PTC - PTC Taking Share In Growing Markets With SaaS Transition As A Kicker

Summary

• PTC's fiscal first quarter results were a little light on margin, but did show slightly better ARR growth and FCF, and I'd call that an in-line quarter on balance.
• PTC appears to be outgrowing its core CAD and PLM markets, and I believe the ServiceMax acquisition adds a meaningful new growth opportunity that is complementary to the business.
• I expect a long run of high-single-digit or better core revenue growth from PTC and meaningful margin and cash flow leverage that will drive a high-teens FCF growth rate.
• PTC is by no means a "value stock", but I believe it is a more defensive growth story trading at a fairly attractive price today.

Quality industrial hardware companies do well to translate “GDP-plus” or “IP-plus” growth into much behind 5% to 6% organic growth, but for business/industrial software companies like PTC ( PTC ), growth in the high single-digits isn’t all that unusual. Specific to PTC, not only do I like the underlying fundamentals of the industrial software space, but I like this company’s leverage to further shares, a tailwind from SaaS transition, and opportunities to leverage longer-term growth in areas like industrial IoT (or IIoT) and augmented reality.

Up more than 20% over the past year, it’s not as though PTC’s qualities have gone unnoticed by the Street, and these shares have likewise been a strong performance over the longer term. I don’t see a huge discount to my estimate of fair value, but the fact that there’s any discount at all is a positive to me in a space that has often sported nose-bleed premiums.

A Mixed Quarter

While PTC did come up a little short on operating margin in the fiscal first quarter, it was basically an in-line quarter all things considered, and management’s guidance saw them tighten the range on revenue without changing the midpoint despite a little more caution in the commentary around the macro environment.

Revenue rose 2%, modestly beating expectations, while annual recurring revenue (or ARR), the more relevant metric now for many software companies, rose more than 15% in constant currency terms (and 14% in organic constant currency terms), again good for a few percentage points of upside relative to the Street. The CAD business grew ARR by 10%, while the PLM business grew 20%, the former marking a slight sequential slowdown, but both growing in excess of their underlying markets.

Operating income rose 5%, with margin up 110bp to 35.6%, and that was a little shy of expectations, driving a small EPS miss. On the other hand, FCF was a little better than expected, so I would say this all netted out to a basically in-line quarter.

Guidance was barely changed, with the top and bottom end of the ARR range ($1,910 to $1,960M) both coming in by $5M. Management is looking for 11% to 14% core ARR growth, with another 11% coming from the ServiceMax acquisition (so, around 22% to 25% total growth). While the ServiceMax contribution was trimmed modestly (about 3%), given some changes at Salesforce ( CRM ), an important partner, and the overall macro concern, I think there were worries that the revision would be worse.

Growing Share And Expanding Its Addressable Markets

It may arguably be premature to declare PTC a share-gainer this early in the reporting cycle, but Dassault ( OTCPK:DASTY ) reported mid-single digit growth in CATIA (its CAD package), and I expect to see a little upside relative to Siemens ( OTCPK:SIEGY ) as well. PTC has been effectively leveraging Creo and Onshape at different ends of the market, and while still the lagging player (#4), PTC has closed the gap. Likewise in the PLM space, where PTC has been growing ahead of the market for a little while now and should continue to do so on the strength of its Windchill and Arena offerings.

Grouped within these larger segments, I’d like to see better performance from the IIoT ( Thingworx ) and augmented reality ( Vuforia ) platforms. Management has been restructuring these businesses to better match the resources and costs expended to a more modest growth rate expectation (around 20% instead of 30%-40%), but I continue to see good opportunities for both businesses.

IIoT is still in its early days, and I expect to see a more meaningful ramp over the next five years, though competition from the likes of Amazon ( AMZN ), IBM ( IBM ), Oracle ( ORCL ), and others isn’t to be ignored. Augmented reality is even closer to its infancy, and will likely need at least five to 10 years to really mature as an option for most industrial customers, and PTC may end up deciding that they need to make additional acquisitions to build out this offering (the IIoT platform was built through multiple deals over several years).

In addition to growing what it has (at above-market rates), management continues to selectively expand the business through M&A. The most recent deal, the acquisition of ServiceMax, was large by PTC standards (about $1.46B in cash), but the multiple was reasonable relative to ARR growth (around 8x), and I like the expansion into the field service management (or FSM) side of service lifecycle management (or SLM).

ServiceMax’s offerings focus on automating service technician workflow, including managing external requests, shift optimization, and data analysis (including predictive analytics). Given that service can be a key differentiating offering in many markets, but also a potential source of overspending and margin headwinds, automating the process (and getting more visibility into the moving parts) makes sense for many businesses. Adding ServiceMax adds about $3B in immediate addressable market, and another business growing at a double-digit rate.

While not really fitting into the share gain or market expansion buckets, PTC’s ongoing transition to a SaaS is another significant driver. As of the November investor day, management disclosed SaaS was 16% of ARR for FY’22, up from 14% in the prior year. Management is targeting the mid-20%’s for FY’23, with an eventual goal of 33% in FY’26. With this transition, PTC is hoping to not only see a more predictable recurring revenue stream, but also expand the number of users per customer and further embed themselves in their customers’ workflow. For the customers, they get faster turnaround on innovation and upgrades to the platform, and there’s savings in not having to pay for and maintain on-premises infrastructure.

The Outlook

I expect basic CAD and PLM demand to continue growing at a high single-digit rate, with PTC gaining share and growing even faster. While there can be some macroeconomic sensitivity to these businesses, I don’t think PTC is going to see any sort of sharp downturn. Between core CAD/PLM offerings, newer opportunities like ServiceMax, and “legacy growth” opportunities like Thingworx and Vuforia , I’m expecting long-term revenue growth of a little over 8%.

As the business expands, particularly with increased SaaS penetration, I expect to see meaningful margin uplift. I expect about three points of EBITDA margin improvement over the next three years (though likely not much this fiscal year), and I expect to see meaningful acceleration in FCF margins over time, driving high-teens FCF growth.

I value companies like PTC on the basis of discounted adjusted cash flow (“adjusted” primarily to account for stock option expense) and a combination of ARR growth and margins – over time, there has been a fairly predictable relationship between ARR growth and margins and EV/revenue multiples. With the former, the shares look around fairly-priced, while the latter, which supports a forward revenue multiple of 8.5x, suggests some undervaluation.

The Bottom Line

PTC isn’t going to meet some readers’ standard of “undervalued”, and that’s fine – nothing is for everyone. For me, the fact that it seems to be trading at any sort of discount to fair value is appealing. While I do see some risk that a wider macro slowdown will impact growth over the next 12-18 months, I consider it a minor risk relative to the long-term growth potential in the core software businesses and the opportunity to leverage that growth into better margins and cash flows. All in all, for more risk-tolerant investors, I believe it’s a name well worth considering for further due diligence.

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