2023-12-04 15:20:33 ET
Summary
- Proto Labs' business is growing despite macro headwinds, but the company still needs to demonstrate the economics of its network business.
- Digital Network growth will likely drive gross profit margins lower, pressuring profitability unless Proto Labs can begin to realize operating leverage.
- Proto Labs' valuation leaves a lot of room for error, particularly if sentiment towards small-cap stocks improves and the manufacturing sector picks up.
Proto Labs' ( PRLB ) business continues to gather pace, despite facing macro headwinds. While Proto Labs now appears to be returning to growth after a multi-year period of stagnation, it must still demonstrate the economics of its network business. Gross profit margins are deteriorating, and the burden of operating expenses has remained constant as Proto Labs' business has scaled. These negatives appear to be more than reflected in Proto Labs stock price though. The company's valuation is near all-time lows despite growth, positive cash flows and a healthy balance sheet. Most of this is probably due to the problems that rising interest rates and a post-pandemic hangover have caused for smaller companies exposed to manufacturing. Investors must now weigh the fact that rate rises are likely done against the probability of a recession.
Market
While Proto Labs' growth has stagnated in recent years, the company still believes that it has a 100 billion USD opportunity ahead of it. This raises questions about the true size of Proto Labs addressable market. For example, the rapid prototyping market was estimated to be worth only 2.5 billion USD in 2021. Proto Labs clearly serves a larger market than this, but the use cases where it has a compelling value proposition are likely far more modest than the 100 billion USD figure.
Proto Labs is currently trying to expand its business through a network of manufacturing partners, but it still needs to demonstrate it can capture more than a small fraction of the opportunity ahead of it. Regardless, there are a number of trends which could favor Proto Labs' business going forward:
- SKU proliferation across a number of sectors is increasing demand for prototyping and low-volume part production.
- The life cycle of many products has decreased, supporting demand for prototyping.
- Digital manufacturing and ecommerce are increasing the feasibility of outsourcing more prototyping and low-volume part production.
- Geopolitical and supply chain resiliency concerns are contributing to the onshoring of production.
Figure 1: Proto Labs Market Opportunity (source: Proto Labs)
Even if Proto Labs' serviceable addressable market is relatively modest, outsourced manufacturing is a fragmented market that still provides a consolidation opportunity. Digital manufacturing should support consolidation by increasing the importance of economies of scale.
Proto Labs believes that its Digital Factory and Digital Network businesses position it favorably relative to competitors, and any advantage is likely to compound if Proto Labs can reduce friction in the buyer journey and increase automation.
Figure 2: Proto Labs Competitive Landscape (source: Proto Labs)
Proto Labs has more pressing concerns in the near term than market size or competition though. The macro environment is still uncertain and manufacturing conditions in the US and Europe continue to deteriorate . In the current environment, demand for Proto Labs lower price, longer lead time offers is high relative to demand for its quick turn offering. This is pressuring both growth and margins.
The optimistic base for Proto Labs would be manufacturing conditions improving on the back of steady/declining interest rates and the pandemic supply chain bullwhip moving into the rearview mirror. Investors need to be aware that there is a high probability of the macro environment deteriorating as the impact of tight monetary policy continues to work its way through the economy though.
Proto Labs
Proto Labs offers a low touch outsourced manufacturing service that is focused on prototyping and low-volume use cases. Manufacturing capabilities injection molding, CNC machining, 3D printing, and sheet metal fabrication.
The company's initial focus was on fast turnaround times, but a recent shift in strategy has enabled Proto Labs to provide a broader range of services with less focus on lead times.
Figure 3: Typical Manufacturing Workflow (source: Proto Labs)
Proto Labs utilizes technology to eliminate the skilled labor required to quote and manufacture parts, with most of its business being conducted over the internet. The company started with plastic injection molding in 1999 and has expanded its offerings over the years:
- CNC machining (2007)
- 3D printing (2014)
- Rapid overmolding technology (2016) and insert molding technology (2017)
- PolyJet and Multi Jet Fusion 3D printing (2017)
- Sheet metal fabrication (2017)
- Carbon Digital Light Synthesis 3D printing (2019)
Proto Labs' Injection Molding product line uses CNC machining to produce molds, which are then used to produce plastic and liquid silicone rubber injection-molded parts. This business is primarily targeted at on-demand production, bridge tooling, pilot runs and functional prototyping.
