This Software Stock Crushed the Nasdaq by 31% in 2022: Here's Why It Has Room to Run

In a year when most tech stocks are tumbling, shares in industrial software provider PTC (PTC -1.00%) are crushing it -- up a little, over 1%, while the Nasdaq Composite index is down 29%.

However, I think there's more to come. Despite suffering a recession in 2020 and a significant change in its business model, the company is on track with its medium-term growth aspirations, and its long-term outlook is excellent.

Here's how and why PTC deserves a look in every growth investor's portfolio. 

PTC specializes in four key areas

PTC focuses on four primary areas. This includes two "core" products: computer-aided design (CAD) and product lifecycle management (PLM). Then there are its two "growth" products: Internet of Things (IoT) and augmented reality (AR).

You can think of the company as a play on the "fourth industrial revolution." In other words, the integration of digital web-based technology in manufacturing. It's a "digital thread" that runs from the initial design using CAD through managing the manufacturing process through PLM, with IoT connecting the physical and digital worlds and the use of AR to improve performance. 

The company likes to measure each product's progress in terms of its annual run rate (ARR). This is the annualized value of its active subscription software, cloud, software-as-a-service (SaaS), and support contracts -- measured at the end of each reporting period. 

The following table gives you an indication of how important each business currently is to PTC. Keep in mind that the greater growth rates of IoT and AR should increase their importance over time.

Data source: PTC presentations.

Three reasons PTC can continue to outperform 

First, despite the recession in 2020, PTC remains on track for the 2024 targets the company laid out at its "Investor Day" in November 2019. Management anticipated a range of free-cash-flow (FCF) outcomes for 2024 based on various outlooks ranging from "optimist" ($900 million) to "recession" ($700 million).

Of course, a recession occurred, so PTC has reduced its outlook. It is now forecasting an adjusted FCF of $550 million to $600 million in 2023 and $700 million to $750 million in 2024. To put these figures into context, PTC's current market capitalization is $14.5 billion, so the stock trades for 25 times 2023's estimate and 20 times 2024's estimate -- at the midpoint.

Those are excellent valuations for a business whose management believes it can grow ARR at a mid-teens annual rate and FCF at a 25% to 30% rate over the medium term.

Historical and future growth

Second, investors can feel confident in PTC's ability to grow because its end markets are growing. The massive growth in data analytics and the need to improve manufacturing processes in light of the supply chain difficulties in 2022 have highlighted the need for manufacturers to invest in digital technology.

All four of its product lines grew more than the market, with particular strength in ARR growth in its core (CAD and PLM) business -- together, they make up almost 75% of its ARR. 

Data source: PTC presentations. *Three-year compound annual growth rate

The SaaS transition will increase growth 

Third, shifting from an on-premise software license model to a software subscription model has become popular in the software industry. Initially, companies see a loss of upfront revenue but then a gradual shift to greater profitability over time. PTC is also a beneficiary of this shift, but management believes it has another growth kicker coming from making its products available as a SaaS option.

Delivering solutions via SaaS rather than by subscription allows for greater collaboration as multiple users can share the use of an aspect of a software application by accessing it online via SaaS. So, for example, multiple designers (across many different functions) can collaborate on CAD based on SaaS, and multiple users can access data created by PLM, say, from the performance of machinery in a factory. This should improve the time-to-market of product development and the efficiency of a manufacturing plant. 

Only 14% of PTC's ARR was SaaS at the end of 2021 so there's plenty of growth potential.

A stock to buy

PTC, alongside most other software companies, will be negatively impacted by any extended economic slowdown, but its recurring revenue model gives it some resilience. PTC's leading position in the PLM  in market places it at the heart of the digital revolution in manufacturing. Its recent deal to acquire cloud-based PLM company, ServiceMax, will enhance its already strong position. (Note the above-market growth for PLM in the table above.)

As such, the company is expanding its footprint in its strongest growth area, and if it only hits the low end of its FCF guidance of $700 million in 2024, it will look like a great value for a company with excellent long-term growth potential.