In our Investment Comments last December 2014, we highlighted the slowing of international economies:
“China’s third quarter GDP grew at an annualized rate of 7.3%, down modestly from earlier this year. Europe is barely growing at a 0.6% rate and struggling with dwindling inflation, only 0.4% in the third quarter. Japan’s economy slipped into recession, falling 1.6% in the third quarter after a 7.3% contraction in the second quarter. Both China and Japan have responded with stimulus efforts, with Europe likely to follow.”
Of course, Europe did in fact follow suit, as ECB President Mario Draghi began a quantitative easing program in the first quarter of 2015. International growth has only gotten worse since our update last December. China’s official GDP numbers continue to show a deceleration, with third quarter 2015 GDP growth dipping to 6.9% year-over-year. Skeptical economists who track underlying metrics like rail cargo traffic, electricity consumption, and demand for loans suggest the real number may be closer to 4%-5%. Meanwhile, Europe continues to inch along at 0.3% sequential growth in the third quarter, and Japan just slipped back into recession. Emerging economies like Russia and Brazil remain mired in deep recessions thanks to the collapse in commodities, with Russia posting four straight quarters of negative GDP growth and Brazil posting two.
In an environment where international growth is anemic and expected to stay that way for the foreseeable future, small-cap companies are a good place to seek insulated secular growth. One such company is rapid prototype (RP) manufacturer Proto Labs, Inc. (NYSE: PRLB), which we profiled in the December 2014 IAS issue. Proto Labs uses computer numerical control (CNC) machining, injection molding, and 3D processes to manufacture custom parts for automotive, aerospace, consumer product, medical, electronics, and other industries. The firm’s customers upload part designs from their CAD (computer automated design) software to Proto Labs’ website and parts can be manufactured and delivered as soon as the very next day.
The company derives about 80% of its revenue from the United States, so it is pretty well insulated from international growth and currency headwinds. It is not fully insulated, however, as the remaining 20% of sales come from Europe and Japan. Currency translation effects had a -4% impact on top-line growth in the most recent quarter, but constant-currency growth clocked in at a blistering 28%.
With sales growing well faster than 20% in each of the last four quarters, shareholders might have expected a bit more from the stock over the past year. As of November 30, 2015, PRLB stock has a one-year total return of 4.3%, while the S&P 500 has returned 3.0%. One of the reasons for the somewhat lackluster performance is the market’s insistence on lumping it in with all 3D printing-related stocks. The stock took its first big dive when 3D printing pure-play Stratasys issued alarmingly weak full-year 2015 guidance back in February. Never mind that additive manufacturing (3D printing) constitutes less than 10% of Proto Labs’ sales and that the company is quite profitable in contrast to all the money-losing 3-D printing pure-plays. The short-sellers have been tossing Proto Labs into the same basket as 3D Systems, Stratasys, and ExOne, pushing the short interest in PRLB to 20% of the float on a routine basis. Only a few days after selling off with all the 3D printing stocks in February, Proto Labs delivered Q4 results that beat estimates and management provided bullish long-term sales growth and operating margin targets of 25% and 29%, respectively. The stock popped 19% the day of the announcement. A short squeeze no doubt added fuel to the fire, and the shares rallied all the way to the mid $70s in the coming weeks.
The shorts had their day, however, after Q1 results revealed growing expansion costs related to product and materials development and sales and marketing that held back EPS growth to just 3% on the back of 27% revenue growth. The stock tumbled back to the mid $60s. EPS grew a lackluster 5% yet again in Q2, but strong 21% sales growth and guidance for a return to 20% EPS growth in Q3 was enough to send investors bidding the stock back to the mid $70s. Negative sentiment on 3D printing was the stock’s downfall once again at the beginning of the third quarter, when the company’s announcement that it was acquiring German manufacturer Alphaform to expand its additive manufacturing capabilities in Europe sent the stock down toward $60. It has recovered a bit in recent weeks, after Q3 results showed robust 28% constant-currency sales growth and slowing expense growth, leading to EPS up 19%. Interestingly, Proto Labs’ additive manufacturing segment, which is the main subject of the market’s disdain, grew a whopping 78%, all organically.
At a current quote of $68, the stock sports an expensive trailing price to earnings ratio of 39, which is certainly another reason it has attracted a contingent of short-sellers. When taking into account the long-term targets of 25% growth and 29% operating margin, however, the valuation seems reasonable enough on a PE to growth basis for more speculative-minded investors. The original company strategy was simply to deliver customized parts faster than any of its competitors, but has now expanded into a diversified one-stop shop for all methods of creating custom parts. The Firstcut CNC machining service grew 27% in the most recent quarter; the Protomold injection molding service grew 17%; and the Fineline 3D printing service grew 78%. The path to 25% long-term growth certainly looks on track for now.