A Deeper Dive Into 3D Systems' Q1 Results

Shares of 3D Systems (NYSE: DDD  )  closed down 9.1% on Tuesday to $44.80, after the company announced its first-quarter 2014 results before the market opened. The leading 3-D printing company's adjusted earnings per share came in right at analysts' estimates of $0.15; revenue jumped 45% to $147.8 million, sliding past the consensus of $145.5 million; and the ever-important organic growth rate was a solid 28%. So, why the big sell-off on heavy volume?

Likely reasons for sell-off: expectations, margins, and profitability
Expectations were the primary reason for the sell-off, in my opinion. Granted, 3D Systems' results came in essentially in line with both earnings and revenue estimates, but investors were hoping for beats, especially on earnings, as the consensus had edged lower recently.

More importantly, investors were surely hoping for a bump up in 2014 guidance, whereas the company merely reaffirmed its previous guidance, which analysts consider low on the earnings side. 3D Systems expects 2014 revenue in the range of $680 million to $720 million, adjusted EPS between $0.73 and $0.85, and GAAP EPS between $0.44 and $0.56. The analysts' consensus for revenue of $701.1 million falls right at the mid-point of the company's revenue guidance range; however, analysts are expecting adjusted EPS of $0.81, which is closer to the high end of the range. At the midpoint, the guidance represents an adjusted earnings decrease of 4.7% on revenue growth of 36.6%. It seems to me that it was unrealistic to expect a guidance increase just four months into the year, so I don't view the lack of a bump up in guidance as a negative.

Compression in the company's gross profit margin was a possible contributor to the sell-off as well. Gross margin for the quarter was 51.1%, down from the previous quarter's 52.4%, and also less than the trailing-12-month average of 52.1%. There was good reason for this slight dip: Printer sales grew faster than sales of print materials, and materials have the highest profit margins. This fact actually bodes well for future material sales – the more printers sold now, the more materials customers will need going forward.

While investors knew to expect a decrease in profitability, the reality was likely a hard one for some to take. 3D Systems' adjusted EPS of $0.15 was down 29% from the year-ago period, while its EPS on a GAAP-basis of $0.05 represented a decrease of 17%. This decreased profitability is due to the company's growth strategy of sacrificing short-term profits for spending on activities aimed at fueling long-term growth and capturing market share. 

Lastly, there's the possibility that some investors viewed the company's organic growth rate of 28% as reason for pause. Granted, organic growth was down considerably from last quarter's 34%, but quarterly metrics will vary for all kinds of good reasons, so it's usually best to compare metrics to trailing-12-month averages. The slight dip from last year's 29% organic growth rate isn't a concern, in my opinion, though, organic growth remains a key metric to monitor. 

A possible under-the-radar yellow flag if it continues: operating cash flow
There remains a considerable disparity between 3D Systems' reported operating income and its cash flow generated from operations. The former was $9.5 million in the quarter, and the latter was $308,000. In other words, on a cash basis, the company barely eked out an operating profit.

This situation existed last quarter, but to a much greater extent, and I explained in this article why this mattered. Quarterly fluctuations in cash flows, largely attributed to inventory, are to be expected when we're dealing with a company that has 3D Systems' growth dynamics. That said, this metric should be watched closely going forward, as there could be cause for concern if this divergence persists. 

Bright spots: print materials, demand for metals printers, and health care
First, a breakdown of revenue:

  • 3-D printers and other products: Revenue jumped 53% to $60.8 million, accounting for 41% of total revenue.
  • Print materials: Revenue increased 41% to $40.4 million, accounting for 27% of total revenue.
  • Services: Revenue rose 38% to $46.6 million, accounting for 32% of total revenue.
  • Healthcare segment: Revenue grew 53% to $21.7 million.
  • Consumer segment: Revenue soared 150% to $9.7 million.

The growth rate for materials is accelerating, which is a considerable positive, as this category has the highest margin. Revenue generated from materials rose 41% in the quarter, up considerably from 2013's growth rate of 24%, and up slightly from the fourth-quarter's 39%.

3D Systems' metals printers business continues to look like a bright spot. The company noted that its backlog at the end of the quarter "included $17.9 million of printer orders, in part reflecting increased demand for the company's Direct Metal 3D printers, which continues to outstrip manufacturing capacity." I would like to have known how much revenue was generated from sales of metals printers in Q1, but -- unless I missed it -- none of the analysts asked this question during the conference call.  

As to this business, 3D Systems generated $14.3 million of revenue from sales of its direct metal printers in 2013. This represented a very small portion of its overall revenue, simply because the company only recently acquired metals printing capabilities when it bought Phenix Systems last summer. During last quarter's call, CEO Avi Reichental forecasted a huge ramp-up in revenue from this business:

Metals is in the beginning stages of what we believe is a very exciting journey. As we have said repeatedly now, we have been sold out of capacity every quarter since we acquired this business [Phenix] and we expect that this year it could generate some place between $25 million and $50 million in revenue and it's just the beginning

Notably, the company's health-care revenue grew faster than its overall revenue. In 2013, this segment grew in line with total revenue, with each increasing 45%. Reichental stated on the call that the health care market "remains one of our fastest-growing verticals as we continually focus on expanding our applications and reach." Investors should expect to see growth in this space remain strong, given 3D Systems' announcement last month that it was acquiring Medical Modeling, which uses 3-D printing to produce anatomical models for surgical planning and manufactures medical devices. This acquisition is expected to be "immediately accretive" to the company's earnings.  

The consumer segment continues to grow nicely, but I don't consider this one of the top bright spots. The big money is being made in the commercial and industrial markets, and it seems to me that this will continue for quite some time.  

Foolish final thoughts
3D Systems turned in a solid earnings report, and there doesn't appear reason for long-term investors to not stay the course. The 3-D printing sector is projected to grow more than 20% annually through 2021 -- an estimate that I think will prove conservative -- and 3D Systems remains one of the top players in this fast-growing space. 

After Tuesday's 9% sell-off, 3D Systems' shares are selling at 37.3 times 2015 earnings, a reasonable valuation for those who are fairly confident that the company's growth initiatives will pay off in the long-term. Those who aren't so confident and the more risk-adverse investors, however, might want to wait to see if management's expectation of a greater portion of 2014's "revenue and earnings to be generated during the second half of 2014" materializes before jumping in.  

In addition to the headliner revenue and EPS numbers, gross margin, organic growth, and operating cash flow continue to be key metrics to monitor going forward. 

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