Author: Ben Rose
Facebook: Grappling with User Privacy
Balancing user privacy with the desire of advertisers to collect insightful user data is a challenge Facebook has faced since its inception. As evidenced by the company’s recent affirmation of its ad-driven business model, Facebook has no plans to alter its basic value proposition. However, recent industry events have once again brought the conflict between user privacy and advertiser demands to the attention of regulators in the US and in Europe.
By way of background, less than a year before its IPO, Facebook signed a consent decree with the US FTC, under which it agreed to settle charges without admitting or denying guilt that it had deceived consumers by telling them they could keep information private, but then sharing it repeatedly. In signing the consent decree, Facebook agreed that it must obtain consumers’ express consent before their information is shared beyond the privacy settings they create. As part of the settlement, Facebook agreed to audits conducted by independent third parties once every two years for the next 20 years to verify that its security procedures exceed the standards set by the FTC. The FTC is currently investigating whether Facebook has violated the consent decree, which could result in penalties of up to $40,000 per user per day.
Facebook maintains that the data harvested by a third party app utilized by the consultancy Cambridge Analytica was obtained and applied in violation of its policies, specifically procedures put in place in 2014 to prevent so-called “abusive apps” from gaining unauthorized data from Facebook users. The Cambridge Analytica imbroglio is particularly significant, in light of new privacy regulations that are being imposed by the European Union under the General Data Protection Regulation (GDPR), which goes into effect later this week. Under the new regulation, advertisers must be transparent about their use of customer data, and users must give their expressed consent to allow advertisers or other third parties to utilize their data. In response, Facebook and other internet advertisers are working to comply with European regulators, who could impose penalties of up to 20 million Euros, or up to four percent of annual revenue, whichever is greater. In the case of Facebook, a violation could result in a penalty of up to $1.6 billion.
The initial GDPR impact on Facebook is likely to be a decline in the rate of growth in its European user base, which currently stands at 282 million daily active users, or 19 percent of its user base. Beyond that, the impact is unclear. One school of thought suggests that Facebook could face declines in advertising revenue, based on a lower base of users reachable by advertisers. The counter argument is that users who give their consent will be more susceptible and receptive to ads that they are implicitly agreeing to view, thus making the remaining base of users even more valuable to advertisers.
In the mean-time Facebook is redoubling efforts to root out third party apps that violate its data privacy rules. Facebook has stated that it has more than 10,000 people working on security and safety issues now, with plans to double this number by the end of this year. Last week Facebook announced that it has already examined thousands of third party apps, and has suspended about 200, pending a thorough investigation into whether the apps misused user data. Any of the apps in question that are found to be in violation of Facebook’s policies will be banned from Facebook, and users of the app will be notified.
The recent Cambridge Analytica imbroglio, combined with the rollout of GDPR is likely to keep the spotlight on Facebook and other internet advertisers. By taking more proactive measures to ensure user privacy Facebook is likely to navigate the conflicting demands placed upon it by users, advertisers, and regulators.
Amazon.com: Eyeing the Home Robot Market?
According to what appears to be a credible article in last week’s Bloomberg Technology, Amazon.com is proceeding with plans to create a home robot, through a product development effort that has been code-named Vesta, as part of its Lab126 consumer device division, based in Sunnyvale, California. Lab126, led by Greg Zehr, a former head of R&D for Palm, a pioneer in mobile computing, is credited with the introduction of Kindle e-book reader, and is responsible for the Amazon Echo, FireTV set top boxes, and Fire tablets. It is unclear what purpose an Amazon.com home robot would serve, but in general terms the speculation is that Amazon.com is looking to build on the success of the Amazon Alexa assistant and Echo home speaker product line by creating a roaming version of Alexa, perhaps with the ability to conduct basic house chores.
The authors of the article indicate that prototypes have been built with advanced cameras, and that Max Paley, a former Apple executive, is working on computer vision technologies for a home robot. The Bloomberg article suggests that Amazon.com plans to “seed” robots in homes by the end of this year, and could potentially launch a commercial robot sometime in calendar 2019. The article also indicated that based on Amazon’s prototypes and tests, it may choose not to enter the market.
Is Amazon.com’s Entry Plausible?
