1 Outstanding Software Stock for the Digital Revolution

When it comes to investing in companies driven by the latest technological advances, investors quite often face a conundrum: Will the secular growth drivers of the said business be strong enough to offset any cyclical weakness its customers are going through?

Right now, industrial software company PTC (PTC 0.62%) is facing such a time in its history. Better put, can PTC hit its medium-term targets, knowing its long-term, secular growth prospects are intact?

I think the answer to the question is "yes," and its recent results underline the case.

PTC's medium-term targets

PTC's software solutions are a play on the digital transformation of the industrial sector. At the heart of its offerings lies the concept of the digital thread -- a seamless flow of real-time information that starts with the product's design, and runs through its manufacturing, servicing, and ultimately, to its disposal.

The benefits include improving the product's time to market, enhancing product quality, ensuring regulatory compliance, and reducing costs while predicting servicing requirements.

The demand drivers of digital transformation aren't dependent on the economy, and PTC expects them to lead to ongoing demand for its solutions throughout the economic cycle. The key metrics to follow when it comes to PTC's growth aren't so much revenue and earnings as they are its annual run rate (ARR) and free cash flow (FCF). ARR is the annualized value of its subscriptions and contracts, and represents recurring revenue.

As CEO Jim Heppelmann noted on the company's recent fiscal Q4 earnings call, "ARR is the primary driver of cash flow," and PTC has ambitious plans for growth in both.

Having delivered organic constant currency ARR growth of 13% in its fiscal 2023 (which ended Sept. 30), management laid out the following targets for its next three fiscal years on the earnings call.

Based on the current market cap, the FCF-based valuation looks attractive. They are the kind of multiples a growth investor will pay for a company generating mid-teens growth in its critical ARR growth.

Data source: PTC presentations. *author's analysis.

How PTC can hit its targets

Aside from the natural growth in digital adoption driving its software sales, PTC's track record of adding solutions to its suite of products suggests it will remain on course to meet its targets. Management likes to talk of its products being part of a comprehensive "closed loop" digital cycle.

In other words, the digital thread enables a closed loop of digital information that can be used for continuous improvement of systems and processes. For example, consider if digital data comes back from a production process using PTC's product lifecycle management software, indicating that if a product is redesigned, it could be produced more efficiently. This can lead to designers using PTC's computer-aided design software to redesign the product.

Image source: Getty Images.

The closed loop also includes service lifecycle management (SLM) software and application lifecycle management (ALM); the former relates to servicing a product, and the latter refers to the lifecycle of software so software engineering teams can collaborate.

PTC added to its SLM capability with the acquisition of ServiceMax earlier this year, and to its ALM capability with the 2022 acquisition of Intland Software (Codebeamer ALM software) for $280 million.

The addition of Codebeamer is particularly intriguing. Automakers are keen to adopt ALM because they are moving toward software and vehicle electrification. Heppelmann noted that PTC signed five deals with automakers in the quarter, including a major deal to use Codebeamer "to support the software development for the next generation of electric vehicles from the Volkswagen Group and its brands" according to the press release.

A stock to buy?

The deals with Volkswagen and others have come during a period when other companies are reporting that automakers have been scaling back on their spending plans due to slowing sales. However, PTC is signing deals and generating growth from a business it acquired a year ago. That's a sign that PTC's growth drivers are primarily secular, and should give investors confidence that its growth plans can resist some cyclical weakness.

If so, then the stock looks an excellent value, bearing in mind the cash flow growth the industrial software maker will potentially generate over the next few years.