Description

We believe 3D Systems (TDSC) represents a terrific short opportunity with over 1/3rd downside potential.  While we believe there are a lot of negatives attached this company, we can boil down the main elements of our short argument to the following:

·       This company has never made much (if any) any money yet it trades at very high multiples.

·       Its new product (called the V-Flash) will not be the growth and profit driver bulls need it to be.

 

Description (highly simplified)

TDSC develops and markets solid imaging systems that produce three-dimensional objects from computer-aided design data.  What this means is that designers and engineers who create prototypes using CAD software can use TDSC’s systems to create a physical part or product to evaluate it for form, fit and function.  TDSC’s systems are used for 3-D printing/modeling, rapid prototyping and rapid manufacturing solutions.

It is worth discussing these three different market segments.  Rapid prototyping (RP) has been the longest standing part of this market and is characterized by expensive machines making very high quality (and low quantity) parts. Systems can range from a few hundred thousand dollars to as much as $1 million.  Given the price tags involved, RP systems are not sold in large volume.  3-D printing/modeling is a “lower end” of the market in which the price points for the systems typically range from $15,000 to $50,000.  Vendors in this segment might sell several hundred of the units each quarter.  One of TDSC’s competitors – Stratasys (SSYS) – pioneered this market back in the 2003 time frame by introducing a machine called the Dimension at approximately $30,000 per unit and this move down in price point began to expand the market dramatically.  Lastly, rapid manufacturing (RM) is the application around which there is growing discussion.  RM refers to the production of finished, production grade parts rather than prototypes.  For products requiring significant customization, RM may be more cost effective than traditional manufacturing techniques and equipment and, given the size of the manufacturing equipment market, RM sounds like an application with a lot of potential growth.

TDSC’s business model is to design and sell systems and the associated consumables (typically plastics) that serve as the material for making the parts.  The company also generates revenue from Services in the form of extended system warranties, annual service agreements, hardware and software upgrades, etc.

Why Investors Like This Stock

·       This is a razor/blade business model.

o        TDSC sells systems (with some margin; not given away) that require materials to make parts.  TDSC develops and markets consumable, engineered plastic and metal materials and composites under several brand names for use in all of their systems.  Management wisely figured out that they were missing out on this consumables revenue stream in the past so with their new system designs they developed proprietary delivery systems to match the consumables to their equipment.  While this irritated customers according to our channel checks it was probably the proper business decision.

·       This can be a very profitable business as evidenced by TDSC’s peer Stratasys (SSYS).

o        SSYS has a very similar business model to TDSC.  It sells systems and consumables and generates services revenue.  SSYS is the market leader in 3-D printing and has an installed base of thousands of units now into which it sells consumables.  It also participates in the other market segments with its proprietary FDM delivery technology.  Up until this year SSYS also re-sold a mid-range system for an Israeli company which lowered overall margins but that has been washed out in the YTD numbers.  YTD 2007 gross margin for SSYS was 54.5% and operating income was 17.1% (after stock-based comp expense). Note: there are numerous references to SSYS in this write-up.  That, too, is an expensive stock but at least that company has a solid, profitable business model and has executed very well.

·       TDSC has a new 3-D printer on the horizon.

o        In January 2007 TDSC announced the introduction of the “revolutionary” V-Flash Desktop Modeler which would hit the market at a $9,900 price point to the end use.  Putting aside the fact that the company did not yet have a manufacturing partner at the time of this announcement (Canon was announced in June) and is not hitting the market until late September with the product, hopes are high for this product to enable TDSC to penetrate the high unit volume 3-D printer segment of the market that Stratasys and Z Corp. (private competitor) have exploited so well.

·       Potential growth of rapid manufacturing (RM) demand.

o        TDSC management has anecdotally provided figures around the percentage of parts made on the company’s systems that fall into the category of RM used in such in applications that can range from hearing aids to filters for jets.  Again, given the much larger market for manufacturing equipment such as CNC machines, the potential for TDSC’s systems to penetrate this market bolsters the bull argument in the stock.

