The Key to 3D Systems' Future Earnings

When a company is growing as quickly as 3D Systems (NYSE: DDD  ) , in an industry with tremendous promise, it can be difficult to gauge the importance of earnings. Do you ignore profit while the company builds sales? And if the quality of those earnings is difficult to assess because of recent acquisitions, should you just focus on the company's valuation versus its peers?

The short answer is that earnings always count, and even in situations where the herd is snapping up shares largely for future potential, understanding a corporation's current profit or loss can arm you with the confidence to either to jump in or pass on the opportunity. Moreover, it can illuminate which aspects of earnings will be important in the future.

A considerable GAAP
Like many other companies, 3D Systems includes non-GAAP earnings and metrics in its earnings releases and SEC filings. GAAP is an acronym for "generally accepted accounting principles," and publicly traded companies are required to file their financial statements under these guidelines, which seek to ensure that the economic reality of a company is reflected across its financial statements. Corporations are allowed to provide alternative numbers alongside GAAP earnings. According to its most recent SEC filing, 3D Systems asserts that it uses non-GAAP earnings to help investors better understand the impact that numerous acquisitions have had on the company's results.

In the first six months of 2013, 3D Systems' non-GAAP, or "adjusted," earnings were roughly 2.5 times greater than GAAP earnings ($0.40 per share and $0.16 per share, respectively). This is an increase over 2012, when non-GAAP earnings were 1.75 times higher than GAAP earnings in the first six months.

How does management arrive at these adjusted numbers? The most prominent item the company strips out on a consistent basis is amortization of intangibles. In the first half of 2013, adding back amortization improved earnings by nearly 40%.management understandably wants to remove amortization to arrive at what it believes to be a more representative portrayal of earnings. After all, it's a non-cash number -- a way to assign expense to intangible items. Does the expensing of items like patents and licenses really have any bearing on the day-to-day operations of the company?

In 3D Systems' case, amortization has everything to do with earnings, and you should read management's non-GAAP presentations, but not rely on them as the primary view of results. The reason stems from the path the company has taken to grow. If you follow 3D Systems, you're probably aware that it's a serial acquirer of other companies. After sleepily plodding along for most of the 2000s, it began buying up smaller 3-D companies in 2010, and since then, it's been in a royal hurry to acquire revenue and stay ahead of rivals such as Stratasys (NASDAQ: SSYS  ) . Since 2010, the company has generated $125.3 million in operating cash, yet it has raised almost $590 million through stock and debt issuances, and it's used up $381.7 million of that cash to fund acquisitions.

As a result, goodwill and other intangibles are now the largest assets 3D Systems owns. The following table and chart give us a sense of the proportion of these assets to tangible assets:

Balance Sheet Category Size in Dollars
Goodwill and Intangible Assets $437,567
Cash and Equivalents $349,255
Accounts Receivable, Net $111,459
Inventories $49,771
Equipment, Net $36,466
All Other $19,847
Total $1,004,365

Source: company SEC filings. All dollar figures in thousands.

In the case of 3D Systems, which, after raising more than half a billion dollars in cash, has only $36.5 million of property and equipment on its balance sheet, you need to have some measure to gauge how successfully the company is making use of its intangible assets. Amortization sets a reasonable bar to help the average investor determine whether management is effectively employing the patents, licenses, technology, software and trade names of the companies it buys. Is enough income being generated to offset the decay of the intangible assets that drive the earnings power?

Here's a case in point: In its SEC filings, 3D Systems discloses that it has spent $89.6 million cumulatively on the acquisition of customer lists. Accounting for the portion that has already been amortized, that's still $77.6 million, or nearly 8% of the entire asset base, that's been attributed to customer acquisition. As a shareholder, you want to follow the amortization of this asset, and you want to see net income on the books even after the amortization is taken into account. In this way you'll be comfortable that 3D Systems is using its customer lists in an efficient and profitable manner. In a global sense, because of the amortization of intangibles, 3D Systems has a much higher cost of sales (both operational and general/administrative) than one might realize from just looking at non-GAAP earnings.

Goodwill: not amortized, but significant
Goodwill presents a slightly different situation. In financial reporting, goodwill is a balance sheet account. When a corporation acquires another company for more than book value, it records the excess in this account. Companies are no longer required to amortize goodwill; rather, they test goodwill each year for "impairment." Expense is recognized only if management determines that the value of the goodwill has declined.

For 3D Systems, which has grown primarily through acquisition and has a proportionately large goodwill account, reviewing GAAP earnings can help an investor discern whether the company is generating reasonable income from the acquired assets. While there is no recurring amortization bar as with intangible assets, prolonged GAAP losses are a potential flag that a company has overpaid for its acquisitions.

