Value Investors Club / Proto Labs Inc (PRLB)

Description

INVESTMENT MEMORANDUM PROTO LABS, INC. (PRLB)

July 25, 2016 Current Price: $63 │ Target Price: $33

BUSINESS DESCRIPTION

Proto Labs (PRLB) is a leading online and technology-enabled, quick-turn, on-demand manufacturer of

custom parts for prototyping and short-run production, manufacturing parts for product developers and

engineers worldwide, utilizing injection molding, computer numerical control (CNC) machining and 3D

printing to manufacture custom parts for their customers using proprietary CAD technology. It has a $1.5B

market cap and ~$100M net cash.

INVESTMENT THESIS

PRLB has been a great growth story since its IPO and it is trading with a rapid growth multiple of ~37x

GAAP earnings. However, PRLB revenue growth is materially slowing down from ~27% annual rate to a

relatively flat guidance in the past year— QoQ revenue growth (no/very low seasonality). Additionally, gross margins

are lower by about 600 bps from Q1’14. Sales and marketing expenses as well as other opex is higher by

200 bps and 300 bps, respectively. The main problem is that PRLB does not have significant barriers to

entry, and it seems that the company has more competition that are using 3D CAD. Additionally, 3D printing companies 3D Systems and Stratasys have become viable competitors/substitures — in fact PRLB knows this and currently its fastest growing segment is 3D printing which have lower gross margins. The competition is spendingon marketing, and a google search will show you many

ads of different companies offering 3D

injection mold. PRLB head of North America sales has left the

firm. They have yet to find a replacement.

In 2014, PRLB saw that margins were declining due to more

competition and customers substituting its core offering for 3D

printing, and it decided to enter the 3D Printing market in Q2’15

and have since acquired a had a coupleof bolt-on acquisitions,

which masked the decline in revenue growth rate.

Even though they don’t have any debt, PRLB has not really

generated any cash in the past, generating only $15.7M in the past twelve months, roughly 1% of its

market cap. Its Capex is very high and it somewhat alarming the how they have boosted their PP&E.

Machinery and Equipment is up 40% or a bit over $30m. A potential concern is that PRLB is capitalizing

expenses that could be expensed.

Sell-side expects PRLB to return to 20%+ revenue growth and expand pre-tax margins 270 bps. However,

this business is not particularly seasonal, and QoQ growth trended negative in Q1 and was up 3% in Q2;

management guided for ~-2% to 4% QoQ growth. I expect the stock price to face selling pressure as

investors and sell-side bring down very high expectations.

Of note management stated in Q2, “Given the nature of our business with a very diverse and fragmented

customer base and the early stage in the company's life cycle, it's difficult to identify a single economic

indicator which consistently and clearly tracks the fluctuation in our revenue growth. However, there are

several factors which are impacting our growth and demonstrate some correlation. U.S. industrial

production remains weak. Consumption of cutting tools, an indicator of utilization of U.S. machining shops,

has declined 9% through May 2016 compared to the prior year. And finally, many customers have indicated

delays in projects as a means to control expenses.”

INDUSTRY ANALYSIS

PRLB operates in a fragmented, mature industry facing low barriers to entry. PRLB is composed of three

segments

: Injection molding, CNC machining, and 3D printing. According to Plastics Custom Research,

Protomold injection can serve a $50B+ market in the U.S. The CNC machining division represents a $35B

market in the U.S.

Management seems to often get the question from investors askinghow big the market is for injection

molding and CNC. On their investors’ relation website they have published research by ORC International

that calculated to be $8B the low-volume contract manufacturing. On PRLB investor presentation, they

mention: “Proto Labs knows of no significant, organized competitor.”

I believe the company is confusing

first-mover advantage based on their proprietary software technology (which there are various free

versions online now from CAD to CNC) to a real barrier of entry.

According to industry research

, Injection molding is expected to grow 4.9% for the next five years.

However, 3D printing is currently a substitute of injection molding and it has a potential to disrupt that

industry. For instance, Stratasys (SSYS) is pursuing 3D printing with CNC machining printing parts. PRLB

entered the 3D printing business because it saw 3D printing as a real threat. Both SSYS and DDD have saleshave decline in the past quarters due to excess

capacity in the market. There is a large disconnect from how PRLB explains the industry and its barriers to entry to the investor community versus what is actually occurring in the industry —lower sales growth, lower margins, higher marketing expense. A simple google search displays

many options as results and paid ads that can perform the work with similar results to PLRB. Management has not yet fully addressed this, and in their investors’ website they still have slides up which show they can grow a long-term rate of 25%.