So What Do We See

As part of our assessment of TDSC we could enumerate many negatives derived from our observations and channel checks such as: the CEO Abe Reichental’s hubris and promotionalism; the customer unfriendly culture that has persisted for years at the company, the performance issues surrounding its latest high-end systems and field service issues in trying to repair them; the company’s disastrous ERP conversion beginning in 2006 whose effects linger today; the long-term challenge of trying to support three different systems technologies plus new materials from an R&D perspective, etc..  However, there are just a few reasons why this stock should go down:

·       The company’s earnings power is poor and will come nowhere near (now lowered) analyst expectations.

o        TDSC has had an operating loss of $7MM in the first six months of 2007.  Making (generous) adjustments for sales discounts (see below) and abnormal operating expenses in the first half, one can raise operating income to $2.6MM to a 3.5% operating margin.  This Op Income annualized delivers pro forma EPS (at a 40% tax rate with 22.9MM F-D shares) of $0.14 for a P/E of 175x.

o        Over the last three years the highest four quarter pro forma EPS of the company was $0.30.

o        In the Q2 earnings release, the CEO explained the disappointing Q2 gross margin (down 600 BPS sequentially) by saying that TDSC had sacrificed 400 BPS of margin by discounting “several large system sales in order to promote certain long-term strategic opportunities” supposedly related to their “targeted Rapid Manufacturing growth initiatives.” The CEO asserted, however, that the recurring revenue from materials consumption from these systems in future periods will more than offset the gross profit margin setback incurred during the second quarter.”  We strongly question this explanation.  To us it looks like TDSC cut prices to sell systems to make its quarterly top line look better.  To achieve a 41% GM in the quarter the company would need to have generated another $2.5MM in sales (COGS is unchanged so divide $22.9MM by .59 instead of .63 to arrive at revenue).  We think it will take quite a while for the buyers of “several” systems to rack up $2.5MM of materials consumption.  (This is another example of disingenuousness that we believe the CEO exhibits.  And by the way, the CEO disavowed the practice of end of quarter discounting a shortly after arriving at the company.)

o        Management gave some guidance about SG&A and R&D in its Q2 press release.  Using the following inputs:

§         $150MM revenues

§         42% gross margin

§         SG&A of $24MM for the next six months ($48MM annualized) and $12.5MM of annual R&D

§         Then Operating Income is all of $2.5MM or less than a 2% margin.  There is something wrong with their economic model.

·       We do not believe the V-Flash will be a smashing success.

o        The V-Flash is not TDSC’s first attempt to penetrate the higher volume 3-D printer segment.  Its initial InVision 3-D printer product was an abject failure and subsequent “enhancements” to the InVision have really been patches to try to fix problems.  From what we have learned the V-Flash is an entirely new design.  However, we expect that the company’s poor reputation for performance in the 3-D printer segment to linger.

o        Challenge of establishing distribution.  Given the low price points involved, 3-D printers need to be sold through indirect distribution or resellers. According to our channel checks, TDSC has tried before to develop a reseller program for lower priced systems without success.  Also, both SSYS and Z Corp. have been in the market for several years with their reseller networks in the CAD space.  It will be difficult for TDSC to duplicate what its competitors have built for distribution.

o        We question the economics on the V-Flash.  The V-Flash will be sold through resellers at a $9,900 price point.  Assuming a 25% reseller margin (based on our evaluation of SSYS), that means that TDSC is selling the V-Flash for $7,500 per system.  Assuming that TDSC ‘s resellers sell 100 units per quarter for the next four quarters, that amounts to $3MM of systems sales or approximately 2% of the company’s current total revenue run rate.  Where do we get 100 units?  It is a guesstimate.  Our best reference point is Stratasys who is now probably selling over 500 units per quarter at price points ranging from approximately $19,000 to over $30,000.  But SSYS has been in this market segment for over four years and is the clear leader in the 3-D printer segment with a proven, reliable technology and extensive distribution.  We think it will be quite a while before the V-Flash approaches Stratasys’ unit volumes notwithstanding its (currently) lower price point.  Also, one has to ask how much profit TDSC will make on each unit.  We wish we knew what the bill of materials is and what margin Canon will make as TDSC’s assembly partner.  Again we can only guesstimate that if the units cost $4,000 to build and Canon makes a 20% margin then TDSC will make $2,500 in GP per unit or 33% gross margin. This would amount to contribution of $1MM for 100 units / quarter over the next four quarters.

