A Deep Dive Into 3D Systems, Part 4: How Healthy Is Inventory?

The stock price for 3D Systems (NYSE: DDD  ) fell 37% in the first three months of the year -- and has gone down further since. If you're an investor, this should probably raise your eyebrows and cause you to ask what's going on.

In the previous article in this series, I showed why investors should be concerned about the amount the company has been spending on capital expenditures. Today, we'll look into how well management is managing inventory and running cash through the business. Is there something to be worried about here, as well?

As before, I'll start off with an explanation of what's being looked at and why, present the data and talk about it, and then wrap it up with some conclusions.

Inventory control is important!
I know I'm stating the obvious, but many companies sell "stuff" -- including chips (potato, not silicon), other chips (silicon this time), and clothing. Companies have to buy those clothes and chips and stuff or buy the raw materials to make the stuff. This stuff available for sale, of course, is inventory, and strong companies manage it well.

Investors need good inventory management, because, frankly, inventory can tie up a lot of capital. The company spends cash buying its inventory, but until it actually sells it, that cash is sitting in a warehouse or on a shelf somewhere, unavailable.

If management is on top of its game, however, cash rapidly moves along the path of buying inventory to selling the products to collecting payment.

That's the cash conversion cycle, and when it's humming along, cash moves through the business pretty quickly. If management misjudges demand, however, the company ends up with a lot of inventory sitting there with no way to get the cash back out. And that can lead to "70% off sales" to move product or outright junking inventory paired with a writedown, both of which hurt earnings.

The question here, though, is to ask whether this is happening at 3D Systems. Before I answer, let me give just a bit more explanation. If you already know about the cash conversion cycle, however, feel free to skip ahead.

Inventory and the cash conversion cycle
Parts of inventory
. Inventory is a single line on the balance sheet, but as I hinted at, it actually consists of three parts: raw materials, work in progress, and finished goods. By digging down to this level, you can learn how inventory is split up and get a sense of what's happening.

For instance, raw-materials buildup could mean the company's gearing up to meet higher demand. Great! On the other hand, finished-goods buildup (assuming it's not a clothing retailer getting ready for the holiday shopping season) could mean demand is slowing down, and, in an extreme case, we'll be seeing some "70% off" sales. Not good.

Tying this into cash conversion cycle analysis gives real clues about the operating efficiency of the company and hints as to what might be coming.

The cash conversion cycle. Remember, the faster management runs this, the more flexibility it has about using cash, as well as less worry about liquidity problems, because it's not tied up in inventory or uncollected sales, aka accounts receivable, or A/R. Those are good things.

On the other hand, if the cash is locked into the inventory or A/R, the company has less flexibility, the risk of losing all or part of the cash (what if fashion tastes change on a retailer?), and more worry about having enough liquidity to survive.

The cash conversion cycle is a quick way to view this situation. It's measured in days, and is calculated as follows.

  • CCC = days sales outstanding [DSO] + days inventory outstanding [DIO] – days payables outstanding [DPO]
  • DSO = 365 / receivables turnover (for a one-year period)
  • Receivables turnover = revenue / average A/R
  • DIO = 365 / inventory turnover
  • Inventory turnover = COGS / average inventory (where COGS = cost of goods sold)
  • DPO = 365 / payables turnover
  • Payables turnover = inventory purchases / average accounts payable
  • Inventory purchases = ending inventory + COGS-beginning inventory

Turnover is how many times in the period (usually one year) that item is completely replaced. For example, an inventory turnover of 6 means that inventory is completely replaced six times a year, or every two months. (Remember, this refers only the accounting cost of inventory. Any given widget in inventory can actually sit there for years.)

Here's an example: When Dell introduced its "just-in-time inventory" system back in the day, it was able to get its CCC number below zero. That meant it was getting paid for what it was selling before it had to pay its vendors. This was like an interest-free loan from the vendors! Very powerful.

Wal-Mart Stores has a very low CCC of only 12 days. Over the past 12 months, it's collected on its sales every 4.7 days, it has 45 days of inventory (meaning it goes through its entire inventory every 45 days -- and for a company the size of Wal-Mart, that's impressive), and it pays its vendors in 37 days. Add it up: 4.7 + 45 – 37 = 12.7 days to cycle cash through the business. Efficient!

Applying to 3D Systems
Remember, last time I saw indicators that 3D Systems' management was not as on top of things as I'd like to see. Is that holding true for inventory management?

To find out, let's look to see where 3D Systems stands both on its own and among its peers in inventory trends (CCC trends is discussed in a moment). We're comparing 3D Systems with Stratasys (NASDAQ: SSYS  ) , ExOne (NASDAQ: XONE  ) , and, for comparison, Cisco Systems.

Ideally, inventory should grow roughly in line with revenue growth. Looking at several years of data lets us spot patterns and development. Following are the past six years, showing growth in each item on a year-over-year basis. (Note that there's limited data available for ExOne.)

