3D Systems Analysis
Board: Value Hounds
[The Post of the Day will be on hiatus until April 2. Please check the archive for posts you may have missed.]
We believe that 3D Printing is at the cusp of accelerated growth and that the ultimate measure of our success will be the sustainable value we create from our share and scale gains over time.
We believe that we have a head start as the leading industrial healthcare, consumer electronics, athletic, toymakers and food companies are receptive to forming the relationships with us and this other and potentially larger
players marketing resources 3D printing opportunity.
Overview additive manufacturing (AM)
Avi is right about being on the cusp of growth in AM. While it’s been around for almost three decades the buzz is only a couple of years old and has pushed almost all AM stocks to record highs in the past two years.
Global sales in 2012 were $2.2 billion and it’s still a small business. Expectations for 2015 are sales of $4 billion in 2015 and CAGR at 23% for the next 8 years with projections of $11 billion in sales by 2021.
By most accounts, it’s not consumer/hobbyists that will create $11 billion in demand but rather big applications like plane parts from GE & Boeing, car parts, just in time parts manufacturing, and medical/dental reconstructions. Software applications should explode and Autodesk, Dassault and Siemens will be players. At present, jewelry, dental/medical implants, models and prototypes are major consumers of 3D machines.
3D Systems does have a big percentage of the global market. 2013 global AM sales are not in yet but estimates put it around $3 billion. DDD’s $516 million in revenue gives them around 17% of the market. By 2015 if DDD does $1 billion in revenue (Avi’s guidance) they will increase that to 25%. I have a few doubts they can gain that much traction, but the boyz at DDD are positive they will.
By the time I arrived at SA last August 3DS was already near $50 per share and since I didn’t know anything about three D printing and since it was nearly double the 52-week low and miles above the 2012 rec price, I didn’t bother doing anything with it.
I went back and read the original recommendation several times and it gave me almost no idea of what 3DS does and how the company operates. In June 2012, when it was recommended a second time, DDD at $19 and the second analysis did little to shed more light on who the company was and what they were doing or why the price doubled in just six months. The reason to buy 3DS in January 2012 was solely the historically fast accelerating growth that could be counted on to continue and eventually push sales to $3-$5 billion.
The split adjusted share price in January 2012 was $10 and the following is the basis for the recommendation:
The Future Is Now--from the original SA recommendation
Companies’ newfound love of additive manufacturing has brought 3D Systems consistent profitability and improving margins. Management believes revenue will hit $400 million to $500 million over the next three or four years — an inexact target, but one that suggests 24% annual growth in the near future. I think the stock price could double over a similar period. If 3-D printing takes off among individual consumers, even that target could prove conservative.
In the two years since this paragraph 3DS revenue in 2013 was $516 million and ahead of the predicted schedule. The split-adjusted price has increased from $10 to $56. In spite of almost no company-specific in the write-ups to guide an investment decision, this has been a brilliant stock. You didn’t need to know or even want to know more about 3DS other than it was cutting edge disruptive tech and had the potential to more than double revenue in 3-4 years. It was largely an investment made on faith in growth of demand for the technology and the ability of 3D to take the technology and make it saleable—which they did and kudos to Avi Reichental for vision and enterprise and perseverance over nearly three decades.
Do we need to know anything more about 3DS now than we did originally since it is $56? Or is the future still one of rapidly accelerating growth and nearly limitless applications creating growth? It’s emotionally more difficult to invest at $56 than $10 but does it require tedious number crunching or just the continuing belief revenue can again more than double in the next two years?
Guidance was revised down in October, again in February and the stock went from a high altitude cruise above $95 down $56. In October non-GAAP EPS were revised down to $0.93- $1.03 from $1.05-$1.20 –a big miss. In February guidance was re-revised to $0.83- $0.87—a huge miss from original guidance.
