Investing in the industrial sector used to be a lot easier. You simply looked at trends in reliable indicators like purchasing manager indices (PMI) and industrial production in order to get a read on where most industrially focused companies were heading.

However, the Institute of Supply Management (ISM) PMI Manufacturing Index has indicated a contracting manufacturing economy for the last nine months. Yet industrial software company PTC (PTC -1.29%) expects mid-teens percentage growth in its key growth metric in 2023. What's going on, and can it continue?

PTC and the industrial sector

The company's traditional core offerings are in computer-aided design (CAD) and product lifecycle management (PLM) software. However, through a series of acquisitions and internal growth, PTC has developed a so-called "closed-loop life-cycle" management strategy. 

In plain English, PTC offers a collection of software that allows customers to collect and use information across the whole cycle of a product's life -- from design to production to servicing, and ultimately, to disposal. As it's a "closed loop," customers are constantly using the data to make iterative improvements -- for example, redesigning a part if its production proves inefficient. 

While the secular growth prospects of such solutions are clear -- driven by the increasing adoption of digital technology in manufacturing -- there's no doubt that a cyclical slowdown in the manufacturing sector will still impact PTC. 

How PTC is bucking the trend

That's the theory, anyway. Indeed, CEO Jim Heppelman acknowledged that the "sluggish" economy (as seen in the PMI and industrial production data) "no doubt has cost us a small amount of growth here in fiscal 2023." However, the reality is that PTC continues to grow its key metric, annual run rate (ARR), at a mid-teens percentage rate, and management actually raised its full-year organic ARR guidance to 13% growth from a prior estimate of 12% growth. 

ARR represents the "annualized value of our portfolio of active subscription software, cloud, SaaS, and support contracts as of the end of the reporting period." I've discussed this at greater length elsewhere, but suffice it to say that it is ARR that ultimately drives the company's cash-flow generation. And as the graph below shows, PTC's ARR has consistently grown at a double-digit percentage pace -- even in 2020 when the pandemic hit.

PTC ARR change in constant currency.

Data source: PTC presentations. 

PTC's outlook for 2024

Management's commentary for its fiscal 2024 (PTC's fiscal years finish at the end of September) indicates ongoing growth. A couple of points of note that CFO Kristian Talvitie made on the most recent earnings call:

  • "I would not be surprised to see an ARR guidance set up similar to this year going into next year."
  • "I would think that we would expect to deliver a free cash flow (FCF) result within our previously guided fiscal 2024 range regardless of the ARR outcome for the year"

Given that PTC started 2022 forecasting organic ARR growth in constant currency of 10% to 14% for 2023, it's reasonable to expect management to give guidance for double-digit ARR growth for its fiscal 2024, too. As for FCF, back at the end of 2021, Talvitie told investors to expect $700 million to $750 million in FCF in fiscal 2024. Wall Street analysts have $701 million penciled in for 2024, and $859 million for 2025. The latter figure is in the middle of the $825 million to $875 million range offered by Talvitie in late 2022 at PTC's investor day.

For reference, PTC has a market cap of $17.3 billion, so Wall Street's estimates would put it on a price-to-FCF multiple of 24.7 for 2024 and 20.1 for 2025. 

Augmented reality in manufacturing.

Image source: Getty Images.

Why PTC can keep growing

There's good reason to believe PTC can keep growing. For example, that suite of products helping customers create "closed loops" gives it cross-selling opportunities. Moreover, PTC's PLM software has "been taking share for years," according to Heppelmann, who believes the company is now the leading global player.

On top of this, PTC has been aggressive in building out its software-as-a-service (SaaS) offerings and has a significant growth opportunity as the market transitions from on-premises software to SaaS software. 

Meanwhile, there's no shortage of interest from manufacturing companies looking to improve their productivity by using digital technology. PTC's ARR gives it a strong base upon which to generate recurring cash flows and sell new solutions to its customers. 

All told, the company trades at an attractive valuation for a growth stock, and it's demonstrating that it can continue to grow despite a slowing economy -- something that augurs well for its performance when economic growth picks up again.