a 3D CAD model and the appropriate material. One key drawback to current 3D printing technology is the amount of time it takes to print an end product. With most printers currently able to build vertically at 0.75 inch per hour, it takes reasoned patience to endure the typically hours-long process. An automotive design engineer may be willing to wait, but a consumer tinkering at home may not. The other notable shortfall is that 3D printers are severely limited by the materials they use. Currently available materials do not duplicate what machined steel can accomplish. At some point in the next several years, this factor may be nullified a bit, but until then we don't consider this a substitute for traditional manufacturing. For that, among other reasons, we see the real growth opportunity in the rapid prototyping market, where 3D printed solutions have the capability to dramatically reduce development costs.
The Business Case for Rapid Prototyping
During the design process of new products such as shoes, toys, and car systems, engineers and designers iterate through several prototypes before getting close to final production. Custom prototypes can cost around $10,000 per unit. With professional-grade 3D printing machines starting around $10,000 and going up to $100,000, the quick payback period for these machines make these worthwhile investments, particularly considering the quicker turnaround time that 3D printers offer. In short, 3D printers reduce the cost of errors in the research and development process.
While the hobbyist market gets a fair amount of attention, the equipment still lies at the high end of consumer tastes, and the most common applications center on trinket-making. Through the cubify.com service with 3D Systems and Redeye with Stratasys, as well as numbers of other forums, users can swap ideas and models, making models at home. The primary limiting factor is having a 3D CAD model and potentially some 3D design experience, though we think this barrier is relatively easy to overcome. To the extent that this market takes off, we believe that 3D Systems has a respectable edge over Stratasys, offering four different printers for the hobby market as well as extensive Internet-based user forums and product exchange capabilities.
The Moat Is in the Materials
Material is important to the sustainability of economic profits for 3D printers in two ways: proprietary refill solutions create a barrier for poachers, and unique materials for a given printer will allow the manufacturer to carve a territorial moat. Following the traditional razor/blade model, printers protect their long-term profitability by only allowing a proprietary refill for use in the machine. Gross margins on the material are consistently north of 60% for both companies, while equipment margins hover in the mid-40s. To ensure that customers are locked into using the original-equipment manufacturer's materials, 3D Systems has started using radio-frequency identification technology to signal to the machine when the printer cartridge is empty and the machine will not operate until an appropriate RFID is restored. In other cases, using rogue materials will void warranties, rendering damaged equipment useless.
Once customers move up the scale of 3D printers, type and grade of material becomes more of a distinction point. Units that can print a wider variety of material, proving more flexible for end users, are often highly regarded. That said, given the payback periods, customers have expressed willingness to buy more than one unit, each capable of producing a different final product. The key innovation focus for manufacturers is clearly on expanding the compatible material base for each printer. We think this approach is prudent, as more material grades not only attract future customers, but also limit the potential profitability that a pirate could make from recreating the particular composite. In this regard, we view the firms' moat dependence on material more akin to filtration companies Donaldson and Pall than traditional paper-based printing firms.
The limitations of the technology establish barriers between firms and make user needs, not price, the primary determinant on purchase decisions. To that end, Objet has built a reputation for printing more visually appealing models since its printer can deal with multiple colors and can also mix materials, giving users more color and texture options. To achieve this, the Objet printers sacrifice product durability, so it is unlikely to see any of their end products in the field; instead they are ideal for visual verification. Stratasys' fused deposition model technology, which essentially melts small increments of plastic and lays it down, is more durable and useful for function and fit prototyping.