2013 EPS (non-GAAP) were $0.85 for the year. GAPP earnings were 45¢. Non-GAAP guidance is poor substitute for GAAP guidance especially in a serial acquirer. Non-GAAP earnings removes options compensation expense, amortization and acquisition expense. Since acquisition are an ongoing highly active strategy for DDD, considering these expense as one-time and non-recurring, these particular non-GAAP estimates are misleading and come in far above GAAP earnings. Investors need to clearly understand what 3DS is telling them when they discuss guidance. Non-GAAP EPS are twice as high as GAAP.
The CEO and CFO aren’t shy about predicting big things for 3DS in 2014 and 2015. But with their track record in 2013 of missing estimates and investors need to think hard about the business and if it has the potential to meet Reichental’s numbers.
GAAP guidance for 2014 spans a fair amount of territory
They expect 2014 revenue to be between $680 million to $720 million with the greatest growth in the second half. At the high end that’s 51% growth in revenue. Since organic growth was 29% and 22% in 2013 and 2012 respectively, this 51% increase should be nearly half from acquisitions. Avi expects DDD to reach $1 billion in revenue by the end of 2015 up 40%.
2014 GAAP earnings will be in the range of 44¢ to 56¢ per share and at the high end of the range, the increase is 11¢ and 24% over the 45¢ earned in 2013. If DDD earns 44¢ and loses a penny year-over-year and that might catch the market’s short attention span long enough to send the 3DS down even further. I would be looking for guidance updates to direct any ongoing decisions to buy or sell. At present they have covered all their bases between great results and abject failure making it difficult to know where they will land.
There’s a lot of slippage between the top line 50% growth and a bottom line that may underperform 2013 EPS and that’s largely due to:
1) High expenses unlikely to moderate
2) Contracting margins from unfavorable product mix
3) NOLs that are winding down and higher provisions for taxes with increasing cash taxes
3DS expects a reported tax rate for 2014 to be in the range of 32% to 35% and cash taxes to converge with the reported rate in 2014. It’s exactly this that crunched earnings in 2013 after years of low-to-no taxes-to tax benefits from carrying forward NOLs and deferred tax assets. Their return on invested income hit 4-year lows in 2013 as cash taxes took a bite out of EBIT and net margins (among other things).
The guidance included specific numbers for both direct metals and consumer.
For direct metals, at the high end of guidance ($50 million in revenue), sales would almost quadruple. The range is wide and at the low end ($25 million), it only doubles. On a pro forma basis, direct metals revenue was $14.3 million in 2013 compared to $4.7 million in 2012.
In consumer sales, 2014 expectations are high. In spite of disappointing sales in Q4 2013 of only $9 million, sequentially down from $13.5 million in Q3, 3DS expects revenue to increase by 2.4x-3.5x ($80- $120 million), primarily driven by lower cost consumer printers. In the CC, they are leaning heavily towards the high side and expect consumer to triple in 2014. The positive feedback from the CES is guiding their thinking.
CES introductions showcased 20 significant new consumer products:
“We expect will shape and define the future of the consumer retail 3D printing categories and address completely new marketplace opportunities, including, ceramics and food printing.
We think that certainly in the case of consumer, it's early days and based on all the experiments that we conducted in 2013, we believe that we have built the presence, the product and the necessary muscle via some of our new co-ventures and alliances to actually plan on tripling revenue again there.”
Acquisitions alone should increase revenue 25%-30%
DDD will keep acquiring new businesses to push revenue growth but GAAP EPS will lag revenue gains. As with the original recommendation, revenue growth and meeting guidance will be the key numbers investors look at when giving 3DS a price. According to management, acquisitions are going to hurt for short-term profits but may not have much effect on the stock’s market price if they manage to meet guidance:
We are prioritizing initiatives and investments ahead of short-term earnings during this phase because we believe that the fundamentals of our business model remain intact and because we fully expect the higher investments that we are currently making to favorably influence our results and our competitive advantage in the coming periods.