o        Further on the economics, one could argue that we should be focused on the “blades” or the consumables.  TDSC management has maintained that consumables sales could be $5,000 to $20,000 per unit.  We are highly skeptical of the high end of this range (unless the unit cost per replacement cartridge is astronomical).  Again as a benchmark, various analysts have inferred that SSYS generates $5,000 per 3-D printer in consumables sales.  We actually think that figure is too high and could be as low as $3,000.  In the case of the V-Flash, we would be very surprised to see a price sensitive customer looking to pay $9,900 for a 3-D printer be willing to pay $20,000 for a year’s worth of consumables.  So if we assume that each printer uses $4,000/year of consumables that would equal $1.6MM in revenue for the next four quarters on 100 units/quarter.  Assuming a 60% gross margin on these sales, that is ~$1MM of contribution to TDSC.  However, we should haircut these numbers because the reseller should participate in the revenue stream; if they did not, they probably would have a lot less incentive to sell the V-Flash.

 

Valuation

TDSC is a remarkably expensive stock.  Its Enterprise Value equals $530MM.

·         22.9MM F-D shares (including in-the-money options) x $23.81 stock price = $547MM market cap.

·         Net cash of $16.8MM (thanks to a recent PIPE done at $17.50(!) and the conversion of the last convertible security in the cap structure

In terms of multiples, TDSC sports the following:

·         EV/TTM (or 1^st half annualized) sales of 3.6x (SSYS at 4.3x).

·         EV/2007 consensus[1] sales of  3.4x (based on 2007 Est sales of $157MM; SSYS at 4.2x)

·         In terms of earnings multiples, they are all quite high for TDSC given the low level of profitability.  For example:

o        P/E on 2007 Est EPS of (now lowered) $0.13 = 179x.  P/E on 2008 Est EPS of $0.61 (not sure how all analysts are treating taxes) of 38.8x.  Again by comparison, SSYS is at full multiples of 34.3x & 27.6x of 2007 and 2008 consensus earnings, respectively.  TDSC just does not make money.

 

TDSC Management has submitted a target economic model (see May 1, 2007 Investor Day presentation) with a 15-25% Operating Income margin range and a 10-15% Net Income margin range that is supposed to be achieved by a company with approximately $150MM in revenue. Last I checked, TDSC is operating at very close to a $150MM revenue run rate.  Let’s assume that TDSC does achieve a 20% operating margin or $30MM (as a reference point, YTD Operating Loss = $7MM before adjustments), TDSC would still be valued at 17.7x this exalted level of Operating Income and 29x Net Income.  If this stock is not priced for perfection I do not know what is, especially given how far away the company is from its peers or its targets in terms of profitability.

Risks

·         We could be wrong and TDSC could sell a lot of V-Flash units with better economics than we are estimating.

·         To make money being short, someone has to sell.  This has been a very resilient stock in the face of at times terrible and at other times merely very disappointing financial results.  The top shareholders have been in the stock for a while.  Shareholders have not thrown in the towel yet.

·         TDSC as takeover candidate.  We heavily discount this hypothesis but anything is theoretically possible if large cap tech companies like HP or Kodak for some reason (no indications at all to date) decide they want to participate in this market.

Catalyst

Catalysts
• We expect the company to continue to generate extremely sub-par profitability notwithstanding year-over-year top line growth (off depressed 2006 levels for at least one more quarter).
• The company’s new V-Flash product will be a flop.