The COVID-19 pandemic has obviously affected end demand for industrial companies, but it's also had a major effect on their internal operations. Plants have had to be shut down, key personnel have had difficulty getting to work, and supply chain disruptions have affected the sourcing of critical products. Simply put, there's even more emphasis now on ensuring the efficient running of a factory or a logistics operation. Here's how and why that's great news for industrial software companies.
Three reasons why industrial software companies can win
The shift toward digitizing factories was already in place entering into 2020, with leading industrial software vendors like Dassault Systemes (OTC:DASTY), PTC (NASDAQ:PTC), Autodesk, and the software arm of Siemens (OTC:SIEGY) all reporting good growth as 2020 began. Incidentally, the three pure software plays have all outperformed the S&P 500 this year, and are significantly ahead of the industrial sector that they sell into.
Industrial companies are not very high-profile among investors, so it's easy to forget that manufacturing companies are set to be the biggest beneficiaries of the internet of things (IoT).
For example, industrial companies can create "digital twins" of physical assets. Using web-enabled devices, engineers can monitor, simulate, and analyze the digital twin's data in order to make the physical asset work better. Meanwhile, augmented reality (AR) solutions allow operations to be run remotely, with equipment being analyzed and serviced even with the key technical expert not on premises.
Moreover, product lifecycle management, or PLM, is the process of managing a product from design and engineering through to manufacturing and disposal. Put the jargon aside for a moment and consider how important it is for Boeing (a client of Dassault Systemes) to design and manufacture planes on budget, or an engineering contractor to deliver a power station on time. That's something that's only going to become more important as the global economy gets more complex.
The COVID-19 pandemic
The lessons learned from the pandemic are only likely to accelerate their deployment. As COVID-19 broke out in China initally, a raft of manufacturing companies saw their ability to source and/or manufacture critical products impaired by crisis in the first quarter.
Of course, the problem got a whole lot worse when the pandemic spread overseas, and companies were forced to seek alternative sourcing and/or shift manufacturing activity elsewhere.
Many of these issues would have been alleviated if production was more automated and managed remotely using digital technologies and IoT solutions.
There's also the issue of manufacturing companies looking to shift production/sourcing away from China in order to avoid tariffs and the potential for trade conflict with China in the future. It all points to a pressure building for companies to onshore production and/or shift production to the country of consumption. A possible example is Taiwan Semiconductor's decision to build a new chip factory in Arizona.
There's an opportunity for automation and software companies to take advantage of any potential onshoring because they are an integral part of making factories cost-effective enough to justify manufacturing in higher-labor-cost countries.
The companies in 2020
Here's how PTC Chief Executive Officer James Hepelmann put it on the recent earnings call: "We expect that the new normal that follows this crisis will create stronger tailwind to the already high-growth IoT and AR markets, and will make PLM more relevant than ever," and that the "AR pipeline is off the charts."
The coronavirus has taken its toll, with PTC now expecting full-year annual recurring revenue growth of 9%-12% compared to a previous estimate of 14%-16%, but double-digit revenue growth in an industrial recession is a sign of the long-term growth potential.
It's a similar story at Dassault Systemes. Management now expects full-year revenue growth of 12%-13%, compared to a previous estimate of 21%-23%. Turning to Siemens, its management recently affirmed that its software revenue would outgrow end market growth of 8%. That's an impressive result considering the carnage done to the economy in the second quarter.
The post-COVID-19 environment
Double-digit revenue growth in a trough year for the economy would be a good result for any industry, but the interesting thing is how the pandemic could spur faster adoption of IoT, AR, and PLM solutions during an ongoing economic recovery.
As such, it's reasonable to argue that the long-term valuation of industrial software companies should be increased as a consequence. That's not a conclusion you can make about many companies right now. As such, investors should look closely at Dassault and PTC, as their long-term earnings prospects are improving.