Through our accelerated actions and investments, we believe that we set the stage to substantially compress the time it will take us to extend and solidify our leadership position and deliver greater value.
3DS’ key investment in 2013 was the Xerox R&D team and facility. By 2015 they estimate revenue of $1 billion made possible by doubling down on R&D expense/investment. Wilsonville is an R&D facility specializing in product design, engineering and chemistry. 3DS had a 15-year licensing relationship with them and the partnership produced its best-selling Projet series. They will now own 87% putting most of the R&D expenses on 3DS earnings statement—long-term.
Reichental is expecting big things from R&D-----
-----catapult us years ahead of the pack and to position us to accelerate our organic growth and set the stage for doubling our revenue over the next two years.
Adequate & focused R&D spending is critical to growth and some experts feel that R&D spending across the AM sector has tailed off and kept companies from making next-gen advances. Focused, demand-driven research spent in areas where evolution is critical will pay back the acquisition. Are R&D dollars well spent on the consumer? The Xerox team was more involved with industrial AM and projects like the Projet series. Reichental didn’t mention what they are working on now and no one asked, but he thinks consumer AM is a fast-growth segment and it’s where at least some R&D dollars will be spent.
R&D spending at DDD went from high single-digit down to around 6% over the years. In Q4 2013 it increased to 11% and hit margins hard. If they are researching high margin high demand product, future sales will offset a fixed R&D spend. If they are going after low margin part-time hobbyists, the dollars will be wasted and the margins won’t expand. If I was an analyst, I would ask about the percentage of R&D spent on consumers and the difference in margins for Cube and Projet et al and how materials sales shadow manufacturing vs. consumer. But I’m not invited to the calls and no one else asked. Maybe the Fool can ask?
Looking at numbers makes investing harder
It’s always a temptation to crunch some numbers just for fun and that usually ends up making the decision more difficult and less likely to result in going all-in on shares all at once. The numbers do give a different picture than the conference calls and the PR. Management tends to over-promise and re-revise lately (bad for the share price) and place too much emphasis on non-GAAP numbers making things look a little better than they are.
And what is integrated materials anyway? Those sales are great while materials are losing ground as a segment. One thing about management is they tend to have slippery numbers and segment overlaps and categories that make a clear understanding of the company impossible. That’s OK when things are going well but it makes knowing when to get in and out a challenge. Investing for the long term (three years according to SA) is nice in theory but I would have hated buying at $97 only to see it drop to $58 when looking a little harder at the company might have sounded some alarms and provided a better basis.
The numbers are convoluted and can be skimmed just to get a sense of the trends. We need to look at total business combined growth and margins and then sift through the three business segments growth, margins and percent of revenue to see how each part contributes to the whole. It makes a lot of numbers but it’s just a trend spotter and can be skimmed or skipped.
The acquisition model
A large part of growth has been acquisitions going from just $4 million in mergers in 2009 to $162.3 million in 2013.
[See Post for Tables]
The company reported organic revenue growth for 2013 and 2012 --29.4% and 22.4% respectively. Acquisitions were 15.8% and 31.1% of growth for 2013-2012. Organic revenue growth is one of the best things about DDD and is going to be one of the main drivers of share price appreciation.
DDD has been free cash flow negative for three years after paying for 32 businesses. The acquisitions are listed separately in the filings, but assets are lumped together in the filings and as most were privately held, no individual company can be evaluated for price, returns, and if it was a great buy.
CFFO in 2013 decreased yoy by 50%. Net income was lower and big increases in receivables and inventory were a problem.
The one or two acquisitions I can find numbers for show 3D paid around 1x-2x revenue. As a percentage of revenue, acquisition revenue could account for 20%-30% of the total and without a constant stream of mergers, growth will look considerably less impressive. Fortunately (or maybe not depending on your POV) DDD sees a brisk market ahead for buying new businesses. The need to acquire will continue to suck up cash and if DDD can't create more CFFO, they will need to keep issuing equity and may need to use some debt. With interest rates low I find it puzzling DDD has not sold any notes.