Earnings going forward
So far, 3D Systems has credibly delivered earnings on a GAAP basis: It's shown a profit in each of the past three fiscal years since beginning its acquisition spree. Going forward, look for differences between unadjusted net income and non-GAAP earnings to decrease over time, as organic revenues replace acquired revenues, and net intangible assets decrease because of amortization. Increasing GAAP income will be a decent indicator of 3D Systems' progress. But decreasing GAAP income in the future will serve as a cautionary flag -- a reason to peel back the onion when reading through the company's quarterly earnings, and reach comfort (or not) with the stock price, given the company's typically high valuation.

3-D printing has the potential to change the global manufacturing landscape. With the U.S. relying on the rest of the world for such a large percentage of our goods, many investors are ready for the end of the "made in China" era. Well, it may be here. Read all about 3D Systems and fellow industry disruptors in "3 Stocks to Own for the New Industrial Revolution." Just click here to learn more.


Read/Post Comments (23) | Recommend This Article (94)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 26, 2013, at 8:21 PM, enIWon wrote:

    "Do you ignore profit while the company builds sales?" - Ask Amazon the same question in 2009.

    "The short answer is that earnings always count" - Nope, you are definite wrong. 2000 tech bubble would never be possible to your assumption.

  • Report this Comment On August 26, 2013, at 8:45 PM, TMFfinosus wrote:

    Hi enlWon,

    As it happens, I'm skeptical about Amazon's long-term prospects and have written on this topic extensively. As for the 2009 bubble, we can both be right about this one. I grant your logic, but of course, without earnings, most of those companies disappeared (similar to other market bubbles). Turns out earnings didn't matter while the bubble expanded -- they meant everything later on.

    Cheers,

    Asit

  • Report this Comment On August 27, 2013, at 7:17 AM, viperciara wrote:

    I can not believe Citigroup upgraded this to a buy and quote "The Motley Fool recommends and owns shares of 3D Systems and Stratasys and has options on 3D Systems." , if this was a bad investment! I agree with EnlWon, Amazon has paid off nicely! Amazon back in 2009 was around $50 a share today $286, $41 this year alone! Quote "As it happens, I'm skeptical about Amazon's long-term prospects and have written on this topic extensively" I am glad I did not see a article from you back in 2009 about Amazon! 3D printers are, are future! Just think of the medical field, knees that are your exact replica being produced while your in surgery, teeth or dentures being made in the denist office while yours are being pulled, artifical limbs that are exact matches! This will be happening soon! Think off all the things it will improve in manufaturing, how about are daily lives! You need to google 3D printing with these words behind it UPS, office depot, staples just to mention a few. This is the future and it is here now! The custermers are here now! I can not believe people have a chance to get into the ground floor of this business and everytime the stock goes up somebody on this board post a article using soft bashing to make people stand back! I am a strong buy on 3D printing and have been for a while! You mention nothing about SSYS or XONE I think at thier prices are way to high for what the company holds! DDD has made good moves in putting thier money now to be ready for what tommorow brings, good investments are a companies best resoures! Please excuse my spelling and punctuation I know they are bad but I am far from uneducated!

  • Report this Comment On August 27, 2013, at 8:28 AM, TMFfinosus wrote:

    Hi Viperciaria,

    I'm not sure what in my article has you so worked up. This is a pretty neutral analysis of DDD's earnings. It's not telling you to buy or sell the stock. The purpose is to help investors better understand DDD's quarterly earnings.

    As for your point about competitors, there are literally thousands of articles explaining the industry,and comparing SSYS to DDD, XONE etc. That wasn't the purpose of this piece, although if you take the basic principles I put forward and go look at SSYS's earnings in particular, you'll see a somewhat similar earnings and balance sheet structure.

    I'm glad you're strong on 3D printing. It's certainly an industry for the future. There's much money to be made here. I'm neither cheering it on nor tearing it down in the analysis; simply trying to point out a single tool investors can use to get comfortable with these investments before they jump in.

    Thanks for weighing in. And by the way, your spelling's not bad at all.

    Best,

    Asit

  • Report this Comment On August 27, 2013, at 9:20 AM, viperciara wrote:

    I am sorry I took it the wrong way! I do not understand why you would use a stock like DDD that has such a upside and future? I guess I would have thought to use a stock that is more common and not the future of everyday life if I was descibing a tool used for investing>"I'm neither cheering it on nor tearing it down in the analysis; simply trying to point out a single tool investors can use to get comfortable with these investments before they jump in." I got the impression because you used DDD that you would wait before buying.

  • Report this Comment On August 27, 2013, at 11:17 AM, rianjones1983 wrote:

    Have a look at the details provided in this Canaccord Genuity's 33rd Annual Growth Conference Transcript @ http://www.earningsimpact.com/Transcript/82927/DDD/3D-System...

