A Deep Dive Into 3D Systems, Part 3: Plant, Property, and Equipment

Investors in 3D Systems (DDD 2.36%) have seen their shares cut about in half so far this year, which should reasonably raise their concerns over the 3-D printer maker's investment thesis. In this series' previous article, we gave 3D Systems a pass for what seemed a suspicious way it was accounting for a lot of the price it paid for a recent string of acquisitions. Now, we'll look at whether the company's spending enough on fixed assets -- its plant, property, and equipment, or PPE -- to keep up with the expense of using them.

What is PPE, how does it get there, and how is it expensed?
PPE is the company's investment in long-lived, physical assets that help it generate revenue -- from buildings and machines to desks and computers. PPE is everything the company uses to go about the business of making stuff and selling it. It shows up on the balance sheet, usually as two line items -- gross and net of depreciation (more on this in a sec), though it might be listed only as the latter.

Companies purchase PPE via capital expenditures, a line item on the cash flow statement. Capex is everything the company spends to buy, install, and set up all the PPE the company needs to operate, and is a negative number (cash flow out of the company).

However, that cash expense doesn't line up very well with how the asset is used. Remember that everything companies buy has a useful life -- a time frame in which the company can use it to generate revenue before it breaks, wears out, or gets used up. If companies used cash accounting, every time they spent $1 million on a piece of machinery, there'd be a huge $1 million expense hit to the income statement, and then nothing for the rest of its useful life.

Accrual accounting tries to match the "expense" of using the equipment against the equipment helps generate. It uses "depreciation," a non-cash expense that spreads out the cash cost of that piece of PPE across its estimated useful lifetime, charging off some portion of the total amount against revenue every period. This accomplishes the goal of matching revenue with the expenses needed to generate the revenue, giving investors a better understanding of the costs of doing business.

On the income statement, depreciation gets buried in cost of goods sold (machinery to make the widgets) and in sales, general, and administrative expenses (SG&A -- all those desks and computers). However, it shows up as a line item on the cash flow statement and appears on the balance sheet as the difference between PPE gross and PPE net of depreciation.

For those who want to learn more about this topic, you can read this discussion board post where I explain it in more detail (part of a group study on reading financial statements).

Why is this important?
Thanks to a lot of flexibility management has in determining depreciation -- it can set each item's total lifespan and final value -- this aspect of accrual accounting is open to the possibility of abuse. These shenanigans could show up as too little depreciation, which lowers expenses and raises net income. As I mentioned earlier, however, 3D Systems has the opposite problem.

However, this raises the following question: How soon is management going to have start spending a lot more in capex to build up (or replace) its PPE, so the company can keep growing? Investors really would like to know, because this helps you estimate how much free cash flow the company will have in the future to potentially return to investors. You can do this by looking at the average age of the assets, which compares amounts spent on PPE and amounts expensed as depreciation. The closer that difference is to zero, the older the assets are, and the sooner they'll need replacement.

Where does 3D Systems stand?
Let's look at these two aspects as they relate to 3D Systems and some comparable companies.

I compared 3D Systems against a set of similar companies: Stratasys (SSYS 1.43%) and ExOne (XONE) -- both in the 3D printing industry -- along with Groupon, Nuance Communications, Cisco Systems, and Facebook, those growing and/or acquisitive high-tech companies used earlier .

Here's a comparison of the average total life of the assets (after adjusting the balance sheet for operating leases, something I haven't discussed here), the average age, and the amount of life remaining in the PPE base.

Source: S&P 500 Capital IQ and author calculations. Average life = total gross PPE / annual depreciation; average life remaining = net PPE / annual depreciation (which I display on a percentage of average life to make cross-company comparisons easier). Average age is the difference.

Of its peers, both 3D Systems and Stratasys show pretty old PPE. So, too, for that matter, do three of the four out-of-group comparable companies: Groupon, Nuance, and Cisco.

Now, this doesn't mean management will have to spend a ton of capex in the next year or two. PPE can be depreciated to nothing and still have real life left, rather than the accounting number "useful life." But if that's so, then it shows that management might not have been initially estimating useful life accurately. And it still leaves the overhang of replacing that PPE at some point.

What's worse, though, is the consistency with which 3D Systems has depreciated more than capex over the past number of years. Going from the last reported fiscal year and back through 2007 (or oldest available data), here's a breakdown for how many times capex was less than depreciation for each of these companies.

Source: S&P Capital IQ.

While Cisco is a little worrisome on its own, the point here is that 3D Systems has been consistently and steadily underspending on capex. Over the past seven years, it's amounted to $41.1 million. Overall, the amount of capex spending has equaled just 35% of depreciation. One might argue that this is a result of its acquisitions, but the pattern was well established before the company significantly increased its acquisition rate three years ago, continuing through to the present.

Conclusion
All of the preceding data suggests that 3D Systems investors should be concerned about this trend. The company must keep its plant and equipment up to date (or at least not let it get too out of date), especially in a competitive industry like additive manufacturing.

I suspect that 3D Systems has preferred instead to spend its cash by buying other companies. Actually, it's been spending much more than the cash its operations generate, averaging four times as much spent in acquisitions as the company's brought in the front doors over the past three years. While that's potentially painful enough, at some point, management's apparent lack of attention on capex is likely to come back and hurt 3D Systems and shareholders.

With the recent announcement of a secondary offering, the company is indeed raising cash. But will it be used for more acquisitions, or will management use it to reinvest in the business and update PPE?

In the next article, we'll look at another way of judging management effectiveness, looking at the related concepts of inventory control and cash conversion cycle (how quickly it's running cash through the business). Stay tuned!

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