Despite its failure in the smart phone market, Amazon.com has emerged as a prolific consumer electronics product company, having made a number of successful bets, most notably having created the e-book market with the Kindle, and more recently creating the market for smart home assistants, via Alex and Echo. Importantly, Amazon has had its greatest success in categories that it creates. In the Kindle e-reader category, Amazon used to have some competition from the Nook, but not much anymore. Google, which is looking to parlay its success with Google Assistant into the Google Home product line, is playing a severe game of catch up to Amazon.com, as the Echo device family holds a more than two-to-one market share advantage against the Google Home product. Alphabet recently merged its Nest division, which provides, smart thermostats, smoke detectors, webcams, and home alarm systems, into its Google hardware division, suggesting that the Google assistant will be more tightly integrated into Google’s smart home offerings.
At this point it remains unclear what Amazon.com’s product and delivery plans are for the smart home, beyond continued updates to the Echo device family. Amazon.com has a growing base of talented engineers, and proven expertise in addressing the smart home, through the success of Alexa and Echo. Amazon also owns its own robotics company as a result of the $750 million acquisition of Kiva Systems back in 2012. Kiva has been focused on robots for warehouse fulfillment operations, and it is unclear whether the robotic R&D efforts of Kiva, based on the East Coast, and Lab123, are linked.
Our sense is that Amazon.com has many of the pieces in pace to create some type of consumer robot. The question we have is how long it would take Amazon to commercialize a product, and what tasks it would perform. Another key question is whether Amazon.com will choose to enter the market at all, given the large number of other product opportunities that it has under consideration.
Care.com: A Linked In For Family Care
With trailing twelve month sales of $165 million, a market cap of roughly $555 million, $96 million in cash and no debt, Care.com has become the leading online destination for finding and managing family care in the US. Like LinkedIn, which matches job seekers with prospective employers, Care.com is focused on matching the needs of families and caregivers creating in essence a one-stop shop for family services throughout the lifecycle of a family or individual household.
Led by founder and CEO Sheila Lirio Marcelo, and Michael Echenberg, EVP of finance and CFO, Care.com targets a large addressable market, as evidenced by the fact that US consumers spent $300 billion on family care services last year, including child day care, housekeepers, nursing care facilities, tutoring, and pet care services. The market remains highly fragmented, served by traditional family care agencies, as well as brick and mortar chains that provide a variety of services.
Last year in the US, consumers spent over $300 billion on family care services, including child day care, housekeepers, nursing care facilities, tutoring, and pet care services. Services providers include nanny agencies, child day care centers, elderly care services, including in- home services and nursing care facilities. Specialized service providers for tutoring and pet care, as well as other online destinations provide a wide variety of competitors in this highly fragmented market.
Family care decisions often reside with a female head of a household, the primary audience targeted by Care.com. Decisions for services providers are often based on word of mouth stemming from personal networks. Decisions must be made with regard to the preference for in-home services, or brick and mortar facilities outside of the home.
Care.com identifies its primary target market as the roughly 46 million US households with income greater than $50,000 per year with either a child under the age of 18 and/or a senior aged 65 and over. The company also includes an estimated 15 percent of households with incomes under $50,000, with similar dynamics. Care.com’s in-home consumer services remain in the early phase of market growth, yet benefit from some compelling demographic facts and trends, which include the rise in single parent households, the prevalence of dual income households, an aging population, and increasing trust in the internet as a destination to help make decisions relating to family, home and health.
In just 10 years, Care.com has carved out an enviable internet presence, which features more than 26 million registered users, comprised of nearly 15 million families, and more than 11 million caregivers. At the end of the most recent quarter, 320,000 paying families purchased a subscription to the company’s caregiver listings, and/or the company’s service for household payroll and tax preparation services.
Key swing factors that will determine Care.com’s ability to rise or fall over the next 12-18 months include it ability to:
- Grow its core US consumer business through continuous improvement to its core matching platform, as well as targeted initiatives to grow senior care, housekeeping, and pet care, leveraging its registered community of more than 26 million members.
- Develop awareness as a trusted source for families and caregivers, through both its own accreditation, as well as the halo effect provided by corporations, non-profits, and potentially insurance plan providers that adopt and promote its services.
- Drive additional revenue growth from three key growth initiatives: employer-sponsored family services for employees, overseas expansion, and marketing programs for daycare, nanny, and elderly care agencies.
For more information on Battle Road’s 24 month assessment of Care.com, please contact [email protected].