CNC milling is a subtractive manufacturing process that cuts plastic and metal blocks into a part. Proto Labs CNC machining business targets prototyping, form and fit testing, jigs and fixtures and functional components for end-use applications.
3D printing is an additive manufacturing process that builds a part in layers using a printing material. While there is a diverse range of 3D printing technologies available dependent on the particular use case, Proto Labs offers SL, SLS, DMLS, MJF, PolyJet, Carbon DLS and fused deposition modeling processes. This business targets functional prototypes, complex designs and low-volume end-use applications.
Proto Labs sheet metal service produces sheet metal parts based on 3D CAD models for rapid prototyping and end-use production parts.
Rather than developing cutting edge technology to manufacture complex or high-performance parts, Proto Labs has focused on scale, infrastructure and automation to serve a large number of customers. Proto Labs believes that machine learning based on data from each part analyzed allows it to improve its technology, potentially providing economies of scale and a sustainable competitive advantage. Over the course of its history, Proto Labs has analyzed over 13 million unique part designs . While this makes intuitive sense, there is little evidence of economies of scale in Proto Labs' financial data.
Proto Labs is also developing software for additive manufacturing, which increases the scalability of its business and supports efficiency. For example, its design for additive manufacturing tool provides feedback to customers to help them design 3D parts. This software also potentially provides value to customers by improving the design of parts. Additive manufacturing is currently a fairly small part of the business, limiting the overall impact of this software.
Hubs Acquisition
While the pandemic, supply chain disruptions and macro headwinds over the past few years make it difficult to assess, Proto Labs' growth appears to have stalled in 2018. This may have been a contributing factor behind the company's decision to acquire Hubs in 2021.
Proto Labs acquired Hubs for 280 million USD (130 million USD cash and 150 million USD stock) with a contingent consideration of up to 50 million USD dependent on performance. Hubs generated roughly 25 million USD revenue in 2020, making this a relatively expensive acquisition, particularly given the large cash component.
As a result of the acquisition, Proto Labs now has two primary businesses:
- Digital Factory – internal manufacturing in the US and Europe (rapid turnaround)
- Digital Network – manufacturing through external network (longer lead times but higher precision)
Figure 4: Proto Labs Revenue (source: Proto Labs)
Hubs was founded in 2013 and through its partner network is able to offer customers injection molding, CNC machining, 3D printing and sheet metal fabrication.
Proto Labs network offering has significantly expanded its addressable market and is currently driving growth. The combination of factory and network capabilities increases the scalability of production as well as providing a broader range of capabilities (parts with tighter tolerances and greater complexity). This includes a broader mix of pricing and lead time options, which can result in more cost-efficient pricing for customers.
Figure 5: Proto Labs + 3D Hubs Market Coverage (source: Proto Labs)
Hubs' platform offers customers access to a network of around 240 manufacturing partners .
Figure 6: Proto Labs Digital Manufacturing Locations (source: Proto Labs)
Customers
Proto Labs primary end markets are:
- Medical
- Electronics
- Automotive
- Aerospace
- Industrial Equipment
Proto Labs serves 85% of the Fortune 500 companies in the above industries.
Table 1: Proto Labs Revenue by Customer Industry (source: Created by author using data from Proto Labs)
Financial Analysis
Proto Labs generated 131 million USD revenue in the third quarter of 2023, a 7% increase YoY in constant currency excluding Japan, with growth driven by CNC machining and 3D printing. Revenue exceeded guidance in the third quarter as orders were stronger than expected after the first few weeks of July. Proto Labs' Digital Network business continues to be a growth driver, with revenue increasing 80% YoY in the third quarter to 23 million USD.
Injection molding is returning to growth with Proto Labs winning larger orders, demonstrating expansion into more production use cases. Injection molding revenue increased roughly 6% YoY in constant currency and excluding Japan. The increase was largely due to higher orders for follow on parts.
Proto Labs’ CNC machining business grew 11% YoY in constant currency and excluding Japan, with revenue through Proto Labs’ Digital Network growing over 85% YoY. This part of the business is driving growth at the moment, but the economics of this business may be less compelling than Proto Labs’ internal manufacturing business.
3D printing revenue grew 7% YoY in constant currency and sheet metal revenue declined 18%. The sheet metal business has been facing headwinds in 2023 but grew 9% sequentially in the third quarter.