The Outsourced Printing Model Adds Revenue; the Moat Is Hard to Find
Both Stratasys and 3D Systems have outsourced printing businesses consisting of roughly one third of total company sales. The business is akin to Kinko's (FedEx Office): A customer sends a 3D design file to the company and the company sends a finished product back at the customer's specification. As a service, there are limited barriers to entry and the business already suffers from pricing pressure. In reality, a motivated, well-financed individual can simply purchase a 3D printing machine and open a business competing directly with the existing businesses. Furthermore, better penetration in the professional markets by the equipment manufacturing side of the companies and for consumers could pull away existing and potential customers. Such a development would erode any pricing power the businesses now claim. To their credit, both of the major printers have tried to consolidate the industry by buying up smaller competitors and instilling some pricing discipline in the marketplace. While this is encouraging, the weak barriers to entry give us pause when considering the longer-term viability of the outsourced printing business model.
Long-Term Thesis Inhibitors and Concerns Since our narrow moat argument for 3D Systems and Stratasys hinges on the switching costs associated with materials and the higher profitability attached to those revenue streams, the evolution of the material business is of primary concern. In particular, commodification of the material or even an industry agreement on a narrower range of plastics and metals would pose a threat to the longer-term sustainability of the profits. Since the two dominant firms are continuing to invest heavily in research and development of new materials, we do not foresee this disrupting the moat in the near future. The wide range of materials also limits the potential profits that a poacher could make when attempting to clone available material. Instead of choosing from 10 key plastic or metal composites, the poacher would have to choose from several hundred different plastics, each capturing a relatively small share of the market.
Another potential threat is simply more versatile machines. While different technologies drive the distinctions among printers now, it is conceivable that manufacturers could continue to develop the machines to be more robust and fill in the current gaps, making them more useful to a wider audience. While this is a likely boon to the manufacturer that comes up with the idea, the success of such a product could narrow the material set to cater specifically to that machine, making poaching aftermarket consumables a more profitable endeavor. This has not occurred with great success across other industries, however. For example in the filtration aftermarket, industry leaders report aftermarket recapture rates exceeding 90%.
Piracy of another sort could also pose legal issues for the industry as a whole. Since the printing machines simply take a 3D rendering and make a copy of that image, individuals only need to obtain an image of the item that they want printed and send it through the printer. Autodesk and other firms have already created mobile apps to create 3D files from phone photos. Many physical representations or products are patented or highly protected by the originating companies, which may not be so happy to see copies of their products in use, or at the least missing out on the aftermarket opportunity associated with a printed replacement part. While this risk hasn't become an issue yet, the advancement of technology and proliferation of printers could make this relevant in the next few years.
Lastly, while the technology has been around for decades, financial success is fairly new to the industry. For example, only within the past few years has 3D Systems made its materials proprietary. With growth heavily tied to salesforce execution and manufacturing discipline, business managers must have the discipline to tend to both long-term profitability and near-term growth concerns.
3D Systems Is More Interesting Than Stratasys at Current Valuations
Current market prices have embedded a healthy amount of growth -- in particular, Stratasys sits above our fair value estimate and not too far from our upside scenario. While we like the long-term business fundamentals of Stratasys, our interest would increase if shares dipped lower. Additionally, Stratasys is on the front end of a large integration. Integration risk may cause some earnings volatility in the near term, making shares less attractive to some market participants.
Even though 3D Systems is trading nearly 30% above our fair value estimate, the shares currently trade at 50% of our upside scenario, which assumes annual revenue growth over the next five years averages 35% and the company manages to expand gross margins by 3 percentage points to 55%. This gross margin target reflects service margins above 50% and equipment and material margins holding flat, with difference made by a higher mix of materials in the revenue stream. Given the same level of industry growth, 3D Systems stands to achieve higher earnings growth, in our opinion, because it will benefit from margin accretion both within its service business and from material sales. Until 2012, Stratasys had led the industry in service margins, which should link the company's earnings growth more to top-line changes. Additionally, whereas Stratasys has conceded the lower-end hobbyist market, 3D Systems has led the charge in extending product reach to the home. To the extent that there is material adoption at the consumer level, 3D Systems is in prime position to dominate that market, though we maintain that the primary investable thesis currently lies in rapid prototyping.
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