Spotlight on Social Media
Spotlight on Social Media: Twitter’s Registration Policies Under Review
Recognizing the rising influence of social media networks on the spread of junk news and unfiltered opinion, Facebook and Twitter have been called recently to testify before Congress to discuss their policies to monitor illegally registered and anonymous users, as well as advertisers. A wide range of concerns are under examination, including the use of social networks by foreign governments to influence the outcome of the 2016 presidential election, as well as foreign governments and hate groups seeking to inject invective into the discourse on current affairs.
Unlike Facebook, which purports to have policies in place to vet the identity of those who purchase ads and post opinions, Twitter has a looser policy as it pertains to posting opinions, one in which a user need not provide details of his or her identity to post messages.
Twitter announced on September 28th that Russia Today, a media organization with strong ties to the Russian government, purchased $274,000 in US ads in 2016 and promoted over 1,800 tweets targeted to the US market. The company also detailed some of its efforts to root out misinformation on its sites, as well as ongoing efforts to eliminate false or spam accounts, which the company estimates as less than five percent of its monthly active user base, which totals 328 million.
In light of prior concerns expressed by US and European regulators, Twitter already has policies in place to root out terrorist postings, hate-related violence, and child pornography from its web sites. Partly in response to calls for Twitter to police its user community, the company recently announced that it has suspended nearly 300,000 user accounts with links to terrorism in the first half of 2017, 95 percent of which were unmasked by the company’s automated spam-fighting tools. 75 percent of the accounts were suspended before the account could fire off its first tweet.
With regard to hate speech, Twitter and Facebook last year pledged to European authorities that they would respond to violent, xenophobic, or racist comments within 24 hours. European authorities have recently requested that the companies respond even faster in cases of suspected terrorist postings.
Twitter has, however, chosen not to be an arbiter over political views or the veracity of news sites espoused by users, in keeping with its policy to allow the free exchange of ideas and opinions, no matter how crudely expressed. This policy has placed it at odds with various national governments over the years, including the US government. Twitter has sued the US government over Twitter’s desire to publish in its transparency reports the precise number of requests sought by government authorities and FISA court orders.
Our overall sense is that government authorities will keep the heat on Twitter to suspend and remove terrorist postings on the platform, but that authorities will be less able to restrict political opinions and regulate foreign news sources, both of which would be anathema to free speech advocates.
ASC 606: Accounting Controversy on the Horizon
A new accounting standard relating to sales expense recognition is likely to create controversy in the world of software earnings quality, particularly given the recent trend toward multi-year contracts associated with software subscriptions.
ASC 606, jointly issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) on May 28, 2014, provides guidance for revenue recognition as well as the accounting for certain sales expenses. The rule allows companies with revenue contracts extending beyond a single year to capitalize and then amortize the incremental cost of the contract acquisition over the life of the contract. Therefore, certain sales commissions can be deferred, even though the commission is paid at the time the contract is approved. This is significant for any software company whose average contract length is more than a year, for it allows the company to defer a certain portion of its sales commissions, reduce its reported sales expense, and boost earnings in the process.
Though FASB and the IASB originally envisioned adoption of the guidelines to occur after December 15, 2016, or, for practical purposes, during the first calendar quarter of 2017, an update provided by FASB last summer deferred the effective start date for one year for public entities reporting under US GAAP. Thus, companies are not required to comply until the first calendar quarter of 2018.
ASC 606, if adopted, will have a significant impact on companies which pay out the bulk of their sales commissions in a particular quarter as part of a yearly incentive structure. For companies with multi-year contracts the reduction in sales expense could be significant in the year-end quarter. It will therefore be important to evaluate the earnings performance of a company as if the accounting guideline had been implemented in the prior year, in order to ensure an apples to apples earnings comparison, and to determine whether a company’s reported earnings may have been artificially stimulated as a result of adopting ASC 606.
Proponents of ASC 606 assert that the capitalization and subsequent amortization of sales expense better matches a company’s ratable revenue recognition pattern for subscriptions. We believe that ASC 606 distorts the P&L by systematically under-reporting expenses incurred by a company at the time of payment. Another argument in favor of capitalizing commissions is that sales expense represents an incremental cost associated with a sale. Yet, so are marketing and promotional costs, as well as R&D expenses, since market awareness and the addition of new product features can directly impact the purchase decision.