Americas revenue increased 5% YoY in the third quarter, with Europe revenue up by 17%. Proto Labs chose to exit its Japanese operations in 2022, and September 2022 was the last month in which this business generated revenue. This has created YoY headwinds which will no longer be present going forward. Proto Labs Japanese business provided approximately 13 million USD revenue in 2021 and 8 million USD revenue in 2022.
Medical strengthened in the third quarter, particularly in injection molding, but still declined YoY. Aerospace, automotive and industrial were areas of strength in the third quarter but electronics remained soft.
A meaningful portion of third quarter revenue growth came from larger strategic customers. This could be evidence that Proto Labs is successfully deepening its relationships with customers. Average order values have also been increasing across both the network and factory businesses, supporting the notion that Proto Labs is driving further adoption within its customer base.
In the third quarter more than 23,000 design engineers and production buyers ordered parts from Proto Labs. This figure was down approximately 3% YoY, although Proto Labs feels this metric is becoming less relevant given its desire to deepen relationships with customers.
CNC machining orders in early October were not as strong as the prior quarter, leading Proto Labs to adjust guidance. The company now expects to generate 118-126 million USD in the fourth quarter, which implies 5% revenue growth YoY at the midpoint in constant currency.
Figure 7: Proto Labs Revenue by Service (source: Created by author using data from Proto Labs)
Digital Factory margins improved sequentially on the back of higher volumes, labor efficiencies and automation. Network gross margins were 33.7% in the third quarter. Proto Labs continues to refine its network sourcing and pricing algorithms and has a long-term target gross margin of 25-30% for the Network business. With Digital Network growth expected to outpace Digital Factory growth going forward, gross profit margins are likely to remain under pressure.
Figure 8: Proto Labs Gross Profit Margin (source: Created by author using data from Proto Labs)
Proto Labs manufacturing headcount was down 9% YoY in the second quarter due to a contraction in volumes. Going forward Proto Labs plans to continue aligning staffing levels with manufacturing volumes. This should mean that hiring is at least broadly indicative of the short-term direction of Proto Labs' business. In this regard, the data appears to point towards stabilization, rather than outright improvement.
Figure 9: Proto Labs Job Openings (source: revealera.com)
One of the most concerning aspects of Proto Labs business is the lack of operating leverage the company has been able to achieve in recent years. This, coupled with a deterioration in gross profit margins, has resulted in the company's profitability being significantly undermined. While Proto Labs is still currently profitable, if the company cannot realize operating cost efficiencies in coming years, it risks slipping into losses.
Figure 10: Proto Labs Operating Expenses (source: Created by author using data from Proto Labs)
Proto Labs hasn't really been able to drive any operating leverage across sales and marketing, R&D or general and administrative expenses. In the case of sales and marketing, expenses appear to be steadily rising, which is a concern given the fact that there is structural downward pressure on gross profit margins. Some of this may be the result of the weak macro environment, but it could also be due to an effort to expand the business. 94% of Proto Labs’ revenue in 2022 came from repeat customers, which could reasonably be expected to lower the burden of sales and marketing expenses. This hasn't proven to be the case so far though.
Figure 11: Proto Labs Operating Expenses (source: Created by author using data from Proto Labs)
Conclusion
Proto Labs valuation appears low relative to its own history and comparable companies. This notion is supported by the company's repurchase of 9 million USD of shares in the third quarter. The company plans to continue repurchasing shares opportunistically, and still has over 100 million USD of cash and investments and no debt on the balance sheet with which to do this.
This under valuation is likely due a current lack of investor appetite for small cap companies and headwinds facing the manufacturing sector. Investors also need to keep in mind that Proto Labs profitability has fallen significantly in recent years and Proto Labs' growth has also been soft. If the company's gross profit margin continues to decline without Proto Labs realizing operating leverage, the stock could remain under pressure going forward, particularly if the macro environment deteriorates going forward.
Given Proto Labs valuation and recent return to growth, along with improving sentiment towards small cap stocks, I believe the risk-reward setup for an investment in Proto Labs is still favorable.
Figure 12: Proto Labs Relative Valuation (source: Created by author using data from Seeking Alpha)
For further details see:
Proto Labs: Overlooked Digital Manufacturing Opportunity