Description

On the surface, the 3D printing sector sounds similar to the SaaS sector: earnings gradually growing into an always-elusive valuation because the stock’s rising too, and therefore a permanent overvaluation with unclear catalysts. Also, because the media puts a very positive spin on this great new industry (and it is great), investors have a perception that this is an industry with lots of positive fat tails.

But 3D printing is actually just another technology sub-sector bubble with weak legs, probably most similar to the telecom equipment stocks or some of tech sub-sectors in the 60s, 70s and 80s. Some of the beautiful stories may happen but they are much further into the future than the market believes and therefore associated cash flows should be heavily discounted.

Even better: the group’s leading stock, and one whose management is solidly promotional in nature, is 3D Systems (DDD). Rather than try to develop one or two strengths, DDD has been busy serially acquiring companies in the sector, rolling up nearly 40 companies in 4 years. They now therefore do a bit of everything and it cannot be said that they have a sustainable competitive advantage in any of them. They make printers of all sizes and prices (from consumer-oriented printers to very specialized, very expensive and precise printers for multinationals). They make custom parts, sell standard parts, provide services of various kinds and perform R&D. They also have their own online platforms for printing items that clients & consumers order, which makes them vertically integrated on top of everything. This is a story of empire building.

DDD has Doubled YTD on the back of almost quadrupling in 2012. It now trades at a P/S of 17 and P/E of 162, with a forward P/E of 58 calculated by analysts who are pumping the story and not taking into account the fact that net income is not even that meaningful given the inordinate amount of acquisitions. I value the stock at a best-case 40x 2021 earnings. For those interested in a pair trade, I’d suggest EOS or SSYS.

I will start by describing and demystifying the 3D printing industry, and then move on to DDD.

3D Printing Reality vs. Conventional Wisdom

First we shall deflate a big myth: 3D printing is not something that has come out in the past 2-3 years. This 1989 video featuring stereolithography inventor Charles Hull will put things into context for the remainder of the write-up: http://www.youtube.com/watch?v=NpRDuJ5YgoQ

Stereolithography is one type of additive manufacturing, which, as the name suggests, consists of manufacturing objects using machines that incrementally add materials to what will be the final piece, as opposed to subtracting from it. 3D printing is a cooler name for additive manufacturing. Industry participants still use both terms today (of course, 3D sounds better in the media).

So since it isn’t new, how to explain the big fuss in the recent past?

3D printing technologies have been, and are, advancing slowly but surely since the 1980s. In roughly 2010, products had gotten refined enough and costs low enough that a slight consumer market began to appear on the horizon. This lit a match in the mainstream media and the fire still burns, with everyone now exaggerating the potential and especially its immanency. Here’s an example of the hype: http://www.youtube.com/watch?v=X5AZzOw7FwA#t=211

As we shall see later, Abe Reichental, CEO of DDD for the past decade, has followed - and then fully invested himself in - this hype.

Actual Commercial Uses as of Today

When you enumerate the different types of 3D printing (categorized by material type and various material properties), the vast majority of the group are only being done for rapid prototyping of products, aesthetic evaluation, assembly testing and other kinds of preparations. For example, Nike 3D prints prototype shoes.

In terms of actual manufacturing, final part production using 3D printing rose to 28.3% of the whole last year vs. 3.9% in 2003. That’s not much at all considering the difference in quantities required (i.e. even though in prototyping the #units is a single-digit or double-digit quantity, all these prototypes were enough to take 71.7% of the pie). Furthermore, additive manufacturing is, and has been long before this bubble, used in very specific fields: jewelry, dental implants, crowns, bridges, bone reconstruction, hearing aids and other medical uses where a single unit is needed and its exact shape makes a difference. Some aircraft parts are also made with 3D – a field where the #units required is relatively small. This industry concentration is largely forecasted to persist. Lux Research, despite their forecasted CAGR of 18%, estimates that even in 2025, automotive, aerospace, and medical will still be the main game, contributing 84% of total sales.

Where 3D manufacturing truly saves money, even in larger quantities, is when something that is made of one 3D-printing-compatible material (basically, an isotropic material) and takes several processes to make the classic way (such as brazing or welding). In these cases, you can 3D print it and accomplish the task in one procedure.

What cannot yet be done in 3D printing:

-          Cheap high-volume manufacturing (i.e. units produced are identical to one another)

-          Treating, carburizing, plating, anodizing, surface grinding, finishing

-          Control object’s mechanical properties

-          Objects made of non-isotropic materials.

Researchers have of course fabricated objects of higher complexity but not in quantity and not cheaply.

Actual Uses in the Consumer Market as of Today

Revenues from personal 3D printer sales for 2012 were 6.5% of the total market. Hobbyists and people who wanted a printer as a toy have bought units like DDD’s Cube, which retail in the $500-$2,000 range. These don’t seem to be able to make much of anything terribly essential. The more sustainable part of the consumer market is consumers choosing designs and ordering items online which will be 3D printed for them and shipped.