In terms of historical precedent, one recalls the enactment of FASB 86, an accounting edict proclaimed in August of 1985, which enables companies to capitalize –rather than expense— certain software development activities between the point of establishing commercial feasibility and “completion” of the product. Upon review of the ruling, Francis (Frank) J. Gaudette, the late great CFO of Microsoft, who helped orchestrate the company’s IPO in 1986, refused to recognize as legitimate any interval between feasibility and product completion, with the view that research and development costs should be expensed entirely in the period in which they are incurred.
By taking a hardline stance against capitalization of R&D under any circumstance Gaudette set a precedent among software companies with conservative accounting practices, whose earnings multiples—like Microsoft’s—have been rewarded over time. As ASC 606 comes into effect, and a spotlight shines on the sales and marketing expense line of subscription software companies, one should take with a certain grain of salt the considerable operating margin improvement that some companies will claim as a result of adopting the new guideline.
Twitter: Obstacles to Overcome
As of this writing in late December, Twitter (NYSE: TWTR) continues to struggle, relative to its internet advertising peers Facebook (NASDAQ: FB) and Google (NASDAQ: GOOGL). Despite a flurry of activity in the fall, during which the company was rumored to be on the auction block, the stock has floated back down to earth, and then some, as investors consider several ongoing challenges faced by the company. Among these are persistent management turnover, a struggle to rekindle user growth, and what we perceive to be mediocre earnings quality.
Management Turnover Continues
In the first 18 months following its IPO in November of 2013, Twitter was plagued by rampant management turnover, including a 60-day interval, during which three of the top five executives listed in its S-1 filing resigned or were reassigned to new posts in the company. Jack Dorsey, Twitter’s Chairman and co-founder, became CEO in October of 2015, and, until recently, management turnover had stabilized.
On November 7th Twitter COO Adam Bain informed the company of his decision to resign, after a six year stint, which featured a role as head of advertising sales. Two days later, Twitter announced that it had appointed CFO Anthony Noto as COO. Noto will continue in a dual role as COO and CFO until a new CFO is hired. The COO position is crucial, as Twitter’s CEO Jack Dorsey continues to split his time between Twitter and Square, another company that he co-founded. Noto, who had been in charge of live content, in addition to his CFO responsibilities, is now in charge of global advertising sales, data, MoPub, as well as global partnerships and business development.
Then on December 20th, Twitter’s chief technology officer, Adam Messinger, resigned. On the same day, Twitter’s VP of product, Josh McFarland let it be known that he was leaving the company to join a venture capital firm.
Working to Rekindle User Growth
Twitter reported its lowest-ever rate of year over year revenue growth in Q3 2016, as advertising sales rose just six percent over the prior year. This was the seventh consecutive quarter that sales growth declined. Monthly active users (MAUs) grew by just three percent in the last quarter. In addition, the company has, for several years, declined to report the number of daily active users, which are suspected to be considerably lower than its 317 million MAUs.
Twitter is working behind the scenes to induce users to utilize the service more frequently. Efforts underway include the addition of new content, such as Thursday Night Football, as well as the application of machine learning and artificial intelligence to improve the user experience, particularly in the area of notifications, and home timeline, where the majority of user time is spent. The company is focusing in particular on improving the relevance of user notifications, and emphasizing topics and interests, rather than following people per se, as methods to improve user engagement.
Earnings Quality Remains Poor
Like most VC-backed West Coast technology companies, Twitter utilizes a healthy dose of stock-based compensation, which reduces the near term cost of compensating employees, but passes the longer term cost along to shareholders, who are left to absorb the increased issuance of stock in the form of reduced earnings per share, once the options grants are exercised. In the third quarter of 2016, stock-based compensation accounted for 32 percent of gross operating expenses. SBC is particularly noteworthy within research and development, where it accounted for 49 percent of gross research and development expenses in the third quarter.
Another area of concern regarding Twitter’s EBITDA presentation is how it accounts for research and development costs. Twitter continues to capitalize, rather than expense, a considerable portion of its research and development costs. While this is a perfectly legal practice, we believe R&D costs should be expensed in the period in which they are incurred, rather than capitalized as assets that can be amortized later through COGS, at which point the non-cash amortized expense is viewed by many to be inconsequential.
Twitter continues to languish relative to its internet advertising peers. Our sense is that the company still has obstacles to overcome, as its management ranks continue to shift, user growth remains tepid, and the company’s earnings quality remains low.
