SSYS - Desktop Metal: Shifting To Hold Rating While We Await Profit Performance In FY23

2023-04-04 19:38:44 ET

Summary

• Desktop Metal, Inc. stock price has already surpassed my target price of $1.9 and now trades at a premium of 2.7x forward revenue, which has lowered the near-term risk/reward ratio.
• The company reported Q4 2022 earnings above and beyond the high end of their guidance range, and management announced plans to cut costs, with the expectation of achieving a breakeven EBITDA.
• Desktop Metal, Inc. has yet to generate positive earnings or free cash flow, and the valuation paradigm remains on a forward revenue basis, which is based on investors' long-term profitability expectations.

Thesis

I believe my bullish thesis has been paying out well and Desktop Metal, Inc. ( DM ) stock has surged upwards from the time I posted my initiation in early January 2023 with a target price of $1.9. In fact, the current share price of $2.30 has already exceeded my target price.

My original thesis was simple – DM stock was trading at an all-time low level, and as management shows progress in cost-cutting, the market will re-evaluate DM in another light, and multiples should inflect. Indeed, multiples (EV/forward revenue) inflected from 1.5x to 2.7x. With the first part of the thesis now down (multiples re-rate), I believe the next stage of upside now lies in management's ability to further drive profitability (magnitude and timing). While the cost-cutting actions so far has been fruitful, I will now shift my view from bullish to a hold for the time being, while I await DM to show further evidence of consistent earnings and cash flow.

How much profits is the focus now

On the back of strong demand across the board, DM reported 4Q22 earnings above and beyond the high end of their guidance range, while cost execution resulted in margins that far exceeded my projections. To put that into perspective, the EBITDA margin improved significantly from -171% in 4Q21 to -49% in 4Q22. Management now sees a path to profitability and has announced plans to cut costs by an additional $50 million per year, for a total of $100 million. The expectation of achieving a breakeven EBITDA run rate by the end of FY23 was, in my opinion, the most important takeaway from the company's earnings report for 4Q22.

This is huge because it means that over the next four quarters, management will need to drive at least $15-20 million in cost savings (with the rest coming from revenue growth) to meet the goal. (DM EBITDA for 4Q22 is -$29.4 million). The key thing I'm watching for in FY23 is the rate at which profitability grows. If DM can significantly increase its EBITDA in the first three quarters of FY23, it increases the likelihood of 4Q23 breaking even, which would be a catalyst for the stock. As of this writing, consensus does not expect DM to break even by 4Q23 (EBITDA is expected to be -$2.2 million in 4Q23). As a result, if management can demonstrate that it can meet this goal, I believe the stock will re-rate higher. This is also one of the main reasons I'm sitting on the sidelines right now, waiting for the next quarter's results to show that DM is on track.

Qualitatively, I believe things are shaping up well. The number of the company's installed metal-based additive manufacturing systems has surpassed 1,100, and the company's margin-accretive P-50 systems have begun shipping. In addition, DM is working to increase its collaboration with companies like Align Technologies, which works with photopolymers. The total addressable market, or TAM, is also growing thanks to new foams, metal-forming, and printed hydraulics technologies. Therefore, I think there are multiple opportunities for expansion and economies of scale in the future.

With a materials portfolio of more than 250, 15 print platforms dedicated to high-volume production, 7,000+ global customers, and 950+ patents pending at year's end, I don't think DM is doing any worse. In general, I think the growth story is still strong, but present-day investors care more about profits than they do about growth. Once DM proves it can turn a profit, the company will shift its attention to expanding while continuing to do so profitably.

As a result, I applaud management's decision to focus so intently on cutting costs in the near future, and I hold out hope that the company will achieve a positive earnings per share inflection by FY25. However, the positive impacts to the stock price will likely be reflected in FY24 when management guides for “positive EPS” in FY25.

Valuation

As previously stated, the Desktop Metal, Inc. valuation has risen to 2.7x forward revenue today, which I believe has lowered the near-term risk/reward ratio (another reason why I prefer to stay at the sidelines). When compared to peers with a longer operating history, such as Stratasys (1.2x forward revenue) and 3D Systems (2.3x forward revenue), DM stock trades at a premium but has lower EBITDA margins, despite higher expected growth. As previously stated, growth is not the primary focus today, and I believe the premium reflects investors' expectation that DM will reach breakeven levels in 4Q23. I have high hopes that DM will meet its target; however, if it does not, the stock may fall as investors reset their expectations.

Importantly, DM has yet to generate positive earnings or free cash flow ("FCF"). As a result, the valuation paradigm remains on a forward revenue basis, which I believe is extremely volatile because it is based on investors' long-term profitability expectations. This also means that DM is highly vulnerable to changes in interest rates (higher rates = high discount rate = lower PV of cash flow, which is far in the future). Given competitive offerings and business models, I believe DM should trade in the range of 3D Systems Corporation (DDD) and Stratasys Ltd. (SSYS), but not at a premium.

Conclusion

While I initially had a bullish thesis on DM, with the stock already surpassing my target price, I am now shifting my view from bullish to a hold for the time being. My focus now is on management's ability to further drive profitability, with cost-cutting actions resulting in fruitful margins that far exceeded projections. I am eagerly awaiting evidence of consistent earnings and cash flow before making any further investment decisions. I believe the rate at which profitability grows in FY23 is a key thing to watch for, as achieving a breakeven EBITDA run rate by the end of FY23 would be a significant catalyst for the stock.

Qualitatively, I think things are shaping up well for Desktop Metal, Inc., with multiple opportunities for expansion and economies of scale in the future. Overall, I remain cautiously optimistic about Desktop Metal, Inc.'s prospects, and I look forward to seeing how the company progresses in the coming quarters.

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