The 3-D printing industry is up and coming, and two companies -- 3D Systems (DDD 3.92%) and Stratasys (SSYS 3.74%) -- are leading the way. Both are growing organically and via acquisitions, and their stocks have been pretty volatile.
However, there have been a few articles published recently on Seeking Alpha -- one by Gray Wolf Research and one by Douglas W. House -- and one by Fool blogger Adam Levy, that have called into question the accounting practices of Stock Advisor recommendation 3D Systems. Frankly, it seems to me that these guys don't know what they're talking about -- especially Gray Wolf and House, who both go to considerable effort to support their conclusions. Levy was following up on what had been published by the other two.
Before I go any further, you need to know that I own shares of 3D Systems, and I work for Stock Advisor. At least one of the authors of the above linked articles was short the shares at the time of publication. (Gray Wolf disclosed its short position in its article.) Onward.
Merger accounting
I'm going to focus on the discussion in House's article that centers around acquisitions made by 3D Systems, and his claim that the way these are accounted for obfuscates what "true" organic growth at the company would be. Each of the above-referenced articles, however, makes, or at least mentions, this point.
What House seems to base a big part of his bearish case on is the practice by 3D Systems of including acquired business revenue into 3D Systems' own revenue and, after a year, calling any growth above that combination "organic" growth (that is, growth outside of acquisitions).
The claim is that this is not accurate for understanding "true" organic growth, and is therefore misleading. In essence, House is accusing the company of accounting high crimes and misdemeanors, using language like "employing dodgy accounting" (summing up what he got from the Gray Wolf piece), as well as "management ... is hiding something" and "the only reason ... is to obfuscate."
In support of his claim, he quotes 3D's CFO Damon Gregoire's (correct) explanation of how 3D accounts for mergers, and how it calculates organic growth, but then dismisses the explanation as a "scheme." House then goes to a lot of trouble -- and, in my view, wasted effort -- trying to ferret out what he believes "true" organic growth of 3D Systems is, measured against what the company is reporting.
House, in other words, is trying to see how the 3D Systems of several years ago "would have" grown if it had not acquired anything, without acknowledging that the company of today is not the company it was several years ago. That is entirely the wrong way to approach this. Let me explain.
In simple terms
Here is how acquisitions work, folks.
Company A buys Company B on 12/31/10. It has never made an acquisition in the past. At the end of each quarter ending 3/31/11, 6/30/11, 9/30/11, and 12/31/11, it reports total revenue (A + B) and may, though not always, break that down into "organic" and "acquired." Organic revenue would be what A generates on its own during 2011, as if it were a separate company, and acquired revenue would be what B does on its own during 2011, again as if it were a separate company.
However -- and this is important -- the further forward in time you go, the harder it gets to separate the two revenue streams. There's nothing misleading about this; it's just that A is busy integrating the operations of B into its own. Sales reps, secretaries, products, manufacturing, and so on.
After one year has gone by, the presumption is that this integration has gone on to such an extent that it is no longer practical -- or even possible -- to figure out which dollar of revenue came from B, and which came from the original A. Therefore, all revenue going forward is attributed to A -- the "base" revenue that Gregoire mentioned -- and revenue growth calculations going forward are now based upon this larger, integrated whole.
If A then buys Company C on 3/31/12, for the quarters ending 6/30/12 and 9/30/12 (and 12/31/12 and 3/31/13 when we get to them), it would do the same thing. Organic growth would be counted from the larger A that resulted from A + B, and acquired growth would be from C. Once 3/31/13 rolls around, all three would be "A," and we'd go from there.
There is nothing shady or dishonest about doing things this way. And if you think about it, you'll see why. Once operations have become commingled, how can you accurately separate them to fairly say this dollar of revenue and that dollar of expense belong to each entity?
Real world lack of silliness
If you want to see how silly House's (and Gray Wolf's) belief that such separation of revenue beyond a year really is, consider the following.
Coca-cola (KO +0.12%) has bought a lot of stuff in the past, including three Scandinavian soft drink and water brands from Carlsberg A/S for $225 MM, back in June 2008. Today, do we see any claims that sales from this acquisition should be split out and tracked separately so that investors can get a "true" sense of what Coca-Cola's growth would have been since then? Of course not; the idea is ludicrous. Then why should 3D Systems have to do this?
One year of seasoning
In short, once a year has gone by, it's assumed that the original company plus the acquired company are one big, happy family -- or at least kissing cousins -- with finances and processes so commingled, that it's useless to try to separate them. The financial statements reflect this; the company's discussion reflects this. But this is not the only situation where one year is long enough.
Consider retailer same-store sales (aka "comps" or "comparable sales"). This is the measure of how much more (or less) stuff stores open for at least a year have sold compared to the year before. The reason to exclude younger stores is to see how sales are doing at stores after they've had a chance to "settle in," so to speak, and to make an apples-to-apples comparison.
Once a new store has been open a year, however, its sales are added to the base, and everything is measured against that expanded base. I have yet to see anyone claim that sales from stores opened in, say, 2010 should not be included in the comps reported in 2012, because investors need to know what the "true" growth is.
Portfolio recommendations
The claims made by House wouldn't be so bad if nobody paid attention to them. Unfortunately, that's not the case. At least one investment advisor suggested that followers should sell their shares based upon House's claims of dodgy accounting. Cody Willard at MarketWatch told his Revolution Investor newsletter subscribers that, after reading House's Monday article, "I don't play with real fire and I certainly don't mess around with questionable accounting, because it burns too. I'm selling DDD on Tuesday."
In contrast, at Stock Advisor, we don't react with a knee jerk to potentially bad news. We look into things further, think about them for a day or two, and then decide. We may give up a few more points if the news is real and the stock slides further, but we'd rather be sure about our analysis.
Oh, and just in case you're wondering, 3D Systems remains an active recommendation at Stock Advisor.
Wrapping it up
Now, there might indeed be problems at 3D Systems, and House and Gray Wolf may have legitimate points. However, given that the two apparently don't understand the basics of how growth from mergers is handled, I wouldn't put too much faith into what else they wrote. It could be just as wrong.
