It's not often you get to buy high-growth companies on good free-cash-flow (FCF) yields, but that's the case with industrial software company PTC (PTC 0.52%) right now. The company's long-term growth prospects are excellent and driven by the most exciting secular growth trend in the industrial world, the digital transformation of manufacturing. Here's why PTC is an outstanding stock to buy.
Introducing PTC
PTC's business is organized into two product groups. The computer-aided design (CAD) group offers software for data authoring, including CAD software and augmented reality (AR).
The second group, product lifecycle management (PLM), includes PLM software, Internet of Things (IoT) software, application lifecycle management (ALM), and service lifecycle management (SLM) software. Management defines the PLM product group as "software used for product data management and process orchestration."
Both the PLM and CAD product groups have software-as-a-service (SaaS) options, and management sees this as a significant growth opportunity as it transitions products to the cloud.
PTC's key growth drivers
The critical growth catalysts are the same across both groups, namely the digitalization of the manufacturing world and the transition to cloud-based SaaS solutions. Both developments significantly increase the value PTC's solutions can offer its customers.
Digitalization means increasingly using digital, connected technology to improve manufacturing design and processes. For example, physical manufacturing processes can be digitally connected, modeled, and simulated using iterative data to produce actionable insights that will improve the physical assets' performance.
Meanwhile, cloud-based solutions allow myriad users to access and contribute to the CAD and PLM product offerings across various devices.
Examples of how PTC's solutions will add more value
Consider how a design engineer traditionally used CAD software to understand the digital and SaaS revolutions. In the past, an engineer would design a product using CAD working on their own with on-premise software, and the finished design would then be used to start manufacturing that product.
However, with the digital revolution, an ongoing iterative process creates data that can be used to continually modify a product's design (using CAD software) to improve manufacturing efficiency. And with cloud-based SaaS collaboration, many different users can contribute.
As such, instead of facilitating a relatively isolated activity at the start of a product's lifecycle, CAD software becomes an integral part of an ongoing process.
Image source: Getty Images.
It's a similar story with PLM solutions. PTC's management likes to talk of a "digital thread" that connects the design of a product (CAD) to its control (ALM) and its management (PLM) and connection to the digital world (IOT) and ultimately servicing (SLM) and augmentation (AR). At the heart of the process lies PLM software.
More digitally connected products mean more data, more analytics and simulations, and more insights created by PLM that can be used to improve productivity.
How PTC is growing its top line and cash flow
The two key metrics to follow with PTC are its annual run rate (ARR) and its FCF. Management argues that the latter is a function of the former, and FCF is undoubtedly a valuable way to value a company.
ARR refers to "the annualized value of our portfolio of active subscription software, cloud, SaaS, and support contracts as of the end of the reporting period"and is the best way to measure underlying growth, particularly in businesses shifting toward SaaS models. Not least because shifting to subscription-based revenue always pushes out upfront revenue.
The chart below shows the evolution of PTC's ARR and FCF over the last few years and includes management's guidance for 2023. If PTC hits the midpoint of its 2023 targets, it will have grown ARR by a 14.9% compound annual growth (CAGR) rate from 2019 to 2023 and FCF by a CAGR of 27.3%.
Furthermore, Wall Street analysts have PTC generating FCF of $704 million in 2024 and $872 million in 2025, putting the stock at a price-to-FCF multiple of 27 times FCF in 2023, 22 times in 2024, and 17.8 times in 2025.
Given management's previous history of acquisitions, it's reasonable to expect management to deploy capital toward acquisitions of necessary. For example, SaaS based CAD business Onshape was bought in 2019, and SaaS PLM business Arena was acquired in 2021, while SLM business ServiceMax was acquiredwas acquired in early 2023 for $1.46 billion in cash.
Still, don't expect a dividend anytime soon, as management plans to focus on paying down debt in 2023 & 2024, with a long-term aim of returning 50% of FCF to shareholders through share buybacks.
Near-term risk?
That said, PTC's growth is still dependent on its customers' spending plans, which means there's always the risk of a cyclical slowdown, given a weakening economy. That's probably why the market appears to be pricing a growth stock like PTC generously. After all, it's not often you get to buy a company with mid-teens underlying growth at a reasonable FCF multiple.
A stock to buy
PTC has some near-term risk, and slavishly following Wall Street estimates is never a good idea. Still, the underlying digitalization trend is secular, and PTC will surely grow reasonably over the long term, even if there's some turbulence along the way.
As such, the current valuation is compelling, and PTC is one of the best ways to play the digital revolution in manufacturing.
