Are Investors 3-D Printing a Bubble?

It seems that every time I write about the sky-high valuations of 3D Systems (DDD 3.66%) and Stratasys (SSYS +0.45%) they just keep on trekking higher (you're welcome!). There is no doubt that the 3-D printing industry will continue to grow and find new customers and applications. According to The Wall Street Journal, analysts estimate that 3D Systems and Stratasys will grow 45% and 39%, respectively, in each of the next three years. However, as more and more investors pile into the companies you have to start asking the question: "Is this a bubble?" Let's go through some valuation experiments below.

The anatomy of a bubble
How does a bubble form? I'm no expert, but I saw this worrisome underperform pitch for 3D Systems from CAPS member LoveMeSomeGreen last week: "People who have never invested a dime in the stock market their entire lives are asking me about 3D Systems and frothing at the mouth to get in at ($60 per share)." That worries me because I've fielded more than one question about 3-D printing companies from friends with little to no investing experience. Gains of several hundred percent make great water cooler talk, but they could be a dangerous trap for investors.

Does the entire 3-D printing industry get a free pass? I don't buy the argument that 3D Systems and Stratasys get a free pass for being the leaders in the industry, either. Big, successful companies can be overvalued without going bankrupt; one doesn't imply the other. Must we remind ourselves of industry leaders around today that tipped the rationality scale in the early 2000's?

Source: Historical data provided by Google Finance

It took Microsoft and Oracle over 10 years to fight back to their valuations from the turn of the century. While there are many differences the underlying message remains the same: the dot-com bubble grew to historic heights as investors overlooked valuation metrics and put their faith in the awesome potential future of the Internet. Sound familiar?

Will acquisitions payoff or make you pay?
3D Systems made 16 acquisitions in 2011, while Stratasys and Objet merged last year to form the current $3.7 billion company. Industry consolidation happens all of the time and with several large companies racing to acquire assets there are big premiums to pay. This is obviously the case in 3-D printing, but should we be so quick to dismiss the numbers? Take a look at a side-by-side comparison of the types of assets, and growth of each, for the two companies:

Source: 3Q12 data provided by 3D Systems, Stratasys. * Intangible assets include intangibles + goodwill.

Not only are investors paying a hefty premium to share in the growth of 3D Systems, but they are also paying a huge premium on the company's useful assets. For sake of experiment, let's say the company wanted to write down goodwill to a more acceptable 20% of total assets (my threshold). The non-cash charges would total nearly $185 million and total assets would weigh in at just $475 million.

Both companies have witnessed intangible asset growth of over 500% over the last three years, but Stratasys has still managed to keep its intangible asset ratio (IAR) at a reasonable 20.2%. We will see how that changes when numbers for the Objet merger start rolling in, but I'm not expecting any shockers. Objet wasn't a hopeful start-up. In fact, it was nearly the same size ($1.4 billion) as Stratasys ($1.63 billion) at the time the merger was announced.

Of course, I've never heard any investor say they are buying the companies above for asset growth. It is also important to note that goodwill proves useful in valuing incalculable metrics like brand recognition and human capital. Nonetheless, a high IAR could mean management is paying too much to close deals meant to grow the company.

Although writing down goodwill is a seemingly painless, non-cash, one-time charge that doesn't affect cash flow, it also means management threw money away at some point in the past. And it does have a direct effect on shareholders' equity. Ask Hewlett-Packard (HPQ 0.14%) investors how they feel about their company blowing $8.8 billion of an $11 billion deal for Autonomy – just another in a long line of writedowns for the company. I'll bet 3D Systems wouldn't mind an additional $185 million in cash on the balance sheet (double 3Q12 levels).

Bitter or sweet?
Intangible assets aside, the recent run-ups for the two 3-D printing giants are causing growth valuations to turn sour for some investors. As I mentioned above, analysts have penciled in some amazing growth rates for the next three years. But with P/E ratios in the triple digits for both companies, investors should certainly question if their money is better placed elsewhere.

Again for the sake of experiment, let's consider what P/E ratios the companies would sport in 2016 if targeted growth rates are achieved and shares prices are frozen. Growing at 45% per year 3D Systems would have a P/E ratio of 18.22, while Stratasys would have a P/E of 23.2 assuming annual growth of 39%. Both are respectable, but the experiment suggests there may be little to no return ahead for investors at current prices. 

Consider that industrial powerhouses like Precision Castparts, which produces metal castings for engines and turbines, trades with a P/E of 22. Allegheny Technologies produces metal alloys and replacement parts for specialty aircraft engines and trades with a P/E of 21. Furthermore, both companies have paid dividends for at least 10 straight years. Just saying.

My analysis is not airtight and both companies could continue to blow by analyst expectations. I just feel the current madness will have to stop eventually. Perhaps investors are better off looking at secondary markets for 3-D companies, where valuations are much more reasonable. Do you disagree with me? Give me an earful in the comments section below.