A Few Years From Now, You'll Wish You'd Bought This Undervalued Stock

The future of the manufacturing industry lies in adopting digital technology, which means industrial software, specifically software that connects the digital and physical worlds. That's PTC's (NASDAQ: PTC) raison d'etre, and the company looks set for solid growth for many years. Moreover, despite a 57% appreciation, the stock's valuation remains highly attractive for growth investors.

PTC isn't firing on all cylinders yet

The increasing adoption of digital technology is a powerful secular growth driver, but it doesn't fully offset the cyclical weakness in some of PTC's end markets. Management defines its five key end markets as industrial products, federal aerospace and defense, electronics and high technology, automotive, medical technology, and life sciences.

It's no secret that the industrial, automotive, and electronics/technology sectors have been under pressure this year. CEO Neil Barua has previously discussed a sluggish sales environment impacting PTC's ability to convert sales leads into larger deals.

But PTC continues to grow its key metric, annual run rate (ARR), by a low-double-digit rate. Management defines its ARR as "annualized value of our portfolio of active subscription software, SaaS, hosting, and support contracts as of the end of the reporting period."

As such, its ARR aligns with what PTC invoices customers annually, and management believes it is the best way to judge the progress of its subscription business. If anything, it's possibly a conservative measure for a couple of reasons:

• PTC does doesn't include price increases in its ARR calculations.
• Customers receive bills for multi-year contracts at the beginning of the year.

Image source: Getty Images.

Given that PTC offers a range of software solutions that operate in a so-called digital thread closed loop, it's likely that many of its customers will buy more of its software solutions after utilizing its core product lifecycle management (PLM) solution. As such, contract values will likely increase if customers increase orders. Similarly, with the adoption of digital technology likely to increase, PTC is expected to have a high retention rate, implying multiyear contract invoicing.

What is the digital thread closed loop?

The digital thread closed loop concept is simply the continual and iterative data flow between the physical and digital worlds. For example, PTC's computer-aided design (CAD) software helps digitally design a product. In contrast, PLM helps manage the product, automating and monitoring its production. And service lifecycle management (SLM) software helps support and service a product (say, an elevator).

Image source: Getty Images.

Data feedback from SLM and PLM in the physical world could lead to a redesign using CAD. In addition, a CAD redesign will lead to changes in the data from SLM and PLM. Ultimately, the solutions will work together to improve and speed up the design and development process iteratively for a customer -- an essential requirement in a world with increasingly complex products.

PTC has a bright future, and so does its earnings

The secular growth drivers discussed above are powerful enough to drive 12% growth in constant currency ARR in its fiscal year 2024, ended Sept. 30, and management expects constant currency ARR growth of 9% to 10% in 2025.

As you can see below, the ARR growth is accompanied by increased conversion into free cash flow (FCF), driven by growth in subscriptions and generating more software-as-a-service (SaaS) revenue by increasing cloud-based software sales and cross-selling solutions to existing customers.

Data source: Company presentations. 2025 estimates are the midpoint of management's guidance. Chart by author.

PTC valuation: A stock to buy?

Management forecasts FCF of $835 million to $850 million in 2025. This includes a $20 million outflow related to restructuring its "go-to-market" structure, which involves hiring a chief revenue officer and realigning its sales efforts around the five critical industrial verticals discussed above.

Wall Street analysts expect $990 million in FCF in 2026. These figures put PTC on an expected price-to-FCF multiple of 27 times 2025 FCF and 23.2 times 2026 FCF. While these multiples seem high, consider that PTC is growing ARR at a double-digit rate and FCF at a mid-teens rate.

Moreover, it's achieving these growth rates in a challenging trading environment, so it's fair to assume it could increase its growth rate given an overall improvement in the industrial, automotive, and technology sectors. That's highly likely to happen given that the industrial sector is still in the early stages of adopting digital technology, and the enhancements PTC brings are tangible and will increase in value as customers get used to using the digital thread in their operations.

It all adds up to make PTC a growth stock worth buying now.

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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends PTC. The Motley Fool has a disclosure policy.