Veeva Systems: Expanding into Clinical Trials
The most significant development in the clinical trial software market is the recent expansion of Veeva Systems (NYSE: VEEV), which until recently had made only a light-hearted effort to address the market. As part of its previous strategy, Veeva had partnered with Medidata Solutions (NASDAQ: MDSO) in an alliance which recognized Oracle (NASDAQ: ORCL) as a common enemy. Veeva, whose strength stems from selling sales force automation software to large drug and biotech companies, including 24 of the 25 largest world-wide, has, in the last two years, set its sites on the research and development activities of the large drug companies, with a series of new database applications.
About four months ago Veeva Systems announced its intent to introduce a clinical trial management system, or CTMS, in the first quarter of 2017. This builds upon the success of the company’s eTMF and Vault Study Startup applications geared to the clinical side of enterprise content management. However, Veeva had not announced plans for an electronic data capture or EDC application, which is often seen as an essential ingredient for a fully-functioning clinical trial system. Instead, Veeva worked alongside Medidata, whose Rave EDC product is well entrenched in many large pharma accounts.
Recently, however, Veeva announced its intent to deliver a cloud-based EDC application, Veeva Vault EDC, which it expects to be available in April of 2017. In doing so, Veeva intends to build on its base of 120 clinical operations customers, which include deployments of its Veeva Vault eTMF in seven of the top 20 pharma companies. Veeva also announced that it will unveil Veeva Vault eSource, a mobile app for clinical trials, by the end of 2017.
Undoubtedly, Veeva Systems faces challenges in penetrating the market, not the least of which is the fact that its strongest relationships in the in the pharma industry have previously been confined to the sales, customer service and IT management sides of the business. Veeva has, however, sold at least one Vault module to at least 34 of the top 50 global pharma companies, and Veeva has an opportunity to expand within the R&D group, which has significant input into clinical trial software selection. Veeva also has the opportunity to approach a new set of customers in the CRO industry.
In summary, we believe that the recent expansion of Veeva into clinical trials holds much promise for the California-based company, and suggests greater ambitions to address the research and development needs of life sciences companies.
Mobileye: Behind the Delphi Automotive Partnership
While much attention has been focused on Mobileye’s (NYSE: MBLY) decision to dissolve its OEM supplier relationship with Tesla Motors (NASDAQ: TSLA), a more important development in our opinion is Mobileye’s decision to work more closely with Delphi Automotive (NYSE: DLPH) on a new OEM solution focused on autonomous driving.
On August 23rd Mobileye announced a new partnership with Delphi Automotive PLC (Delphi hereafter), one of its largest Tier One customers, with whom it has been working for over ten years. The new arrangement envisions the creation of a turnkey autonomous driving package for the most advanced stages of driving automation. A major focus for Delphi is electronics and safety, a business segment through which it provides software, systems, and components for car passenger security, comfort and safety, including passive and active safety electronics, displays, and mechatronics. Delphi’s products for ADAS include technology provided by Mobileye, as well as a number of other suppliers, whose products range from radar, camera systems, and software, to sensors.
Like many of Mobileye’s Tier One customers, Delphi has been working on various initiatives relating to advanced driver assisted and driverless car features. A little more than a year ago, Delphi acquired Ottomatika, a Carnegie Mellon University spin-out, to enhance its active safety and automated driving capabilities. Delphi is now in the process of integrating Ottomatika’s automated driving software into its active safety systems to create a platform to make human-like decisions. Delphi also made an equity investment in Quanergy in order to develop low-cost, high performance solid state LiDAR products that will provide a complete vehicle perception solution for Level 3 and Level 4 automation applications for semiautonomous or driverless vehicles.
A key part of the agreement between Mobileye and Delphi calls for the companies to combine efforts on machine learning to create a new class of machine intelligence that mimics human driving, including ways for a driverless car to negotiate with other vehicles to merge into urban traffic, a key challenge for achieving real-world automated driving. Under the terms of the agreement, the two companies will work toward creating a full turn-key package for Level 4 and Level 5 automation by 2019. Beginning at the Consumer Electronics Show in January, the companies plan to demonstrate a prototype vehicle. Fleet testing is slated to begin in 2017.