VALUATION

PRLB is in an inflection point. The last two quarters and the current guidance point that revenue growth

and margins are noticeably declining. Additionally, we can infer by PRLB’s strategy to enter 3D Printing

tells us that even they believe it is a threat to their business model – and will very likely do so as 3D printers

continue to improve. Sell-side is believing management that there are “transitory and largely macro

related soft U.S. industrial issues.”

Because PRLB doesn’t pay interest, or generates meaningful cash flow,

and it is unlikely that margins will expand with increased competition, I believe the correct metric to value

this company is P/E.

My bull case is that PRLB reverses its quarterly revenue growth decline and accelerates revenue growth

at 15% per year for the next two years and margins will be remain flat, following a ~850 bps decline in the

past two years. At a 30x multiple the company is valued at $60, an upside of just ~5%.

The base case is that growth will moderate at 5 -8%, but margins will continue to decline due to increase

competition 200 bps per year for the next two years. When the street finds out that this company can’t

continue growing at 25% YoY, and that it confused barriers to entry with first-mover advantage, the street

will pay about 20x, resulting in a price target of $30.

The bear case is that revenue growth declines 3% as there are more substitutes and competition catches

up with 3D CAD injection molding. Margins will also decrease from current gross margins at 55%, and sales

and marketing spend will increase. I expect that net income margin declines 350 bps. Given this scenario

the market may only pay 14x earnings for a price target of $11.

DETAILED BUSINESS DESCRIPTION

Proto Labs, Inc. was incorporated in Minnesota in 1999, a leading online and technology-enabled, quick-

turn, on-demand manufacturer of custom parts for prototyping and short-run production. PRLB is

manufacture parts for product developers and engineers worldwide, under increasing pressure to bring

finished products to market faster than their competition. PRLB utilizes injection molding, computer

numerical control (CNC) machining and 3D printing to manufacture custom parts for their customers.

Their proprietary technology eliminates most of the time-consuming and expensive skilled labor

conventionally required to quote and manufacture parts. PRLB customers conduct nearly all of their

Case Price target Probability Notes

Bull $65.00 25% PRLB will grow revenues at 12% for the next two years, EBITDA margins flat at ~29%; P/E multiple of 30x

Base $31.00 50% PRLB revenue will grow at 5%, margins will decline 400 bps; P/E multiple of 20x

Bear $11.00 25% PRLB will decline 3% per year, EBITDA margins decline to 15%; P/E multiple of 14x

Price Target $33.50

business with them over the Internet. PRLB targets their products to the millions of product developers

and engineers who use three-dimensional computer-aided design (3D CAD) software to design products

across a diverse range of end-markets. They have established operations in the United States, Europe and

Japan, which they believe are three of the largest geographic markets where these product developers

and engineers are located. They believe use of advanced technology enables them to offer significant

advantages at competitive prices to many product developers and engineers and is the primary reason

they have become a leading supplier of custom parts.

Custom parts manufacturing has historically been an underserved market due to the inefficiencies

inherent in the quotation, equipment set-up and non-recurring engineering processes required to

produce custom parts. Customers typically order low volumes of custom parts for a variety of reasons,

including:

 they need a prototype to confirm the form, fit and function of one or more components of a

product under development

 they need an initial supply of parts to support pilot production for testing of a product

 they need an initial supply of parts to support production while their high-volume production

mold is being prepared

 they need on-demand manufacturing due to disruptions in their manufacturing process

 their product will only be released in a limited quantity

 they need end-of-life production support

In each of these instances, PRLB believes the solution provides product developers and engineers with an

exceptional combination of speed, competitive pricing, ease of use and reliability that they typically

cannot find among conventional custom parts manufacturers. PRLB technology enables them to ship parts

as soon as the same day after receipt of a customer’s design submission.

Current manufacturing product lines currently include injection molding (Protomold), CNC machining

(Firstcut) and 3D printing (Fineline). PRLB continually seeks to expand the range of size and geometric

complexity of the parts they can make with these processes, to extend the variety of materials they are

able to support and to identify additional manufacturing processes to which they can apply their

technology in order to better serve the evolving preferences and needs of product developers and

engineers. PRLB has experienced significant growth since inception in 1999, growing total revenue from

$98.9 million in 2011 to $264.1 million in 2015, and income from operations from $26.9 million in 2011 to

$67.1 million in 2015.

Their increases in revenue and income from operations are due to the expansion of product lines offered.