3DS has sold convertible debt and issued equity both to raise cash and in exchange for shares of the target businesses. It has resulted in high share dilution but low debt levels. Shares have increased from 68 million in 2009 to 103 million in 2013— 52%.
Over the past three years 3D has acquired 32 businesses. In 2013, they began reporting organic growth in the 10K and 10Qs for 2012-2013. With any extremely acquisitive business (Nuance, Oracle, Tyco), a good measure of value is return on invested capital. The lack of information about each acquisition makes 3DS’s growth a black box with few ways to hold them accountable for smart decisions.
In 2013 the cost of capital was all equity and approximates the premium an investor would demand given the risks. I calculated WACC at 11% representing a risk free rate of 4.5% and a risk premium of 6.5%. Beta was one and probably too low and the WACC should be higher. Regardless, 3DS is a long way from creating value with its acquisitions. Value creation happens when ROIC exceeds the cost of capital and the wider the positive spread, the more value the company is returning to shareholders.
It’s not unusual or a sign of weakness for a growth stock to see a negative spread while it grows and if growth continues to accelerate and earnings increase with the higher growth and better margins, ROIC should climb. The market doesn’t care about valuation or ROIC and that’s not what keeps the price moving up—it’s the promise of tremendous growth and the belief the best is yet to come.
Valuing 3D with a discounted cash flow takes 50% growth per year over 5 years and operating margins of 20% to get to the current price. The company is predicting both.
Highlights from 2013 and the fourth quarter
•Fourth quarter revenue grew 52% from the prior year to a $154.8 million on 34% overall organic growth, resulting in GAAP earnings of $0.11 per share
•Gross profit increased 53% and gross profit margin was flat at 51.7% --CEO and CFO predicted margins would expand and it didn’t work out (more missed guidance)
•Net income was $11.2 million
•2013 revenue increased 45% to $513.4 million on 80% printers and other products growth and 29% organic
•Gross profit increased 48% and gross profit margin expanded 90 basis points to 52.1%
GAAP earnings were $0.45 per share for 2013
Fourth Quarter 2013
•3D printers and other products revenue increased 76% to $73.9 million.
•Print materials revenue grew 39% to $37.2 million.
•Services revenue rose 33% to $43.7 million and was 28% of revenue on strength of Quickparts sales—-last figures available at merger show QP with 1.2% operating margins and more sales may not be better for DDD’s bottom line
•Healthcare revenue increased 67% to $21.8 million
•Consumer solutions expanded 162% to $8.9 million
•Manufacturing and design printer unit sales tripled, but materials increases didn’t keep pace
•Materials revenue increased 39% over the 2012 quarter--- $37.2 million in revenue
•Consumer sales were $9 million, 5.8% of revenue and down sequentially from Q3 sales of $13.5 million. Sales were down 34% sequentially in spite of new Q4 product introductions, expanded retail outlets and Q4’s inclusion of the Christmas shopping season. 2013 annual sales were $34.7 million—triple 2012 sales. DDD expects consumer to increase to $80-$120 million in 2014 and if they miss, guidance may need downward revision. The trend doesn’t look promising for consumer based on Q4, but there may be pent up demand for new product -— DDD is counting on it
Full Year 2013
•3D printers and other products revenue increased 80% to $227.6 million.
•Print materials revenue grew 24% to $128.4 million.
•Services revenue rose 27% to $157.4 million.
•Healthcare revenue increased 45% to $71.7 million.
•Consumer solutions expanded 206% to $34.8 million
•Since acquiring Phoenix Systems in July 2013, 3DS has sold out of direct metals printers each quarter, and on a pro forma basis, tripled direct metals revenue to $14.3 million from $4.7 million in 2012
•Based on the current lineup of direct metal printers, customer demand and planned capacity expansions, DDD expects direct metals to generate between $25 million and $50 million of revenue in 2014
•2013 annual revenue from design and manufacturing 3D Printers increased 60%, with some 50% of those units already sold into outright manufacturing applications.