Even though Delphi is a Mobileye customer, Delphi’s R&D projects raised the suspicion in our minds that the companies might compete against one another in the future. However, the new partnership makes clear that the two will be coordinating their efforts for a number of reasons, not the least of which is a common competitive threat, as each company seeks to blunt the impact of Continental AG and Robert Bosch Group, two German-based Tier One automotive suppliers, both of whom have ambitious driver assisted technology initiatives underway. Since Bosch, Continental, and Delphi each work with all of the largest 25 global car makers, much is at stake. Mobileye has the ability to help Delphi create a truly differentiated driverless car product, and in doing so, will strengthen one of its key alliances.
Proto Labs: Growing Pains Begin
With trailing twelve month sales of $289 million, and a market cap of roughly $1.6 billion, Proto Labs, based in Maple Plain Minnesota, is the largest provider of quick turn manufacturing services, with offerings for plastic and metal-machined parts. Through the use of patented technology for plastic injection molding and CNC machining, as well as an advanced web-based ordering system, PRLB is an outsourced partner to its more than 8,000 customers, who seek help in creating prototypes as well as production runs of up to 10,000 parts. In addition, PRLB has acquired a couple of companies that provide 3D printed part services, which collectively account for about 13 percent of sales.
Proto Labs provides customers with the crucial benefits of faster time to market, improved product quality, and the ability to quickly customize low volume production runs. With seven manufacturing facilities around the world, Proto Labs derives less than 25 percent of its revenue from overseas operations. The company’s customers include manufacturers and designers of medical devices, cars, aerospace, defense, and aviation products, as well as consumer electronics, and industrial machinery. Each quarter, Proto Labs conducts a high level of repeat business within its customer base, typically around 80 percent. Importantly, no customer accounted for more than two percent of sales in 2015.
Large industrial manufacturers have been reluctant in the past, for a variety of reasons, to outsource prototyping and production. The reasons relate to the desire to maintain captive production of prototypes and custom parts, and the preference to keep low volume manufacturing in house. However, the trend toward mass customization, in which consumers desire near custom-built products in smaller quantities with fast turnaround times is at odds with the core competency of many manufacturers who are unable to achieve the desired unit costs that come with low volume production. Outsourcing production also allows companies to concentrate on other core competencies, such as product design, marketing, distribution, and customer service.
However, recent challenges attendant to soft demand in the industrial machinery vertical, as well as challenges in integrating the Alphaform 3D printed parts service will weigh on sales growth and margin expansion.
Proto Labs: Recent Developments
Soft Demand in North America
Proto Labs’ Q2 revenue of $75 million grew by 17 percent over the prior, including the results of Alphaform, a 3-D printing operation which was acquired last year, and contributed nearly $5 million in revenue in Q2. US revenue, which accounts for 74 percent of sales, grew by just six percent versus the prior year, the slowest rate in a couple of years. Despite the fact that no single customer accounts for more than two percent of sales, Proto Labs is seeing weakness in its top 20 accounts, and cited industrial and commercial equipment as particularly soft verticals in the quarter. Importantly, plastic, rubber and die cast injection molders and machine shops, who normally outsource prototypes and low volume production runs to Proto Labs, are now doing more in-house manufacturing of these parts and prototypes, due to their own excess capacity.
Proto Labs is also seeing project delays. CNC Machining operations, which normally account for about a quarter of quarterly sales, were relatively weak, rising by just seven percent over the prior year. Bright spots during the quarter include relatively strong performance from both Europe and Japan, which account for 23 percent, and three percent of sales, respectively. Europe, excluding the contribution from Alphaform, grew by 24 percent, and Japan grew by 46 percent.
Despite a soft quarter, Proto Labs’ quality of reporting remains consistently strong. During the second quarter PRLB generated $20 million in cash from operations and allocated $14.1 million to capital expenditures, of which $8 million were for facilities, as the company is adding capacity in North Carolina, and in Japan. As a result, cash on the balance sheet increased by $7 million on a sequential basis.
Alphaform Impact
Alphaform, a German-based 3D printing operation acquired at the end of 2015, remains an integral part of Proto Labs’ strategy to accelerate its European operations in the 3D printed parts services business. 3D printing contributed $9.1 million in revenue in Q2, flat with the preceding quarter, and up 67 percent versus the prior year. However, the growth was almost entirely due to the addition of Alphaform last year. When excluding the $4.8 million contribution from Alphaform, 3-D printer revenue growth was nominal.
