The Number That Should Really Worry You About 3D Systems

Maxxwell A.R. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I have played the role of devil’s advocate for valuations in the sustainable chemicals industry numerous times in my first year with The Motley Fool Blogging Network. It is impossible to come up with a concrete future value – much less a discounted cash flow (DCF) – for companies such as Solazyme or Amyris, which are still hammering out their production capacity. As a basic investment rule, I like to take the cautious route when assessing current market valuations of companies. This can be quickly determined by looking at the sea of red-thumbs on my CAPS page. 

Questionable accounting or a casualty of growth?

One of those cautious red-thumbs occurred on Aug. 8 for 3D Systems (NYSE: DDD), which has endured a rough few weeks in the blog-sphere. A post on Seeking Alpha by Gray Wolf Research was the first to raise concerns about how the company generates and reports revenue from its numerous acquisitions. The author has written only one post to date and is short the stock. Seems a bit fishy to me.

The focus on revenues continued with a tremendous effort from Douglas W. House, who presented an extremely detailed argument questioning the growth of the company. The Motley Fool’s Jim Mueller launched a rebuttal article explaining exactly how the company has acquired revenue streams, which doused my concerns about the company’s revenues.

That being said, I didn’t red-thumb 3D Systems because I thought they were dishonestly reporting revenue. They are a super high growth company in a highly saturated and competitive industry. How do you expect organic revenue streams and those of acquired and gradually integrated companies to be clearly drawn in the sand? It is not a realistic expectation. As Mueller points out:

“[Douglas] House, in other words, is trying to see how the 3D Systems of several years ago ‘would have’ grown if it had not acquired anything, without acknowledging that the company of today is not the company it was several years ago. That is entirely the wrong way to approach this.”

Don’t be distracted by a non-distraction

What concerns me about the company’s valuation requires little detective work, but could be considered a derivative of the acquisition revenue concern of investors: goodwill and intangibles. In the classic investing book It’s Earnings That Count, Hewitt Heiserman lays the foundation for a solid growth investment. One of his balance sheet suggestions is that goodwill and intangibles never comprise more than 20% of a company’s total assets. This number is called the intangible assets ratio (IAR).

After compiling the numbers for 3D Systems it looks like investors are overlooking a major red flag in a lack of understanding of merger growth accounting (all numbers in millions of dollars):

<img src="/media/images/user_6293/ddd_goodwilltable_large.PNG" />

I have included industry peer Stratasys (NASDAQ: SSYS) for comparison:

<img src="/media/images/user_6293/ssys_goodwilltable_large.PNG" />

Here’s a look at revenue growth over the same time periods:

<img src="/media/images/user_6293/3dprinter_revenuetable_large.PNG" />

As you can see, goodwill growth has far outpaced revenue growth for 3D systems in recent years. Am I being overly cautious? Perhaps.

Goodwill does have real value, especially in the high growth world of 3D printing. No one knows what smaller acquired companies could have developed into on their own. Conversely, management doesn’t truly know the real value of each company it acquires at the date of purchase. Some value that gets lumped into goodwill is dead on (or, very rarely, an underestimation); some value is funny money that must be written off in the future. With a startling IAR of 48% I would be racing to the “unusual expense” line with each passing quarter if I were an owner. In fact, 3D systems observed its first ever unusual expense in 3Q12. Will it be a sign of things to come?

Foolish bottom line

Goodwill is more than a wins-losses column for management acquisitions. Writing off a large chunk of goodwill could spell disaster for any investment.  Don’t think it can happen to yours? Try searching the phrase “goodwill write-down million” on Google and you’ll receive 1.27 million results! Even more frightening: “goodwill write-down billion” returns 469,000 results! (There is good news. The phrase “goodwill write-down gabillion” only returns three related results.)

With great growth comes great risks – and 3D Systems certainly fits the bill. But rather than fretting about a lost million dollars here or there due to merger accounting practices, I would be looking at three simple lines on the balance sheet. You don’t always need to go out of your way to sniff out trouble. Unfortunately, it is only in hindsight that we realize the problem was in front of us all along (Check the goodwill to market cap ratio of all S&P 500 companies here).

Follow me on Twitter to keep up with my future posts on energy, sustainable chemicals, and undervalued growth companies @BlacknGoldFool.

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BlacknGold has no positions in the stocks mentioned above. The Motley Fool owns shares of 3D Systems and has the following options: short JAN 2014 $55.00 calls on 3D Systems and short JAN 2014 $30.00 puts on 3D Systems. Motley Fool newsletter services recommend 3D Systems and Stratasys. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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