Product lines have expanded over the years by the introduction of:

 plastic injection molding in 1999

 CNC machining in 2007

 liquid silicon rubber (LSR) that expanded the breadth and scope of their injection molding product

line in 2014

 3D printing, including stereolithography (SL), selective laser sintering (SLS), and direct metal laser

sintering (DMLS), through the acquisition of FineLine Prototyping, Inc. (FineLine) in 2014 and

expanded through the acquisition of certain assets, including shares of select subsidiaries, of

Alphaform AG (Alphaform) in 2015

 Lathe-turned parts that expanded the breadth and scope of CNC’s product line in 2015

PRODUCT LINES

PRLB 3D Printing (Fineline): product line includes SL, SLS and DMLS processes, which offers customers a

wide-variety of high-quality, precision rapid prototyping and low volume production. These processes

create parts with a high level of accuracy, detail, strength and durability. 3D Printing is well suited to

produce small quantities, typically in the range of one to 50 parts.

CNC Machining (Firstcut): CNC Machining (Firstcut) product line uses commercially available CNC

machines to cut plastic or metal blocks into one or more custom parts based on the 3D CAD model

uploaded by the product developer or engineer. These efficiencies derive from the automation of the

programming of these machines and a proprietary fixturing process. The CNC Machining (Firstcut) product

line is well suited to produce small quantities, typically in the range of one to 200 parts.

Injection Molding (Protomold): The Injection Molding (Protomold) product line uses 3D CAD-to-CNC

machining technology for the automated design and manufacture of thermoplastic, metal or liquid

silicone injection molds, which are then used to produce custom injection-molded parts on commercially

available equipment. The Injection Molding (Protomold) product line is used for prototype, on-demand

and short-run production. Prototype quantities typically range from 25 to 100parts. Because PRLB retains

possession of the molds, customers who need short-run production often come back to Proto Labs’

Injection Molding product line for additional quantities typically ranging up to 10,000 parts or more. They

do so to support pilot production for product testing or while their tooling for high-volume production is

being prepared, because they need on-demand manufacturing due to disruptions in their manufacturing

process, because their product will only be released in a limited quantity or because they need end-of-life

production support. These additional part orders typically occur on approximately half of the molds that

PRLB makes, typically accounting for approximately half of total Injection Molding (Protomold) revenue.

Process: The process for 3D Printing (Fineline), CNC Machining (Firstcut) and Injection Molding

(Protomold) begins when the product developer or engineer uploads one or more 3D CAD models

representing the desired part geometry. Using PRLB proprietary software that uses algorithms to analyze

the 3D CAD geometry, analyze its manufacturability and support the creation of an interactive, web-based

quotation containingpricing and manufacturability information. A link to the quotation is then e-mailed

to the product developeror engineer,who can access the quotation, change a variety of order parameters

and instantly see the effect on price before finalizing the order. For 3D Printing (Fineline), the quote is

reviewed and then scheduled for production. For CNC Machining (Firstcut), the tool paths are then

reviewed and routed to their high-speed CNC machining centers for execution. In the case of Injection

Molding (Protomold), the proprietary software supports the creation of the mold design and the tool

paths required to manufacture the mold components, which are then routed to PRLB CNC machining

centers for execution. Once the mold is assembled,it is placed in one of their injection molding presses

to create the required parts. For CNC Machining (Firstcut) product line, PRLB ship parts as soon as the

same day as the order is received. For theri Injection Molding (Protomold) and 3D Printing (Fineline)

product lines, they ship parts in as little as one business day from design submission. PRLB ships parts via

small parcel common carriers on standard terms and conditions.

RISKS

The market for custom parts manufacturing is fragmented and highly competitive. They compete for

customers with a wide variety of custom parts manufacturers and methods. Some of their current and

potential competitors include captive in-house product lines, other custom parts manufacturers and

alternative manufacturing vendors such as those utilizing 3D printing processes including

stereolithography (SL), selective laser sintering (SLS) and direct metal laser sintering (DMLS). Moreover,

some existing and potential competitors are researching, designing, developing and marketing other types

of products and product lines. Future competition may arise from the development of allied or related

techniques for custom parts manufacturing that are not encompassed by their patents, from the issuance

of patents to other companies that may inhibit their ability to develop certain products and from

improvements to existing technologies.

Furthermore, PRLB competitors may attempt to adopt and improve upon key aspects of their business

model, such as development of technology that automates much of the manual labor conventionally

required to quote and manufacture custom parts, implementation of interactive web-based and

automated user interface and quoting systems and/or building scalable operating models specifically

designed for efficient custom production. Third-party CAD software companies may develop software that

mold-makers, injection molders and CNC machine shops could use to compete with PRLB business model.

Additive manufacturers may develop stronger, higher temperature resins or introduce other

improvements that could more effectively compete with them on quality.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

- Earnings miss

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			2017	2018
Price:	63.30	EPS	1.70	0
Shares Out. (in M):	27	P/E	37	0
Market Cap (in $M):	1,677	P/FCF	0	0
Net Debt (in $M):	-201	EBIT	0	0
TEV (in $M):	1,475	TEV/EBIT	0	0
Borrow Cost:	General Collateral