Here are some examples of what’s in the market today:

http://www.freedomofcreation.com/collection/products

http://i.materialise.com/materials

There is great hype about how consumers will buy 3D printers for the home. It is highly questionable how much volume can be generated that way. A 3D printer at home would not be used frequently because it can’t print anything, and even if it could, it would take long. And even if it wouldn’t, it would cost a lot to make the items people want, especially objects that have multiple colors, materials, textures etc. In terms of hobbyists, or entrepreneurs who would be buying more expensive printers with the goal if printing and for others for a fee, the online competition would be too tough. The people who wanted to own the current generation of these machines have bought them to a significant extent. As mentioned above, printer capabilities are not going parabolic but expanding at a healthy clip since the 1980’s. The current hype will probably calm down until the next major improvement in 3D printing. Google Trends confirms this. The search term “3D printer” is down significantly from its peak early this year. “3D printing” is also faltering but not as much, confirming the challenging market of selling the actual hardware.

And it isn't about the price of the box, it’s the time and effort to make anything useful. For the “designers that we will all become”, as DDD’s CEO claims, the future isn’t that easy. Even for professionals, software like AutoCAD and Creo isn’t that easy to use. Plus, one has to decide what they want to print, including color matching, material selection, getting the right finish. And on a physical level you need to get the material, fill the machine with it, debug the printer perhaps, clean up when done… the average person doesn’t have time for that.

But even in the case printers enter many of our homes, there’s no guarantee DDD will take the cake, especially given that they’re spreading themselves too thin. Big companies are evaluating how 3D printing affects them and those in tangential businesses are of course paying even closer attention. As a matter of fact, printing leader HP had entered into a distribution and manufacturing agreement with Stratasys (SSYS), but that agreement was terminated in August of 2012. Meg Whitman now asserts that HP will enter 3D, and not via acquisition.

The Views of Terry Wohlers

Perhaps the most respected name in 3D printing today is Terry Wohlers, founder of a consulting firm that specializes in the field. We shall compare and contrast his views with those of CEO Abe Reichental. Even though Terry is clearly very excited about additive manufacturing, he doesn’t participate in the hype. Here are some quotes from various places:

Manufacturing process:

We certainly see a strong appetite for improvement in system reliability, new versions of systems, systems that can operate in a manufacturing environment with quality controls, and new materials. Those are areas that need attention, and some customers are somewhat frustrated by the lack of progress in these areas.

Prices for commonly-used materials in 3D printing (such as PLA and ABS) are expensive.

Then, there is the general public who read about it in USA Today and other mainstream publications. And, there's currently so much media attention on the industry. You'd have to live in a cave to not to know about 3D printing. People are learning, but still know very little about it. When they read an article, is there hype associated with it? Often, yes. Is it by design? Not always, but sometimes. Stories often omit important details. We will be printing living tissue and human organs at some point, but it could be 10 years, 20 years, or even further out. It's not unusual for the media to omit important information such as this.

It’s unsettling to read this oversimplification (of 3D printing technology) where you push a button and out pops a shiny new thing.

System reliability and process repeatability are challenges, especially when using AM for manufacturing. System manufacturers are addressing these challenges with real-time process monitoring and control software, but a lot of work remains. The current limitation in build speed and maximum part size are challenges, too.

It seems as if some people believe 3D printing is a superior manufacturing method just because it’s 3D printing.

Consumer market:

DIYers, hobbyists - people who like to get their hands dirty and make things. Those are the current buyers, along with educational institutions. A price between $1000 and $2000 is the sweet spot for this market. And so, I expect there will this market segment for a very long time. But, it is a market segment, and not the entire population. It is not the average individual or family, most of which has little interest in 3D design and manufacturing. Design tools and 3D printers will become much easier to use, but that doesn't mean everyone will use them.

They (hobbyists) generally print out a part or two and forget about it (the machine).

The problem of developing a moat for any manufacturer:

Thirty-one companies from around the world manufactured at least one professional-grade 3D printer in 2011. That gives you some idea of how many system manufacturers are currently in this space.

Instead, I believe that most people will engage with the technology online, just as people do at Amazon.com today. The big difference will be the wide variety of products and new businesses that emerge because cost of entry is so low compared to traditional manufacturing. Will consumers care that these products are made by 3D printing? Most will not because most people only care about good value and that the product performs as advertised. The average individual does not and will not care how it's made.

Before we proceed to quotes by Abe Reichental, those who are interested can watch this 1-hour Google Hangout session organized by GE where they invited 4 well-known people in the industry, including Wohlers and Reichental.

http://www.ge.com/research/live/

When asked what the current limitations of the technology are, Reichental says “let's start with what can be done” and then proceeds to go into details for two and half minutes, after which he talks about the “opportunities”. A complete salesman’s positive spin, with not even a mention of the obvious – the challenging transition from prototyping to manufacturing.

