3D Systems One-Dimensional Quarter
Board: Value Hounds
3DS didn’t have a great second quarter with shrinking margins and organic growth. Inventory excess remains a problem and the gains in the consumer segment that were promised failed to materialize. Unchanged is the guidance that says the second half is going to be successful and back half earnings are going to be good enough to meet the guidance. Guidance has not been revised downwards in spite of 3DS earning only 5¢ per share in Q2. Guidance is for EPS of 44¢-56¢. First half earnings are 16¢ and the back half is going to have to deliver far in excess of H1. If they guide down, the floor is going to collapse along with the stock price.
Medical and metal continue to outperform but medical is only 18% of the business. Consumer has been a big disappointment and predicted pent up demand hasn’t materialized.
From Q4 2013:
In the Q4 2103 CC, management was leaning heavily towards the high side of expectations for the new consumer printers and expected business to triple in 2014. The positive feedback from the CES guided 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.
[See Post for Tables]
Inventory, working capital and cash flow shortfall
The ramp up of 20 new consumer products created an inventory bulge that seriously compromised cash flow from operations (CFFO). 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.
3DS kept introducing products through the last half of 2013 and cited the “pop” in inventory as a temporary bubble that would be deflated from pent up demand for irresistible new consumer printers.
Cash from operations was impacted by our continued inventory buildup in anticipation of new product releases. We believe that we concluded this buildup during the first quarter and expect to begin to liquidate a portion of our finished goods inventories as we commenced commercial shipments of our new products later in the second quarter.
3D Systems didn’t make much progress liquidating the inventory and turning it into the cash they had been predicting since Q4 2013. Most of the build was for new consumer product that was going to hit the market running from pent up demand for the new consumer-friendly printers that were going to be in every room. That didn’t happen and in fact, consumer is losing ground year-over-year and sequentially.
The second quarter has come to a close and consumer sales were in decline both year-over-year and sequentially. However in Q1, they predicted it would be H2 before the demand picks up and the poor Q2 showing may not be entirely surprising. As they keep moving the timeline forward for growth, it makes those quarters more critical and any misstep will be a disaster.
“We expect accelerated growth in our consumer category in the second half of this year. As we began shipping the recently announced Cube 3, CubePro and iSense scanners late in the second quarter and as we often completely new consumer and consumer application with the ChefJet, CeraJet and CubeJet 3D printers that our slated for commercial shipments during the second half of this year.”
It wasn’t only the ramp in consumer that caused inventory levels to remain high. Polymer printers were backed into backlog as customers deferred delivery.
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, Q1 2014 or even Q2 2014. Their guidance is that the second half is going to see high sales and inventory liquidation. Working capital remained high in Q2 2014. Inventory growth far outpaced revenue growth and days in inventory increase year over year.
Receivables that were a problem sucking up cash in 2013 and Q1 2014 improved in Q2 along with cash flow
The working capital (wc) over revenue is not an absolute value that has numerical meaning. It’s based on a quarterly revenue basis and that gives us a relative trend but not a percent of working capital/revenue for 12 months (that would have absolute meaning). The relative trend is up -— way up in Q2.
From 3DS cash flow troubles in 2013
During the fourth quarter of 2013, cash flow from operations was 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.
Apparently this production of dozens of new products failed to sell well in Q1 and Q2 2014. There is no explanation given other than holding up a couple of consumer Cubes for enhancements (3DS-speak for technical glitches?) and the belief consumers weren’t buying the older product and were waiting for the new models.
Cash flow was better in Q2 than Q1. Q1 2014 CFFO was a miniscule $310,000. Much of the cash consumption in Q1 was inventory and that didn’t relent much in Q2. 3DS had CFFO of $19.3 million for the first half largely due to better receivables numbers. Free cash flow was negative due to acquisitions-- ($43.2) million. The negligible cash from operations in Q1 was blamed on inventory build in anticipation of big sales in the back half of 2014. We sort of heard the same story in 2013 with expectations that by Q2, high inventory levels would be resolving. In fairness, 3DS has always said the second half would be great and the first half not so much.
While cash flow from operations was positive in Q2 2014, it fell short of covering capital spending and acquisitions
Free cash flow (43,161)
The shortfall was made up by selling 6 million shares and raising $307 million. 3DS also issued 20 million shares for an acquisition in 2014. Dilution to shareholders this year is 6.7%.
Disappointing growth was the 3DS story in the second quarter. It was reasonable for a “normal” company but 3DS is anything but that. There are infinitely accelerating sales expectations built into 3DS’s thesis and that hasn’t happened in 2014. Qi and Q2 have been distinctly disappointing and the market has decided the story is dead.
Organic growth was especially worrisome and the pace of acquisitions in 2014 is slow.
Deceleration of growth was on the minds of analysts especially for materials. Quarter over quarter, materials growth declined as did consumer. Consumer was down sequentially and year-over-year. Management says this will correct in the back half. Consumer was held back as the company enhanced some features. According to 3DS there were no manufacturing glitches. Polymer printers accounted for some slow down as customers deferred delivery and SLA an SLS printers ended up in backlog. Metal printers continue to experience a bottleneck and capacity comes on line in 2015. Materials will recover when the printer backlogs and bottlenecks resolve.
Gross margins dropped 4% yoy and net and operating were down 6% and 11% for operating. Net and operating were impacted by large increases in R&D from an acquisition of an R&D unit and a substantial increase in SG&A to push sales of new printers.
Gross margin decline is a little more interesting because analysts were focused on a probable fundamental weakness in demand that signaled a big change in the business. Management was quick to reassure analysts several times during the call that the setback was temporary and gross margins were set to return to historic norms in excess of 50%. Temporary problems include transition to new product that is loaded with higher costs at launch although piling up of inventory would tell us this might not be exactly true. There’s a lot of new stuff still sitting on the shelves unshipped and not purchased. The other temporary problems are a one-time inventory write-down in the second quarter, the incremental cost of bringing several manufacturing facilities online and first half sales mix
“Gross profit margins are poised to rebound and resume their extension trajectory. Specifically we expect to begin to see materials margin recovery in the third quarter and further expansion thereafter. We see a rebound in printers.”From the CC
Gross profit for the quarter was $72.4 million and gross profit margin was 47.8%. The decrease in gross profit margin reflects the absorption of a one-time inventory write-off from our aggressive shift to multiple new products which accounted for a 1.3 percentage point compression, and the change in mix of sales which amounted to another two percentage points.Guidance
Guidance has not been revised down and revenue was adjusted up to reflect acquisitions. EPS were left the same indicating that acquisitions are not going to be accretive this year. Part of the failure to raise EPS guidance may be due to the dilution from cash raises from equity sales and shares used for acquisitions. Once more unto the H2 breach
There is one overriding important bottom line for 3DS and that’s the second half of 2014 better be incredible. Incredible for 3DS is organic growth of 30% or better and combined growth of 40%-50%. All segments need to perform and I would suggest all eyes will be on the success of the consumer printers and materials. That puts an outsized level of pressure on the back half results and if 3DS falls short anywhere, it’s going to get even uglier. I don’t have a clear prediction for how H2 will turn out. Avi Reichental is a salesman and nothing negative ever comes out of him. He has been missing guidance and projections the last few quarters and it sometimes looks like selling the company to analysts is more important than honest evaluation.