•The growing installed base in manufacturing accelerated materials growth rate and generated a 40% increase in integrated materials revenue for the year-- further material sales upside as more manufacturing facilities come online.
•Presented 12 new professional, design and manufacturing products at EuroMold 2013 to further sales in aerospace, automotive, medical device and jewelry manufacturing
Margins and growth annual
Even as gross margins increased over 4 years, operating margins declined in 2013 and net margins fell off a cliff. In Q4, gross margins hit a plateau at 51.7%, as increased sales of printers could not offset the slowing higher margin materials sales. The product mix was what they term “unfavorable”. This isn’t concerning for one quarter.
Printer sales are growing faster than either materials or services and materials is the high margin business.
They spent time reassuring analysts it was a temporary setback, but if printers and services continue to be 75% of revenue, 52% margins may be the new norm. Adding to the pressure will be increasing consumer printers that are lower margin.
Materials is by far the highest margin business and it looks like its losing share dropping its rate of growth from 46% down to 25% in the past year. If materials is the razor blade to the printer razor, sales should be increasing in line with printer sales.
Why are materials lagging so far behind printer sales over the past four quarters? As printers are sold, materials should be flying off the shelves –a printer without print material is useless. Integrated materials sales increased more than 40% in Q4 but I don’t know why those are a leading indicator and why they aren’t part of materials. Anyone know what it is?
The margins for materials is the reason these sales have to increase. Just like 2-D printers and ink, this is where the bigger profits are.
Percentage of revenue by segment
As services and printers become a bigger percentage of revenue, margins will remain on the hot seat.
A temporary slight margin contraction from changing product mix is not going to bother the market, but at the same time, it’s starting to look like expenses are on a runaway train unlikely to slow any time soon and if combined margins look permanently lower than historical norms, investors may love DDD a little less.
R&D was predicted to increase by $1.5 million, but increased by $5.8 million and SG&A came in $5.4 million over the expected increase of $3 million. These are not expected to moderate and higher revenue and a higher margin mix will be the fix.
From the CC Q4:
Third, from our revised guidance it should be evident that the next few periods we are accelerating our unit growth rate further in order to capture a higher recurring revenue stream in future periods, specifically our higher margin materials, because we believe that our materials revenue can become a larger contributor to mix and earnings power.
A more immediate indicator of material growth rate is integrated materials growth rate, which for the quarter I believe was in the high 40s as compared to total material growth rate, which was only in the 30s.
So if you wanted a real finger on the pulse of material growth as it relates to more recent printer sales, the integrated material growth rate, which was 49%, more closely mirrors and mimics what’s happening in the here and now.
I can’t find any separate category for integrated materials at their website or any subcategory of materials in their filings. Materials are materials and rate of growth has lagged printers all year.
Service gross margins are about the same as printers, but I suspect operating margins are far worse. Quickparts was their biggest acquisition in 2011 and accounts for a majority of their properties. At the time of the sale, operating margins (not net) were 1.2% and part of the business was discontinued in 2013 due to unprofitability. There was also reference to the recently acquired Rapid Product Development Group is hurting margins in 2013 -0- another low margins parts company.
Higher expenses will mean lower margins and management warned analysts that over the next two years R&D and SG&A are going to be high. They softened the blow by emphasizing revenue will be doubling and that doubling is made possible by increasing R&D spending.
From the CC:
We more than doubled our fourth quarter R&D spending and continued to rapidly increase our sales, marketing and infrastructure expenditures in support of our growth initiatives and recently announced joint developments and alliances.
Although, in October, we guided for reduced earnings to reflect these actions, additional opportunities that added to our quarter expenditures ramp surpassed our expectations and compressed our net income to $11.2 million and our earnings per share to $0.11.
