This Stock Could Be 2020's Best Profit Opportunity

The damage from the coronavirus pandemic has extended far and wide, and industrial software company PTC (PTC -1.00%) has certainly not been immune. That said, there's a strong argument that its long-term growth prospects will actually be enhanced in the aftermath of the pandemic. If this thesis is correct, then the company could be significantly undervalued at its current price. Let's look at the investment case for PTC.

Medium-term growth objectives

To understand why PTC is such an interesting stock, you have to look at the medium-term growth expectations outlined by management earlier in 2020. For reference, management characterizes its traditional computer aided design (CAD) and product life-cycle management (PLM) as being its core product offerings. Meanwhile, its Internet of Things (IoT) and augmented reality (AR) products are its growth offerings.

Image source: Getty Images.

The key argument here is that PTC's core offerings, CAD and PLM, are obviously being hurt in the near term, but interest (and ultimately the rate of adoption) for its IoT and AR solutions is being enhanced by the pandemic. As you can see below, PTC's growth products (IoT and AR) aren't the key drivers of revenue and profitability right now, but their growth rate will ensure that they will be in a few years' time.

Data source: PTC presentations.

How PTC makes money

Demand for CAD solutions is tied to the willingness of customers to invest in new products or projects that need CAD software for design. PLM software allows customers to manage the life cycle of a product from creation (using CAD) to production, use, and ultimately disposal. It's an exciting market in itself, not least because the adoption of internet-enabled devices and greater analytics capability is improving the efficacy of PLM software.

Turning to the growth products, IoT product demand will improve with growth in the adoption of the digital factory. In a nutshell, PTC's IoT solutions connect a company's physical assets with the digital world. Through the use of web-enabled devices and advanced analytics, the physical asset (say, a gas turbine) can be better monitored and serviced. Meanwhile, AR allows technicians to access real-time information and service assets without even being present.

Near-term challenges, long-term benefit

There's no way to sugarcoat matters: PTC is also suffering from the pandemic. Going back to first-quarter earnings, management had expected full-year average recurring revenue (ARR) to be in the range of $1.27 billion to $1.3 billion and adjusted EPS of $2.15 to $2.65. But the decline in the economy has caused a reduction in expectations in ARR to $1.2 billion to $1.3 billion and adjusted EPS of $2.20 to $2.35.

The decline in expectations might not seem like much, but during the recent earnings call, CEO Jim Heppelmann outlined that the pandemic and production shutdowns had caused customers to push out orders, and bookings were down 20% in the third quarter.

Engineers working on an augmented reality model. Image source: Getty Images.

But there are three reasons the long-term growth prospects for IoT and AR are being strengthened in the current environment. First, the pandemic heightened awareness of the benefit in being able to monitor, guide, and service assets remotely using IoT and AR technology.

Second, the supply chain issues that many companies have suffered during the pandemic will encourage them to digitize their operations. For example, during the earnings call, Heppelmann outlined how medical companies had expanded "their smart, connected product deployments, enabling them to remotely monitor and service their product fleet seamlessly despite the operational challenges caused by the pandemic."

Third, a combination of the pandemic and the ongoing trade war is seen as encouraging U.S. companies to shift production out of China. If this takes place, then automation and digitization are likely to be a large part of it because companies will seek to offset the increased labor costs implied by moving production from China.

Looking ahead

During the company's investor day presentations in 2019, management laid out a range of scenarios for the 2019-2024 period, from "recession" to "optimist," and implied free cash flow (FCF) in 2024 from $700 million to $900 million. The low end puts PTC at 14.1 times FCF in 2024 and the high end at 11 times. To put these figures into context, the company's current trailing twelve month FCF is around $200 million, so clearly PTC is a stock being bought for its growth prospects rather than its current valuation. 

While there obviously has been a recession since those forecasts were made, there's reason to believe that PTC's growth products (IoT and AR) will see a step up in growth after the pandemic is over. As such, it's reasonable to expect PTC will hit a FCF figure somewhere in the $700 million to $950 million range in 2024. Even the low end would leave it very attractively priced for a business with very strong long-term growth prospects.