Three-dimensional-printer maker 3D Systems' (DDD 2.15%) shares were doing quite well -- but since the beginning of this year, they've plunged almost 50%. In this series, we've been looking closer at the company's inner workings to find out why. Today, we'll examine the ratios that tell us how much of the company's sales are reaching its bottom line. And we'll discover why 3D Systems's management's comments about lower margins have so spooked the market, and why you should pay attention to those margins.
Why do ratio analysis?
As we covered in a previous part of this series, ratios make financial statements' sometimes overwhelming numbers a lot easier to understand. With ratios, you can easily compare a company with its peers, whether you want to see how it stacks up at one point in time, or spot a trend in its ongoing performance.
Remember, always use ratios as part of a larger analysis, rather than taking them in isolation. A single ratio, such as P/E or debt-to-equity, means nothing by itself. You can only draw meaningful conclusions by looking at a company through a multitude of ratio lenses.
Profitability ratios
Gross, operating, and net margins measure how profitable a company is at different points between its top-line revenue and bottom-line profits. They're a percentage of revenue -- essentially, how many pennies the company keeps for every dollar of sales it brings in. Gross margin measures that profit after removing the cost of goods sold, which tells you how profitable the goods or services the company sells are. Price competition or lower-margin products show up here.
Operating margin takes out operating costs, such as selling, general, and administrative expenses, or SG&A, and research and development, or R&D. These costs should grow at about the same rate as revenue, but when they grow faster (and operating margins drop over time), you'll want to find out why. The company could be investing heavily in R&D for new products (future revenue), or it could be overpaying its salespeople (or management).
Finally, net margin removes interest and tax expenses, as well as non-operating expenses, leaving the famous "bottom line." The costs of having too much debt (higher interest expense) hurts this number, while operating in more favorable tax environments helps.
Note that because of accrual accounting, the profits you see on the income statement don't always translate into cold, hard cash. Even if its 9% net margin makes you think a company is profitable, you still need to look at the cash flow statement. Cash from operations should be greater than net income, or at least the same. If it's not -- and has remained that way over time -- dig deeper, because you've found a problem with that company.
You can also size up a company's performance with return ratios -- returns on assets, capital, and equity. These measure how well the company puts its funding to work, by looking at its return on investments. Assets are an investment in itself, while capital (which is debt + equity) or equity (the amount of money shareholders have contributed to the business) are investments by outsiders. Here, we'll just look at return on equity, or ROE, which measures how much net income the company generated from the equity invested into it.
ROE also lets the investor look at the sources of those returns -- efficient use of assets (measured by net margin and the level of revenue generated by assets, called asset turnover) and leverage. In other words, you can break ROE into those three components to see where its profits are coming from -- something called a DuPont analysis.
Higher net margin and more revenue generated from the asset base create higher ROE. But higher leverage can also boost ROE -- and that's where things get dangerous. For 3D Systems, as we'll see, ROE has been dropping recently; we just have to figure out why.
Here's what the data tells us
Today, we're comparing 3D Systems with another 3-D printing company -- Stratasys (SSYS 0.13%) -- and with Cisco Systems (CSCO +0.30%), a well-established high-tech company. Because fellow 3-D printing company ExOne (XONE +0.00%) has such limited information (2011 and 2012 only; both years it had operating and net losses), I won't be using it this time around.
Source: S&P Capital IQ and company filings
As you can see from the trends over time, 3D Systems has been growing gross profit quite nicely, and it's doing a decent job of growing operating profit. The latter flattened out or went down slightly in 2013, which investors should pay attention to this year, especially given how closely its operating and net income margins have tracked each other in the past.
What leaps out, however, is the decline in net margins over the past two years. For a growing company like 3D Systems, that's not good to see, and it's probably contributed to the share price decline this year. From the conference call for Q4 2013, management attributed this to selling more lower-profit items while spending more on its operations, and on R&D. In Q1 2014, gross margins fell a bit further year over year, again because of "unfavorable mix," which means it sold fewer higher-margin products.
If this continues going forward, expect margins to stay lower, though obviously, everyone would like to see that reverse. Higher R&D spending, however, is a good reason for lower margins, because smart R&D spending leads to new products and even new product categories -- but that won't happen overnight. Keep an eye on this trend, too.
Stratasys, unlike 3D Systems, has been relatively stable in its profit margins over the years until 2013. However, unlike 3D Systems, that drop in 2013 was not due declines in sales of higher-margin products. Instead, it was due to the merger of Objet and Stratasys. According to the company, if the two had been together for all of 2012 for comparison's sake, margins actually grew year over year.
For Cisco, you can see that margins have been quite steady. You'd expect this of a larger, more stable company, which Cisco is, especially compared with 3D Systems and Stratasys.
Looking at ROE, 3D Systems shows a sharp decline from the 2011 high. This is due to both decreased net margin (from 15.4% to 8.6%) and to the past couple of years of lower leverage, measured by assets divided by equity (from 1.76 in 2011 to 1.28 in 2013). Paying down its debt during that time, from $139 million in 2011 to $19 million last year, has helped the company lower that leverage. The third component of the DuPont breakdown, asset turnover, has remained steady over the past several years.
In contrast, the ROE drop for Stratasys since 2011 has happened because of the net margin drop (obvious from the preceding graphs) and a drop in asset turnover (from 0.8 in 2011 to 0.2 in 2013). Leverage has fallen slightly from 1.2 to 1.13, so that's contributed some, but not as much as the other two components of the DuPont breakdown. Same overall effect, different reasons.
Finally, because I mentioned it in relation to net margin, 3D Systems has brought in more cash from operations than it's recorded as net income in four of the past six years. Not stellar, but not a big worry at this point.
Conclusions
Despite my comments about cash flow versus net income, companies do need to be profitable over the long term. 3D Systems has done quite well here, growing all of its profit margins steadily for most of the time period reviewed. Gross profit remains strong, but investors should be a bit concerned over the leveling-off of operating profit and the drop in net profit margins.
I wouldn't call it an immediate worry right now, though the short-term-focused market is obviously concerned, having cut the share price roughly in half so far this year. Assuming 3D Systems can restore its net profit margin by changing its product mix back toward higher-margin items and introducing new products from its R&D effort, this should correct itself.
The company could also probably afford to lever itself back up a bit. The drop in leverage had a negative effect on ROE, and a reasonable amount of debt would help bring that back up. Debt, wisely used, is not a bad thing.
This entire look at the company's ratios has revealed that management seems to have taken its eye off the ball in operating 3D Systems efficiently. In my opinion, it's been focusing too strongly on its acquisitions over the past couple of years. Acquisitions are a fine way to grow and expand a company's reach, but not at the expense of letting the rest of the business suffer.
In the next installment of this deep dive, I'll look at quality of earnings, which looks at cash versus accrual earnings and ties into the cash from operations-versus-net income item mentioned above.
As each article is published, you'll be able to find them by clicking here.
