Since the beginning of the year, 3D Systems (DDD 1.07%) shares have fallen hard. At least one investor, however, has made money. Shortly before the share price peaked, respected fund manager Whitney Tilson criticized the company for being overhyped and overpriced, and he went short against the high share price. Let's take a closer look at his critiques and see whether they hold up to scrutiny.
Points from Tilson
In Tilson's short argument from mid-January, he makes four main points. In the following, I list these in italic font and then comment upon them in plain text.
1. Tilson quotes CEO Avi Reichental as saying that "his company is 50% technology, 20% innovation and 30% awesomeness." How, Tilson asks, does one value "awesomeness"?
This is Tilson's weakest point. His comment about awesomeness does have some snark to it, and it points out the showmanship that CEOs use to talk about their companies. Maybe Reichental is more flamboyant than many such leaders, but this seems more to be a literary hook to hang the short thesis on than any serious criticism of the company as an investment.
However, another short thesis author, Citron Research, places a great deal of weight on Reichental's flamboyant nature. I'll look at Citron's points in the next two articles of this series.
2. Tilson references an early 2013 short report from Citron Research. He points out that at that time, 3D Systems was trading at 17.2 times sales, 64 times trailing EBITDA, 63 times next year's earnings estimates. Today (when Tilson was writing), it was trading even higher, at 21 times sales.
Assuming his numbers are accurate, which I have no reason to doubt (unlike some numbers in some of what Citron writes -- stay tuned), this is indeed disturbing and seems excessively high.
3. Tilson gives a review of other companies trading at such multiples over the past 20 years or so. Only a few (he cites 15) have managed to trade at such levels and be successful investments. He calls out three characteristics they share: They serve rapidly growing global markets, they have winner-take-all (or most) business models, and they have extremely "light" business models (can scale globally with very little capital).
Eleven of the 15 are Internet/software companies with very light business models, while the other four have intellectual property (three with patented drugs) that allowed gross margins of 70%-90% and net margins of 20%-30%. He says that 3D Systems meets the first criteria, but in no way meets the other two.
I'll assume that Tilson's survey of other companies and his history of 3D Systems' margins (gross margin has been above 50% in only the past couple of years, and the company's net margin is falling) are accurate for the sake of argument. The comparison is not in 3D Systems' favor, meaning that this particular company is probably not of the same caliber as those that have traded at such large multiples in the past. The company's net margin decline is also worrisome and probably indicates a company that doesn't rate such a high multiple (I discussed 3D Systems' margins here).
4. Taken all together, that is not worth paying 21 times sales.
Tilson is basically making a valuation short. These are tricky, because you have to be right on both the valuation (and he makes a decent case) and right on the timing. That is, the market has to end up agreeing with you in a reasonable amount of time without driving the share price a lot higher.
However, if the market doesn't agree with you and your short position, you can end up losing a lot of money, even multiples of what you could ever hope to gain. For instance, if you had shorted 3D Systems a year before the shares peaked -- at a price of $37.98 -- you'd still be losing money today, even after the huge drop in the share price this year. At the share price high, you would have been 154% underwater.
I don't know at what price Tilson started shorting the company's shares, but he's been right so far, since the share price peaked. Whether he'll close his short position, I also don't know, though he did say that if the company sank to a reasonable two-times-sales multiple, shares would be worth $10.
Final thoughts
Tilson's discussion of the high multiples at which 3D Systems was trading has merit -- setting aside his snarky comment about valuing awesomeness -- and his short call has been accurate since then. Whether shares will fall all the way to $10 remains to be seen.
In the next article of this series, I'll review the 2013 short report from Citron that Tilson mentioned. It's both weaker and more aggressive, and frankly, I was surprised that Tilson paid attention to it.
Readers can find each article in the series by clicking here.
