We're now at the end of a deep dive into 3D Systems (NYSE:DDD). If you recall, this investigation began with two ominous "yellow flags" -- first, how much the company was spending in capital expenditures relative to the expense that capex creates, and second, how much of the purchase price for all those acquisitions 3D Systems had been making got assigned to goodwill.
We found both good stuff (the company's unlikely to go bankrupt) and bad (it's taking longer to move cash through the business). But the bad stuff doesn't necessarily mean investors should drop 3D Systems like a hot potato.
1. When 3D Systems and similar companies buy a competitor, how do they typically split the purchase price between goodwill and net identifiable assets?
Surprisingly, 3D Systems falls in the middle of its competitors with regard to the ratio of goodwill to total purchase price in the companies it buys. When you ranked those purchases' percentage of total assets, 3D Systems also fell in the middle, a level that has held remarkably steady over the past seven years. As long as management doesn't have to impair goodwill -- in other words, announce that it paid too much for what it bought, and write off the excess value -- I'd no longer consider this question a yellow flag.
2. What is the financial situation at 3D Systems, and how does it compare with similar companies?
We covered the company's financial health in several articles:
- Plant, property, and equipment
- Inventory and the cash conversion cycle
- Liquidity ratios
- Solvency ratios
- Profitability ratios
Regarding fixed assets -- the stuff it buys with capital expenditures -- 3D Systems has the oldest set. And for six of the past seven years, it has failed to spend enough to maintain those assets, taking more in depreciation than it spends on capex. By this measure, 3D Systems ranks worse than either Stratasys (NASDAQ:SSYS) or ExOne (NASDAQ:XONE), the two best direct comparable companies, which means this question remains a yellow flag.
3D Systems has also been letting its cash conversion cycle climb over the past couple of years, indicating to me that its management pays too little attention to getting back the cash that it invests into current assets such as inventory. This ties into the worse quality of earnings that we'll discuss in a moment. If this trend continues, it could rapidly turn into an additional yellow flag.
While I have no worries about 3D Systems's liquidity and solvency, its profitability is another story. The company's net margin has dropped over the past four years, even though its gross margin has climbed. Its metrics for return on assets and return on equity have also fallen substantially, mostly tied to those lower net margins. This worrisome trend isn't likely to improve in the near future, given management's recent comments about being willing to accept lower margins. Eventually, investors will want to see this trend reverse.
3. What is 3D Systems's quality of earnings? That is, how closely do the earnings it reports as net income track with actual cash coming into the business? And how does that compare with similar companies?
Quality of earnings looks at how much of a company's GAAP net income is backed up by cold, hard cash. When that percentage becomes too little, the company can get into trouble.
Since 3D Systems began its acquisition strategy three years ago, its quality of earnings has deteriorated significantly. In 2010, only 17% of its earnings were accrued; last year, 45% were. That is not good. I don't know if that shift owes to poor earnings quality at the companies 3D Systems acquired, or whether buying all those companies is distracting management.
However, on the plus side, that 45% ratio has fallen from 69% in 2011. That could mean either that the company's successfully integrating purchases with poorer earnings quality, or refocusing on its own earnings quality, or both. As long as that ratio continues its downward trend, I won't call 3D Systems's earnings quality a yellow flag. But it's certainly something to keep an eye on.
4. What are the qualifications of William Adams (aka will.i.am) as a member of the executive team?
William Adams seems to be a more creative person than I first gave him credit for. He has a similar role at Intel and apparently interacts with that company's R&D team, though I don't know what's come out of that collaboration. Although he throws ideas off like sparks, I don't think that what he does requires a C-level position. Being a consultant or having some permanent relationship with the company, sure. A C-level position, though, probably overstates what he'll end up doing for and at 3D Systems.
I wouldn't call this a yellow flag (unless the company does the same with other celebrities), but I am disappointed. I'd also consider Adams' high-level post a ding against the CEO.
5. Do 3D Systems critics Citron and Whitney Tilson make good points? Does the data back up their arguments to short the stock?
We covered both bearish critics in these articles:
- A look at Whitney Tilson's argument
- A look at the first Citron piece
- A look at the second Citron piece
Whitney Tilson's piece presented a reasoned case and some arguments supporting his decision to short the company's shares. Even after its recent decline in price, 3D Systems sells for 10 times sales -- still a very high multiple.
The two Citron pieces, however, were not really worth reading. The first one failed to provide significant supporting evidence for the points it raised. For instance, it criticized 3D Systems's research and development spending, but it failed to place that spending in the context of the company's competitors. It also focused on the least inspiring examples of 3-D printing (e.g., an egg cup) while ignoring the most impressive (e.g., fairings to cover artificial limbs).
In its second critique, Citron undermined its own good points with a series of errors. It used data from one limited slice of the industry as if it applied to the whole. And it incorrectly mixed two different valuation methods to come up with a supposed fair price for 3D Systems shares. Like the first piece, it also indulged in flamboyant, belittling attacks on 3D Systems that reflected poorly on its argument.
3D Systems is not perfect. After this deep dive, I think its investors should be worried about:
- The level of accrual earnings and its acquisition spree.
- Fruits of an increased R&D spend that might take a while (a couple of years, maybe) to turn into strong products.
- The very high price-to-sales ratio of 10. Amazon.com, a famously "expensive" stock with an outrageously high P/E ratio, sells for a mere 1.8 times sales.
- The decline in net margins, even while gross margins increase.
- Its persistent underspending on capex, which could lead the company into trouble.
- Continued growing competition, though its exact nature and effect on 3D Systems remains unknown.
- The company's apparent attempt to be everything to everyone, bringing out lots of new products and acquiring all kinds of different capabilities and technologies, instead of focusing on a few lines where it can become best-in-class.
With all that in mind, should you buy shares of 3D Systems?
I'd be tempted -- with a caveat. Despite being 30 years old, 3-D printing is beginning to come into its own, I believe. And it will change how manufacturing gets done, though the details of that change won't be fully worked out for quite a few years yet.
However, I would buy 3D Systems only as part of a basket of stocks in this industry. If you want to venture into this market, consider buying shares of several companies involved. Then set them aside to endure their inevitable ups and downs over the next decade. At least for now, there are still too many concerns to make 3D Systems anyone's sole exposure to the 3-D printing industry.
Readers can find each article in the series by clicking here.