3D - The Printing Revolution - Bust Before The Boom?

by: Serge d'Adesky

The 3D printing revolution has crept up on us on quiet mouse feet, but the crescendo of its rise will soon burst forth like a rhino's stampede. 3D printing will fundamentally change the way we make all the objects of our consumer society: from Q-tips to heart valves, from earrings to jet engine nozzles. Ultimately, it will create the largest displacement of labor in human history.

3D printing is a process of "additive manufacturing" which creates objects by adding materials layer-by-layer in cross sections. Fueled by the exponential growth in the processing power of computer chips and their corresponding shrinkage in size, 3D printing technology is growing so rapidly that it is likely to soon replace the almost 100 year-old mass-production model that defined the industrial revolution.

The economic and sociopolitical ramifications of these technologies are mind-boggling. In the process of "creative destruction" made famous by economist Joseph Shumpeter, whole industries will wither and die while new ones arise. Fortunes will be made, and other fortunes lost.

Undoubtedly, the result will be a great reduction in the cost of labor and the demand for it, as machines become able to produce multidimensional objects of incredibly complex design with unerring accuracy. The age of mass-produced items will come to an end, and the age of customized, tailor-made, just-in-time production in local factories and homes will replace it.

Will this favor the small business and individuals as opposed to megalithic, well-capitalized companies? Will the ownership of the machines be concentrated in the hands of few, or be dispersed among the many? Who will control the raw materials that are required by these machines?

How will patent law - and its enforcement - be affected when anyone can print a credible knock-off of any product in the secrecy of his basement? Will one company come to dominate the 3D software fields or will it be overrun by open-source software developers, as we've seen in the field of operating software, telecommunications and many others?

How seriously will this reduce the cost of transportation, when rather than shipping finished products one need only ship the raw materials to make those products? How energy-intensive will these printers be, and will this cause an increase or decrease in the demand for energy? Will we see a shift of economic equilibrium away from China and back toward the US, Japan and Europe as the advantages of cheap labor are displaced by the savings in transportation?

From an investment perspective, there are too many factors at play and too many unknown variables to be able to reliably pick the winners and losers on the stock market. Yet the trend - and its inexorable surge - is too momentous for an investor to ignore.

I liken this situation to the rise of the automobile in the late 19th and early 20th century with the marriage of mass production technologies with the efficiencies of the internal combustion engine.

Many investors at the time had the wisdom to recognize the long-term promise of the automobile in global society and the fortunes to be made by investing in promising automobile manufacturers. But picking the winners in this melee of new entrants was far from easy.

Who still remembers the Duryea Motor Wagon Company? Despite being the first American automobile manufacturing company, the company later floundered.

What about the Packard, the Studebaker or the Stutz? Long term, investors in these successful start-ups also fared poorly.

So how to pick the winners, the Fords and Chryslers? How to know that Nash-Kelvinator Corporation and Hudson Motor Car Company would merge to survive and thrive in the form of the successful American Motors Corporation?

For the long-term investor, my solution is to use the KISS ("Keep It Simple Stupid") principle. Invest in all of the stocks, without trying to pick winners and losers. Accept the fact that you will lose all or most of your money on some stocks, break even on others, and win big on one or two.

Because the winners can increase 100 and 200 times in value over a long period but losers can only lose their original value, this strategy should succeed well over time.

Unfortunately, for the small investor, this can be an expensive proposition. It involves buying an equal weighted share of every company in the industry. But to buy just one share of each of the dozen or so companies already active in this sector, investors at full service brokerage houses may find the commission costs to be very steep. So buying just 1 share of that particular company - which might be what its equal weighting would imply - would severely impact future returns.

My advice to the small investor wishing to use this approach is to find a discount broker such as Interactive Brokers (with trading costs around $1 a trade) or invest through your Registered Investment Advisor (RIA) [DISCLAIMER: i am an RIA] who uses such discount brokers as custodians of your funds.

Ideally, the small investor would want to invest by buying a sector ETF or mutual fund specializing in this field, but none exist to date. The closest that I've found is Robo-Stox Global Robotics and Automation Index ETF (NASDAQ:ROBO), but this invests more in the field of robotics than of 3D printing technologies, although there is a bit of overlap.

Here is a partial listing of the major publicly traded companies in this sector, along with their areas of specialty or differentiation.

Source: finviz.com Jan 17, 2014

Of the companies in this list, two of them, Autodesk (NASDAQ:ADSK) and ANSYS (NASDAQ:ANSS), develop the leading software solution that propels this nascent technology.

3D Systems Corporation (NYSE:DDD) and Stratasys (NASDAQ:SSYS) are the two current market leaders in the hardware sector as manufacturers of 3D printers and 3D printing supplies.

ExOne (NASDAQ:XONE) is the newbie to the 3D printing hardware sector. Its shares went public in February of 2013, and although its revenues are growing, it has not yet achieved profitability. ExOne's main advantage over other additive manufacturers is in the broad range of materials it can use to fabricate items. So far, they can produce in silica sand, ceramics, stainless steel, bronze, glass, iron (infused with bronze), and bonded tungsten.

FARO Technologies (NASDAQ:FARO) is also a manufacturer of hardware and software, however it specializes in the scanning technologies that are crucial to the 3D-printing process. These scanning technologies allow any object to be quickly rendered into three-dimensional wireframe images that can then be further manipulated and/or corrected prior to becoming the data stream that fuels the 3D-printing processes.

Organovo (NASDAQ:ONVO) is probably the most intriguing, but at the same time, the riskiest business among the companies listed. It has not yet reached profitability, and may be years away from doing so. Rather than fabricating generalized 3D printers for use across a spectrum of industries, this company is developing an esoteric bio-printing technology for creating functional human tissues on demand for research and medical applications.