Reichental says companies started in their garage will be able to make something on the same scale as big companies, whereas Wohlers directly contradicts that when he says that many confuse the $1,500 and $500,000 systems. There is an obvious difference in color size materials, resolution and precision, he says.

DDD Management

Abe Reichental seems to have joined, and to now practically lead, the 3D hype. He says 3D printing is “as big as the steam engine”, “as big as the computer”, “as big as the internet”.

http://www.youtube.com/watch?v=LRv4jp-hhBE

He says the consumer opportunity is “on the scale of the microwave” and compares the future ease of use of printers to that of the iPad, though he doesn’t stress the word future! Here’s a quote about Cubify.

We reasoned that infinite cloud computing, mobile devices, sensors and photogrammetry, content creation gamification and crowd sourcing could unleash everyone’s creativity to create and make in 3D.

Even in the 10k, in the beginning of the company’s description, since the K for FY11, it says this:

We are committed to democratizing access and accelerating adoption of our products and services for the benefit of professionals and consumers alike. We are extending the range of our affordable printing solutions from the automotive and entertainment industries to middle school classrooms and garage-entrepreneurs.

Reichental is also very bullish on numbers for no apparent reason. Lux Research forecasted the printed part market will grow from $777 million in 2012 to $8.4 billion in 2025. Wohlers has estimated all 3D printing products and services at $10.8 billion by 2021. Reichental? $35 billion by 2023!

DDD’s Many Acquisitions

From the 10-K: “We are working to accomplish our growth initiatives organically and, as opportunities present themselves, through selective acquisitions, including those we have already completed.”

From the CEO: “Our strategy (which we have been very public about) is to build the most compelling and attractive 3D content-to-print global platform for the benefit of manufacturers and consumers. Each and every acquisition we make is carefully linked to one of our five growth initiatives and provides an important technology, presence or service building block.”

It is of course highly questionable that one is making careful strategic moves when one is acquiring companies at a rate of nearly once a month, and especially that they’re doing so only since 3D hit the mainstream. On top of that, they made over $300 million of acquisitions in these past 4 years but spent less than $100 million in R&D. In order to finance these acquisitions the company has issued equity and converts. Just for comparison, SSYS has only made two big acquisitions and both have been meaningful and strategic. One wonders what Reichental is doing every day. What’s he thinking about all the time? Making decisions about the next acquisition, closing the deals, integrating them, and all his media appearances. There’s no way he has time to actually excel in anything than getting the stock price up. One day it won’t be as easy or as cheap to make acquisitions. A normalization of capital markets will cripple DDD’s ability to raise cash and lower the currency value of their stock.

Valuation

DDD has been public for two decades and never generated FCF. Since 2009 there is some FCF but that’s only valid if one excludes acquisitions. But of course acquisitions is almost all they do. If they were to stop these, they’d be in disarray given the low R&D expense vs. competitors and the mess that has surely been created with all the acquired companies. So the company’s finances are really a special case. Organic growth rates can be gamed and comparing organic return on capital vs. return on acquisitions isn’t a useful exercise. And while we’re on accounting, it may be useful to mention that in 2003 there as an SEC investigation which ended with Deloitte resigning and being replaced by BDO.

If [almost] all you do is acquire, accounting gets very interesting. In theory, if you were to acquire all of your revenue and capitalize the acquisition costs it’d be legal, but the income statement would terribly misrepresent the strength of the business because you’re really just capitalizing expenses (and getting out of it legally because they are acquired expenses). This is what DDD seems to be doing.

But… this stock is so ridiculously overvalued that I will ignore even the accounting issues and the acquisition binge. Let’s take the top line they have today, after all their acquisitions, and assume any future acquisitions will yield an ROIC equal to the cost of capital. 

Wohlers estimates total industry revenue to grow from 2.2 billion in 2012 to 10.8 billion in 2021. Applying this ratio to DDD based on their 353mm in revenues in 2012, and assuming a profit margin of 8% in 2021 and shares outstanding staying constant, we get $1.36 EPS in 2021. That’s a 41x P/E on the earnings 8 years from now.

But the more realistic scenario of course is that the market crashes, the sector loses luster, the acquisition binge stops, they struggle with expenses, with integration, with everything, while having a mediocre diversified portfolio of 3D printing businesses that HP and others don’t really care about. 

I should also mention that China is very excited about 3D printing and channeling heavy government resources into the sector.

Catalyst

-          trouble integrating acquisitions, poor R&D + focus on pumping the stock sets DDD behind competitors

-          excitement for 3D subsides

-          bear market

-          capital markets dry up

-          acquisition binge stops