A Deep Dive Into 3D Systems, Part 8: Are These Quality Earnings?

After peaking in early January, shares of 3D Systems (DDD +2.26%) have fallen hard this year. If you're an investor in the company, you're undoubtedly worried. Forget about the profits on its income statement -- can the company actually earn cold, hard cash? One way to tell is by looking at its quality of earnings.

Why care about quality of earnings?
Questions of about earnings quality -- QE for short -- arise from the difference between cash and accrual accounting. Investors (and companies) want and need cash to be paid into the company. However, cash accounting is horrible for the kind of analyzing and predicting investors need to do.

Remember, in cash accounting, nothing is counted until cash actually trades hands. This throws off the predictability of revenue, however, by counting revenue only when the company is paid. What if it sold a $500,000 machine in March but isn't paid until May? The sale happened in the first quarter, so isn't that where the revenue should be?

Cash accounting says no; accrual accounting says yes, by letting the company put that $500,000 sale into accounts receivable, or A/R. The company's sold the item, but hasn't collected the cash yet, but the revenue is recognized in the period when the sale was finalized.

This kind of time-shifting of revenue and its resulting income makes analyzing and predicting easier and more reliable for investors. But it also raises the possibility that the company won't get paid -- that those accrued earnings won't turn into cash earnings.

In other words, the company is open to the risk that it'll have to take the sold item back, or that the buyer defaults. Either way, it won't get any cash. Because of this, a sale recorded in accounts receivable (instead of cash) is a less reliable (less persistent) sale.

There are many different accrual accounts that a company uses, not just accounts receivable. But they all share the same risk -- namely, that no cash will actually change hands. And without cash flow into a company's coffers, the company dies.

Therefore, you can't rely on accrual earnings as strong, persistent proof of a company's future earnings power -- or its survival. You should therefore weight accrual earnings less than cash earnings when you're forecasting that company's ability to make money in the future. 

Measuring earnings quality
To see just how much accrual earnings might be distorting the company's overall strength, you want to measure the level of accrual earnings relative to total earnings. One way is to look at the change in net operating assets, or NOA, over one year and divide by the average NOA for that year. This ratio tells you what proportion of a company's earnings come from the less reliable accrual earnings. The lower this ratio is, the better; a low number means there are more of the good, solid cash earnings in what the company reports.

NOA = (total assets-cash)-(total liabilities – total debt)

It's best to look at this figure over time so that you can spot trends in its ups or downs. Also, compare the company of interest to others in the industry. If your company has higher accruals ratios than its peers, it might be hiding a problem.

Here's the data
Here are the accrual ratios for 3D Systems and Stratasys (SSYS +1.65%).

Source: Company financial statements and author's calculations.

2010 was the last year before 3D Systems began its highly acquisitive ways. Look at its nice, low accruals ratio. Since then, however, management has been on a buying spree. I believe this contributed significantly to the jump in the accrual ratio in 2011 and the higher levels since then. Maybe the companies 3D Systems has been buying have more accrual earnings than 3D Systems did prior to starting its acquisition spree. Or maybe the task of integrating the acquired companies is distracting, so management has been letting efficiency slip.

Poking behind those numbers, you can see where the higher ratio came from. Remember accounts receivable? Well, that climbed 270% for 3D Systems between the end of 2010 and 2013. Revenue climbed by only 220%, so A/R climbed faster over that time period, helping to grow the accruals ratio. There have been other changes as well, but it's a significant part of the story that A/R growth is outpacing revenue growth.

However, the decline in 3D's accruals ratio since 2011 is a good sign. It may mean that management is buckling down on collecting the cash the company's owed. Looking further, however, we find two areas that concern, me however: growth in doubtful accounts (A/R that might not be collected) and bad debt (A/R that is written off as noncollectable). Sure, that lowers A/R, but not entirely in the good way of collecting what is owed. Again, these may be artifacts from the acquisitions (where the target companies had higher levels of doubtful accounts and bad debt), or it may mean that the company isn't able to collect everything it's owed. This one number cannot definitively tell us how much of each possibility may be occurring. Best we can do from the outside is to watch these numbers closely.

In contrast, Stratasys' accruals ratio is much more lumpy because, I suspect, it's been lumpier in its acquisitions compared with 3D Systems. However, even though it started at a higher level than 3D Systems did in 2010, it's currently at a lower, healthier level.

Conclusion
I believe this is another example of where the company's acquisition strategy is producing less-than-stellar numbers. The jump in the accrual ratio is correlated with the increase in acquisition spending. The quality of other company earnings it is buying appears to be lower, leading to higher A/R write-offs.

Ideally, you'd want to see management slow down on the company's acquisitions and refocus on the operations of the business, including collecting what is owed. Investors will have to see how this plays out over the next several quarters.

Up next: A look at musician and inventor William Adams (aka will.i.am) and 3D Systems's decision to hire him as chief creative officer. Say what?

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