The failure to meet even reduced guidance revised down twice) sent 3D stock down from record highs over $90 to $58. The market is relentless and will lose interest in 3D if they can’t control expenses, fail to meet revenue guidance and earnings come in on the low side again. For 2014, 3D says expenses will continue to be high, but revenue increases will offset that to a small extent. They warn that short-term earnings will be low. That may be why the price has failed to rally even though 2013 results were OK.
One of the biggest drawbacks to the higher inventory levels and receivables is the halving of CFFO in 2013, making even less cash available for acquisitions. Working capital can freeze large amounts of cash decreasing liquidity—frozen assets.
And in terms of inventory popping, Damon mentioned that already in his comments. I mean, we are gearing to introduce as many products in the next few months as we did year to date. So if you think that year to date we introduced 12 new products, we’re going to be introducing just as many products between now and the first week of January. That is largely responsible for the pop in inventory.
Inventory includes work in progress and not getting the product finished and sold increased inventory. Much of the inventory build was failure to sell and an increase in backlog that increased work in progress.
The inventory build didn’t resolve by Q4 and year’s end and accelerated.
Along with the inventory increases, receivables were up and outpacing revenue growth. DDD is just shy of 3 months for collections. Part of that may be acquisitions with high AR. When working capital increases, cash flow suffers and they need all the cash they can free up for mergers. Inventory needs to move faster and they will have to shave some days off collections.
During the fourth quarter of 2013, cash flow from operations were impacted by the timing of purchases related to our increase in inventory, for production of dozens of new products and expanded demand and by the timing of orders and customer and vendor payments.
1) Management now has a history of over-promising then revising down making guidance unreliable. Reichental et al consider current guidance to be on the conservative side, but it looks optimistic at $1 billion in revenue by 2015 with operating margins expected to be 20%. Consumer is looking like the biggest part of that growth and yet Q4 2013 was not encouraging. The CEO and CFO overestimated earnings by a wide margin in 2013 and it’s not clear whether we can count on 2014 and 2015 guidance numbers. Any revisions are going to send DDD share prices further down.
2) Margins will see continued pressure from costs in R&D and SG&A and net will be unlikely to stage a big recovery as DDD loses net operating loss carry forwards and pays higher taxes
3) In spite of the reported 40% growth in integrated materials (?) total materials sales rate of growth declined between 2012-2013 decelerating from 46% to 24% growth and did not keep pace with printers. Will this less margin-friendly mix persist?
4) ROIC is trending lower with increased pace of acquisitions
5) More competition
1) AM is a growth business and 3DS has a meaningful portion of the market already. CAGR will be 23% over the next few years for the industry and DDD is outpacing that
2) Revenue growth will continue to be around 30% organic and acquisitions should keep it over 40%.
3) 3DS will reach revenue targets making the market happy.
4) Metals demand and growth is still in early stages already a triple for 3DPS and the recently acquired Phenix will keep it growing. Metals is expected to generate between $25 million and $50 million in revenue in 2014 and it's just the beginning
5) healthcare products growth is increasing rapidly and grew 66% in Q4
6) Twenty new products coming to market after the 2014 CES to accelerate growth
7) Renewed commitment to R&D
8) Increased scanner and software sales will increase gross margins. These are “other” and included in printer revenue
9) Price is down to $56 from a 52-week high of $97 making it relatively less expensive than it was—big drop!
10) High growth segment including metal and health care look well-positioned for continuing expansion
This is the end. I know a great deal more about 3DS and AM in general. Knowing more doesn’t always translate into successful investing. Those who bought in 2012 on nearly no company specific information have done very well. At most knowing slightly more at these higher prices may help us to keep from overpaying. I am glad I resisted paying $97.
Now if I could solve the fourth dimension and time travel, I might find a place to buy with a little help from back to the future.