Revenue

2013

2012

2011

2010

2009

2008

3D Systems

45.2%

53.5%

44.1%

41.7%

(18.8%

(11.2%)

Stratasys

125%

38.1%

26.9%

24.1%

(20.5%)

10.9%

ExOne

37.8%

87.4%

13.8%

 --  --  --

Cisco

5.5%

6.6%

7.9%

10.9%

(8.7%)

13.2%

             

Inventory

2013

2012

2011

2010

2009

2008

3D Systems

79.6%

65.4%

6.2%

29.6%

(12.6%)

4.9%

Stratasys

30%

198.6%

27.3%

22.4%

(26.6%)

55.7%

ExOne

 70.5%

68.9%

44.4%

 --  --  --

Cisco

(11.2%)

11.9%

12%

23.6%

(13%)

(6.6%)

             

Raw Materials

2013

2012

2011

2010

2009

2008

3D Systems

68%

131%

30.5%

193.9%

37.4%

61.7%

Stratasys

74.5%

103.3%

19.7%

30.2%

5%

18%

ExOne

 27.8%

128.9%

43.5%

 --  --  --

Cisco

(17.3%)

(42%)

0.9%

31.5%

48.6%

(35.8%)

             

Work in Progress

2013

2012

2011

2010

2009

2008

3D Systems

539.4%

(21.3%)

210.8%

(22.9%)

73.3%

15.9%

Stratasys

(94.7%)

876.7%

 --  --  --  --

ExOne

 183.9%

23.8%

10.8%

 --  --  --

Cisco

(31.4%)

(32.7%)

4%

51.5%

(37.7%)

17.8%

             

Finished Goods

2013

2012

2011

2010

2009

2008

3D Systems

54.6%

33.3%

(3.4%)

3%

(17.2%)

5.5%

Stratasys

11.8%

301.7%

33.6%

12%

(47.5%

97.5%

ExOne

 11.9%

(17.5%)

1077.6%

 --  --  --

Cisco

(15.3%)

24.7%

14.9%

24%

(17.6%)

(1.5%)

Source: S&P Capital IQ. Years are fiscal years.

For 3D Systems, work in progress is going up and down like crazy, possibly as a result of its acquisition spree of the past few years. More important, raw material inventory is growing faster than revenue over the past couple of years, which is probably good, assuming the company is growing this to meet demand.

Finished goods inventory is growing roughly the same as revenue over the past couple of years, which is good as well. Yes, I see that it's faster in 2013. However, it's not so much faster as to cause me concern. We'll have to see what 2014 does, however.

What's the CCC telling us?
Next, we'll look at the cash conversion cycle, paying attention to changes over time. Here's the data for the same set of companies:

Days Sales Out

2013

2012

2011

2010

2009

2008

3D Systems

75.4

67.8

68.9

68.0

79.3

74.3

Stratasys

66.2

83.1

59.8

68.4

98.2

88.2

ExOne

 80.7

65.0

53.3

 --  --  --

Cisco

65.7

62.6

63.3

55.5

49.6

45.8

             

Days Inventory Out

2013

2012

2011

2010

2009

2008

3D Systems

86.8

71.2

73.8

89.6

113.9

90.1

Stratasys

110.7

157.7

101.0

96.0

119.7

102.9

ExOne

 154.6

132.0

117.5

 --  --  --

Cisco

30.1

32.0

31.0

30.9

32.3

32.8

             

Days Payables Out

2013

2012

2011

2010

2009

2008

3D Systems

54.8

56.2

77.9

79.0

90.9

82.1

Stratasys

46.3

53.2

37.1

34.4

41.8

34.8

ExOne

 26.3

31.0

25.9

 --  --  --

Cisco

18.3

17.5

19.4

19.9

21.8

21.4

             

Cash Conversion Cycle

2013

2012

2011

2010

2009

2008

3D Systems

107.4

82.9

64.8

78.6

102.3

82.3

Stratasys

130.6

187.6

123.6

130.0

176.2

156.3

ExOne

 209.0

166.1

144.9

 --  --  --

Cisco

77.5

77.1

75.0

66.5

60.0

57.3

Source: S&P Capital IQ. Years are fiscal years.

Cisco's CCC is rock steady from 2011 to 2013, with an eight-day or so jump between 2010 and 2011, mostly because of a similar-sized jump in DSO.

In contrast, 3D Systems's CCC was doing OK in 2010 and 2011 but has rapidly climbed in the past couple of years. It's paying its vendors more quickly (declining DPO, not a good sign), and letting DSO and DIO both increase in 2013 -- not good. I would really want to see this trend reverse, and CCC start dropping again.

Stratasys, on the other hand, saw a big spike in CCC in 2012, but it's brought that back down to previous levels in 2013. I think the level is still pretty high, especially compared with 3D Systems, but it's moving in the right direction.

Looking at a slightly more detailed level, here's a chart showing the DSO, DIO, DPO, and CCC numbers for 3D Systems on a rolling trailing-12-month period.

Source: S&P Capital IQ.

It's obvious that DPO is going down and that CCC is going up over time. Also climbing are DSO and DPO (I've added a trendline for both to make this clearer). Unfortunately, those trends are all in the wrong direction.

Conclusion
This issue is a definite yellow flag for 3D Systems. I do not like the increase in CCC, and all three components have been moving in the wrong direction over the past couple of years. Maybe management's focus on acquisitions over the past few years has pulled its attention away from operational efficiency. Regardless, from this analysis, it seems that something has distracted management from running the company as efficiently as can be done, and I'd prefer to see management regain its focus.

Next up are a pair of articles that look at three sets of ratios that focus more on the company's health, rather than management's efficiency: how fast the company can lay its hands on cash, how indebted it is, and how profitable it is.

Readers can find each article in the series by clicking here.  

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