Although 3D Systems' (NYSE: DDD ) first-quarter 2014 earnings were driven by a 45% increase in revenue, 28% organic growth, and strong demand across its product portfolio, it wasn't enough to please Mr. Market. For the quarter, the 3-D printing giant brought in $147.8 million in revenue, translating to a net income of $4.9 million, or $0.05 a share on a non-adjusted basis. While these results were more or less in line with analyst expectations, the predominant storyline has been that investors were disappointed that 3D Systems only reaffirmed its full-year 2014 guidance; because it didn't raise guidance, it resulted in a 9% sell-off the day it reported. It also didn't help matters that the company's gross profit margin edged down 1.3 percentage points to 51.1% from the year prior.
At any rate, Foolish investors are always better off taking a step back from the noise to focus on the underlying operating results. On the business front, 3D Systems is making great strides to deliver improved operating leverage in the years ahead. Factor in the 50% year-to-date stock sell-off, and things start to get interesting for prospective buyers.
The pulse of business
3D Systems generates revenue from the sale of 3-D printers, the materials they consume, and by offering 3-D printing services that produce parts or repair existing printers. As a glorified razor-and-blade business model, the sale of a 3-D printer is an opportunity for 3D Systems to sell its more profitable materials over the printer's lifetime, which can last as long as 15-20 years, in many cases.
Thinking in terms of 3D Systems' razor-and-blade model and how the 3-D printing industry is expected to experience strong growth in the years ahead, it's currently in the company's best interest to grow its installed base of printers as quickly as possible while demand is strong. Again, the more printers 3D Systems can sell today, the more materials it can sell tomorrow -- at a higher profit.
Being this early in the 3-D printing adoption cycle, 3D Systems investors want to see 3-D printer growth outpacing materials growth because it improves the longer-term profitability outlook. Luckily, over the last two years, printers have been 3D Systems' fastest growing segment, and now represent more than 41% of total revenue, an increase of about 10%.
In the following chart, click on the radio buttons to toggle between the different periods and then hover over the pie chart to see how 3D Systems' revenue mix has shifted in the last two years.
A slight detour
As 3-D printer sales began making up a greater percentage of 3D Systems' total revenue, it started weighing on the company's gross profit margin, simply because the printers themselves carry a lower profit margin than the company average.
Although it's currently in 3D Systems' best long-term interest to sell as many 3-D printers as humanly possible, it comes at the expense of lower gross profit margins in the short term, which investors don't always take kindly to. The ace in the hole for long-term investors is that gross margins around materials sales continue to edge up and are ridiculously lush at nearly 75%. The thinking here is that when 3-D printer sales eventually slow at some point in the future and begin making up a smaller percentage of 3D Systems' total revenue, it will allow material sales to have a greater positive impact on overall gross margins and profitability.
Investors should embrace gross margin declines caused by printer unit growth because the evidence suggests that 3D Systems' operating leverage will not only be quite strong in the future, but it will likely result in margin expansion. In terms of timing, management expects that operating leverage will be "fully restored" in 2016, so investors should get a taste of 3D Systems' earnings potential in late 2015.
A better destination
3D Systems has been hard at work investing heavily in R&D and building out its sales channel in an effort to grow its leadership positioning and market share in the 3-D printing industry. In the first quarter, total operating expenses nearly doubled from last year to about $66 million, representing 45% of total revenue for the quarter. R&D spending surged 165% as a result of 3D Systems' recent Xerox R&D acquisition, and operating expenses have ballooned so much in recent quarters that it's seriously cutting into overall profitability.
While ballooning expenses can certainly pose a significant risk to any business, it could also be argued that 3D Systems is taking the necessary measures to solidify its market positioning in an industry that's rapidly evolving. Unless proven otherwise, 3D Systems' investors should continue to place their confidence in management that the investments it's making today are temporary and will ultimately improve the long-term outlook of the business. After all, the evidence already suggests that 3D Systems knows how to make good investments.
Since December, 3D Systems has announced a total of 24 new products, many of which are expected to ship in the second half of this year. While this highly diversified approach to 3-D printing has its merits, it also comes with its fair share of risk -- in the form of inventory buildup.
If 3D Systems built up its inventory in anticipation of strong sales, and those sales didn't pan out as expected, it could potentially force unsold inventory to become obsolete or outdated. Under this scenario, 3D Systems would likely have to write-off any related inventory at a full or partial loss. Of course, this potentially worrisome situation isn't guaranteed to come true, but surging inventory levels are still something investors should always be watching.
It's worth noting that management believes it has completed the necessary inventory buildup to support the various product releases it has planned later this year. Once 3D Systems begins shipping these products, investors should expect to see inventory levels begin to decrease in future quarters.
Also, it now takes 3D Systems 86 days, on average, to collect payment after a sale has been made, a metric known as days sales outstanding, or DSO. While management expects that DSO will normalize around 77 days in the coming quarters, investors should continue to monitor DSO, because the longer it takes 3D Systems to receive payment, the longer turnaround it faces to reinvest that cash back into the business.
Distilling it down
The major risks facing 3D Systems and its stock today can be distilled down into the three categories, with underlying themes:
- Operational: Anything that involves the inner-workings of the business, whether it's mismanaging inventory, not getting paid in a timely manner, or just general operational issues, could negatively impact 3D Systems' business results.
- Competitive: Companies with unlimited resources, start-ups, and even governments will continue to threaten 3D Systems' business and positioning.
- Valuation: Even after a 50% sell-off, by no means are shares of 3D Systems cheap. Shares currently trade at nine times trailing-12-month sales with a forward P/E ratio of 40.
The million-dollar question for investors is whether today's price is worth more than its risk, and the answer ultimately depends on if 3D Systems' can turn the promise of operational leverage into meaningful results for the business and investors alike -- all while successfully navigating its challenges. As we inch closer to 2016 and 3D Systems' operational leverage begins to be restored, investors should be able to gain a greater understanding of the company's true earnings potential.
Thus far, management has proven that it knows how to make the right kinds of investments, instilling confidence that it will continue to position the company for an increasingly bigger payoff down the road. In the context of 3D Systems' stock and its 50% selloff, paying $5 billion for a company that's in a dominant position of an industry expected to be worth $10.8 billion in 2021 is starting to get interesting.
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