Alphaform diluted the company’s gross margin by 310 basis points, a pattern which has been the case since the company was acquired. The lingering impact of certain Alphaform contracts with lower gross margins, as well as several niche businesses such as metal and magnesium injection molding, which are in the process of being discontinued by Proto Labs, contributed to relatively weak margins in the quarter.
Sales Management Disruption
Back in April of 2016, Proto Labs disclosed that its VP of global sales had resigned. Since then, the company has been hiring new sales managers, in an effort to reduce the ratio of sales managers to sales people. Proto Labs has also engaged a consulting firm to examine its sales processes and recommend new ones, pending their conclusions. The company is also in the process of hiring a new chief revenue officer, which it expects to do by the end of the calendar year.
Prognosis
Despite the above-mentioned growth pains, overall, we see Proto Labs as among the best positioned manufacturing technology companies. Proto Labs maintains a strong balance sheet, with total cash and securities of $164 million, or $6.18 in cash per share, and no debt. The company maintains a conservative current ratio of 6.3, and accounts receivable DSOs were a modest 41 days at the end of the quarter, up by just a day versus the prior year. Return on equity was 15 percent on a trailing twelve month basis, consistent with prior periods. Importantly, Proto Labs has done nothing to stretch its quarterly performance, and maintains a high quality of reporting integrity. The company’s expertise in manufacturing materials and production should continue to position it well for the long term.
3D Systems: Can New Management Turn the Tide?
On April 4, 2016, following a six month search, the board of directors of 3D Systems (3DS hereafter) appointed Vyomesh Joshi, aka VJ, as president and CEO. The appointment occurred as the venerable manufacturer of 3D printers attempts to regain its footing, following an extended period of questionable acquisitions, loss of market focus, and damaged credibility among investors.
Joshi, aged 62, had been president of the Imaging and Printing Group of Hewlett Packard for 11 years, beginning in February 2001, and left as EVP in March of 2012, bringing to a close a 31-year career at HP, after HP, in one of its many reorganizations in the last number of years, combined printers and personal computers into the same business unit. While leading the $26 billion H-P printer business, Joshi doubled the division’s operating profit. Joshi appears to have been lured out of near-retirement with a stock and options package worth a potential $27 million, based in large part on 3DS’ future stock performance. Joshi is currently on the board of directors of both Wipro (NYSE: WIT) and Harris Corporation (NYSE: HRS). He received his bachelor’s degree in engineering from L.D. College in Ahmedabad, India, and a master’s degree in electrical engineering from the Ohio State University.
Joshi replaces 3D Systems’ highly flamboyant and acquisitive CEO Avi Reichental. Over the last few years 3DS has endured numerous set-backs, including an over-emphasis on acquisitions for growth, missteps in the consumer printer market, distribution channel challenges, product quality issues, a delay in the filing of its 2015 10-K, along with a lack of investor confidence, which has resulted in a more than 80 percent contraction in its share price since peaking at $97.25 in late 2013.
Since taking the helm at 3DS Joshi has been somewhat coy regarding future plans, but has noted the company’s lack of operational efficiency, and the challenge to build a sustainable corporate culture from among the company’s employee base of roughly 2,500, many of whom have come to 3DS via acquisition. In mid-June 3DS announced it had hired John N. McMullen, age 58, as VP Finance and CFO, replacing David Styka. McMullen had most recently been at Eastman Kodak, where he took the helm as CFO beginning in June of 2014. Prior to that, McMullen, was SVP Finance and Corporate Treasurer, as well as CFO of HP’s Imaging and Printing Group, where he worked alongside 3DS’ new CEO, Joshi.
The new management team will have much to confront, including helping customers sift through the reality versus the hype of 3D printing, along with the need to create printers with faster speeds and more precision to produce parts that can be used in volume production, in addition to prototypes utilized for visualization and marketing purposes. 3DS has, along with many of its competitors, from time to time over the last three years, produced printers with varying levels of product quality.
With regard to Joshi’s future strategy, we can gain a glimpse into his thinking. In an address before the Net Impact Conference at Stanford in November of 2005, Joshi spoke of the elements required to create a sustainable business. These include: identifying holes in the market, developing appropriate price models, establishing business partnerships, fostering trust and respect among employees, and providing leadership that puts business first, people second, and the egos of managers third.
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