  • Report this Comment On August 27, 2013, at 11:37 AM, TMFfinosus wrote:

    Hi ViperC.,

    I chose it because it can be hard to make sense of rapid growth that occurs when a company buys up smaller companies (as does DDD) on its way to trying to build an edge in a new industry.

    Sounds like you've been long for a while. You've got a company that's already making money as it grows. While its high valuation gives me some pause, on the other hand, the longer your holding period, the less a high trailing or forward PE is an issue.

    Thanks,

    A

  • Report this Comment On August 27, 2013, at 11:43 AM, TMFfinosus wrote:

    rianjones1983,

    Some great stuff in there & thanks for sharing. I've read similar remarks in various earnings transcripts. One interesting theme: Gregoire is laying out all the reasons why DDD's acquisitions should transition into organic revenue. As usual he's pretty articulate in making the case for the company's future.

    Asit

  • Report this Comment On August 27, 2013, at 4:51 PM, chris293 wrote:

    Too much 'goodwill' has been the killer of many companies. Always, the bottom line tells the truth.

    Are the new additions (companies) adding to the profit/earnings within a reasonable time. When the numbers (GAAP) are in we will know for sure.

  • Report this Comment On August 27, 2013, at 6:26 PM, Dwightfish wrote:

    Any company using non-GAAP needs to be looked at like this. If they are carrying good will on the books, which is an ephemeral concept, and allowed to depreciate or appreciate it, it can be a cause for concern. Glad for this article.

  • Report this Comment On August 27, 2013, at 7:01 PM, TMFfinosus wrote:

    Hi Chris293 and Dwightfish,

    You've got a point about goodwill, although the rules regarding how goodwill is expensed are a bit different than they were a few years ago. I agree with the basic premise you both put forward. For a textbook example of what can go wrong if a company overpays, we need look no further than HP's fiasco with their purchase of Autonomy, and huge goodwill write-off last year. As Chris says, the bottom line does tell the truth. So far so good for DDD, but let's keep an eye on future unadjusted earnings...

    Asit

  • Report this Comment On August 27, 2013, at 9:03 PM, dsciola wrote:

    So if mgmt is the one that tests annually, quarterly, or whenever whether or not goodwill shuld be impaired, why then should they ever determine it is impaired?

    Seems to me a bit of a conflict of interest. Don't know the details of HP's impairment, but my guess was it was either so blatantly obvious their acquisition(s) fizzled or shareholders/the SEC essentially forced them to.

    My 2c...enjoyed article nonetheless

    Dom

  • Report this Comment On August 27, 2013, at 10:07 PM, TMFfinosus wrote:

    Hi Dom, interesting comments.

    Re: HP I think it was a case of Meg Whitman being new and cleaning house, plus the first of your guesses: the acquisition obviously wasn't panning out.

    There actually is some conflict of interest (imo) in the way goodwill impairment is tested. Theoretically management has to follow established standards, and auditors of course sign off on the financial statements. But management knows best if an asset is impaired, auditors tend to defer on the finer judgement calls, and thus it would seem that potential conflicts of interest can occur if a company doesn't want to take a hit on their P&L...

  • Report this Comment On August 30, 2013, at 3:06 PM, howiem2001 wrote:

    I was completely unaware of 3D technology until I joined Motley Fools. Their initial article just blew me away and I have been acquring shares for about a year. Thank you fools. I also bought shares in a lightly traded stock called Perceptron. They are a component supplier for 3D tech, among other things. The company just had blow out earnings on their report this week and the stock roared up over 20%. I would take this as a big positive sign for the 3D industry going forward.

  • Report this Comment On August 30, 2013, at 3:38 PM, jackierv wrote:

    It was stated that you have options on DDD - well I was just approved by my broker for covered calls and would like to try it with my DDD shares. I think I know the rules, but where can I learn the smartest way to proceed?

    Thanks.

    Jackie

  • Report this Comment On August 30, 2013, at 5:03 PM, dmvcal wrote:

    The article author is correct. His analysis is neutral & objective. Unlike his brain mine is 90% left skewed: it is from that perspective that this Wharton MBA lauds his insight. Those who bring a highly emotional preconception to the party would best be advised to not manage their own assets.

  • Report this Comment On August 30, 2013, at 5:48 PM, TMFfinosus wrote:

    Howeim2001, I'm not very familiar with Perceptron -- they are quite small in terms of sales, so it would be difficult to gauge what this says about the 3D printing industry. However, it's a time-honored practice to study the movements of the suppliers of a growing industry, so maybe keep your eye on them. TIme will tell...