When looking at the 3D sector, be sure to avoid wannabes and miscategorizations! Proto Labs (NYSE:PRLB) is an online and technology-enabled quick-turn manufacturer of custom parts for prototyping and short-run production. Because it produces parts from 3D software specifications, it is often linked in with 3D companies. But its CSC printing technology is actually the polar opposite of 3D's additive revolution, and that technology is likely to be largely displaced by the additive processes.

As in any young industry, especially one with a relatively low barriers to entry, any attempt to list major participants is almost stale within a few weeks of printing, so consider the listing above to be incomplete as you read this.

All the more reason, in my opinion, to invest in the entire sector rather than the individual companies. Take a look at the image below, which shows the typical product competition cycle.

Image from public copyright of blog.gardeviance.org

From the investors' standpoint, the ideal time to invest is at point Z3, and the ideal time to sell is at point EC2, when the product has gone mainstream and is beginning to become commoditized as too many competitors have entered the fray.

The trick, of course, is to recognize at what point in the competitive cycle a particular industry finds itself. In the case of 3D printing, I believe we are just past the Z3 point, which was achieved in early 2013, and has caused the tremendous gains in this sector's stocks in the past year. We may be at the point of intersection of the purple and pink squares on the illustration.

3D printer products are barely out of their "custom-built" stages, and technology fixes and innovations are being implemented on a very rapid basis. 3D printing is hardly a "settled" technology.

Real competition only begins to heat up when the technology starts to reach around a 10% market penetration. 3D printing revenues of between $3-4 billion are not even 1% of the $10.5 trillion manufacturing industry it could eventually disrupt. That is probably still 10 years off, if we believe the Credit Suisse estimates.

I personally feel it will be before that, based on my experience that we always overestimate the adoption rate of a new technology at an early stage, then greatly underestimate its adoption rate in the intermediate period.

From a qualitative and substantive perspective, then, there is a strong case for investing in this sector. From a technical perspective - reflecting the psychology of the market - extreme caution is advisable.

Look at the investment psychology phases made famous by Gartner.com Research Methodologies in their oft-cited research on the technology investment cycle. It appears likely that 3D printing is approaching the peak of its "hyped-up" stage. In the image below, 3D printing may well be at or close to the peak of the orange zone.

Image copyright of gartner.com

Certainly, most of the products of these companies are in their first generation, and with many of the printers much customization is needed. And with their stock values having soared 4500% since their 2009 lows, one can certainly suspect that euphoria has boosted these stock prices well past their fair-value points.

As a consequence, I would stay out of this market space until a large correction occurs. Only the long-term investors who are comfortable seeing a temporary drop of 30-50% in their portfolio values may want to wade in at these high values, knowing that the real intrinsic values will eventually catch up with the hype and provide a handsome long-term reward.

A more prudent approach, and one more easy to countenance, is to use naked shorts to be paid to buy these stocks at a significant discount to today's values. Unfortunately, such an approach will not be possible for investors using IRA and other retirement accounts. They may just have to use the old-fashioned approach, dollar-cost averaging and buying on dips.

A comprehensive analysis of DDD's fair market value published in mid-2012 put it at around $49, with a range of $32 to $66 using a variety of pricing approaches. Let's say you agree with that analysis. Well, at today's prices at the time of this writing, a January 2015 put at a strike price of $55 could be sold for $5.00. This essentially means being paid 9% in a year to be willing to buy DDD at a 40% discount to today's price.

Similar opportunities exist in all of the 3D high-fliers. But how do you know at what discount these stocks may be fairly priced?

There is no objective value. Each investor and each analyst will come up with a different number, depending on his assumptions. I'll tell you mine. These go a long way to determining whether the stocks will ever exceed their already lofty valuations.

I believe the entire industry will grow at rates exceeding 50% for at least a 10-year period. Where do I get this number from? Those are the growth rates of other technology-revolutionizing companies, both in the hardware and software fields, in the recent past at a time when their industries were in their early stages of market penetration. Here are a few you will recognize:

Stock Company 10-year EBIT
AAPL Apple 67.5%
GOOG Google 43.9%
ISRG DaVinci Surgical 61.7%

Source gurufocus.com

Another important assumption is the discount rate to use. The higher the rate you use, the lower you value future growth prospects in today's dollars. Most analysts and accountants use the capital asset pricing model (CAPM), which adds a risk premium to the long-term risk-free rate of return (such as the U.S. Treasury bond yield) in order to try to account for varying risks by industry. This usually gives a discount rate of around 12%.

I disagree with this convention and use a much lower rate of 6.67%, which I learned from Chuck Carnevale, a value investment guru. (Apparently, I am in good company on this, with the likes of famed investor Warren Buffet using a similar approach.)

Which assumption for discounting you use will dramatically affect today's discounted cash flow value, as the table below demonstrates:

Stock Company Projected 10-year EBIT CAGR 6.67% DCF Valuation 12% DCF Valuation Notes
DDD DDD Systems 48.9% $262 $130
SSYS Stratasys 51%* $139 $75 Book Value CAGR
DASTY Dassault Systems 25%* $251 $144 Assumed accelerated growth
FARO Faro Technologies 50%* $489 $262 < FCF Value CAGR of 85%

Extrapolation using assumptions and DCF calculator from gurufocus.com

How high you think long-term interest rates will go over the next decade should be the main determinant of the discount rate you apply. If you think the 30-year Treasury yield - considered the "riskless" cost of money - will rise to a 10% to 12% average over the next 10 years, you'll want to use the higher discount value, resulting in much lower present valuations.

You know what they say about the future: "The damn thing about the future is it's so hard to predict!" .

May destiny smile on your investments.

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: I have sold naked puts on DDD and ADSK.