    Asit

  • Report this Comment On August 30, 2013, at 6:06 PM, TMFfinosus wrote:

    Jackierv,

    I have three great resources for you. First, please read up on the following options FAQ on our site:

    http://www.fool.com/FoolFAQ/foolfaq0055.htm

    Second, not to sound too self-serving, but our Motley Fool Pro newsletter is a great resource for both long-term investing and writing options for income.

    Third, the Options Institute, run by the CBOE, is a must-read website if you are just getting your feet wet in options trading: http://www.cboe.com/learnCenter/OptionsInstitute1.aspx

    Remember to paper trade for a few weeks (or months) if you can. Writing covered calls can be more difficult than it appears on the surface, but it can be a rewarding strategy, especially in a sideways market (which potentially we could occur in the next year or so).

    Thanks for the question,

    Asit

  • Report this Comment On August 30, 2013, at 6:09 PM, TMFfinosus wrote:

    dmvcal,

    I appreciate the comments. I would gladly trade my left brain / right brain split for your 90% left skew and Wharton MBA!

    Best,

    Asit

  • Report this Comment On August 31, 2013, at 2:36 AM, corkbouy wrote:

    You give informucials for items wE ALREADY SUBSCRIBE AND DON;T OFFER A 'SUBSCRIBERS' LINC. wHAT GIVE WITH THAT!

  • Report this Comment On August 31, 2013, at 10:30 AM, Streator57 wrote:

    A bit on goodwill from a recently retired CPA. First goodwill is tnot the excess of purchase price over book value of the acquired company. First, using DDD as the example, when DDD acquires a company they must put a value on all of the intangible assets of the target that GAAP doesn't allow them to record, such as the value of customer relationships, patents, etc. It's weird, but GAAP doesn't allow a company to record intangibles that it develops but it does allow those assets to be recorded when one company buys the other.

    Economically, goodwill usually is attributed to one of two things (or both) -- the value of the assembled workforce of the target company (which can't be recorded as an asset) and any excess earnings potential. If you read the footnotes to the financial statements when DDD records an acquisition, you should see them explain why they recorded goodwill.

    Finally, to the comment about management's conflict of interest in impairing goodwill -- yes, it exists but the control over that is the auditor, who checks for potential impairment.

  • Report this Comment On August 31, 2013, at 12:23 PM, TMFfinosus wrote:

    Hi Streator57,

    Thanks for commenting. I believe the definition I used, while expressed for our general readership and not necessarily for a more specialized audience, is nonetheless correct, as it conforms to FASB's basic allocation principles of purchase price of net assets less fair value of net assets acquired.

    I'm not sure I agree with how you've stated your definition. If we do want to get technical here, in a purchase, the steps to record are as follows:

    1)Net tangible assets less net tangible liabilities

    2)Identifiable net intangible assets (you mention these, and I do as well in my article, but again, this is not goodwill as you seemed to imply)

    3)The residual after the first two steps, commonly called goodwill.

    I agree with you it's weird that you can't record the non-tangible value you develop!

    Re: economic substance: In the transactions I have worked on in my career, it's not the first but the second point of your points that seems to drive the economic substance of goodwill: the excess earnings potential.

    On your last point, would you agree with me that the conflict exists, and the auditor is the defense against this conflict? Because I'm skeptical on the whole mechanism -- the defense is only as good as the auditor, who may or may not be a subject matter expert on the intangibles he or she needs to sign off on.

    Anyway, really great comments. Even for those in the profession, Goodwill is not easy to get a handle on -- it's fun to engage on this stuff.

    Best,

    Asit

  • Report this Comment On August 31, 2013, at 7:27 PM, Streator57 wrote:

    Agreed, this is technical stuff -- and you're exactly right re: the need to identify and record identifiable intangibles before getting to the residual, called goodwill. However, often one of the valuable assets of an acquired company is its human capital -- the assembled workforce. GAAP chooses to ignore this asset.

    That isn't to say that excess earnings potential isn't often the reason to pay up for an acquisition.However, in DDD's case, for all of the acquisitions they made in 2012, only one apparently had any significant revenue (see Note 3 to their 10-K financials -- all acquisitions were reported as insignificant except for Z Corp and Vidar). So, my guess is that most of the goodwill was related to acquiring human capital.

    Interestingly, I can't find that DDD made the required disclosure under GAAP of why they paid up for their acquisitions.

    And, you're right that many auditors do not have the expertise to evaluate the value of intangibles (although the large firms usually have the expertise in-house). So, the right course of action for the auditor is to hire a 3rd-party expert to help them with the valuation. There is a very large consulting industry out there that supports auditors (and companies like DDD) with valuations of intangibles.

    Complex stuff -- but all non-cash. It's one reason I pay as much attention to cash flow from operations as I do to earnings in a company like DDD.

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