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Tech Stocks

CAD, The Next Generation

By Peter Staas, on Aug. 15, 2017

A few years ago, we highlighted the software-as-a-service (SaaS) model as a key growth theme that would drive outperformance for equities with leverage to this story, especially with the US economy struggling to shake off the hangover from the Great Recession and expand at typical recovery rates. (See Add Some SaaS to Your Portfolio.)

The appeal of SaaS solutions to cor­porate clients is simple: operational efficiency and lower costs.

This approach lim­its customers’ need to invest in data stor­age and server infrastructure and yields a highly scalable solution that doesn’t require massive capital spending to support new users or applications. Given these savings, uptake of these solutions has been particularly strong among small and midsize businesses.

Central hosting also ensures that all users within the organization can access the most up-to-date version of the soft­ware, relieving IT departments from the time-consuming process of updating the programs on each individual computer.

And delivering software applications over the Internet meets users’ increasing demand for access to mission-critical data and functions on smartphones and tablets.

This business model also has compelling advantages for software providers.

Rather than creating new applications and functionalities and then bundling them into a new version of an established product, the software company can introduce incremental enhancements to its offerings and immediately deliver those changes to the entire user base.

In other words, every subscriber will always have the newest version with the most up-to-date features.

In the past, not every customer would upgrade to the latest release; some preferred to save money and stick with older versions. By transitioning to this new model, the software industry swaps periodic, lumpy revenue for the consistency of recurring subscriptions.

The market has come around to this growth theme, with many of the stocks that we profiled trading at frothy levels that have priced in perfection.

Investors seeking exposure to this trend would be better served waiting for a pullback—they happen when quarterly earnings fall short of lofty expectations—or targeting legacy software names that might not get as much credit for making the transition to the cloud. Germany-based enterprise software provider SAP (Frankfurt: SAP, NYSE: SAP) comes to mind.

But our favorite software play stands to benefit from its ongoing transition to a SaaS model and its impressive leverage to growing adoption of the internet of things, a powerful growth theme that my colleague Jason Koepke highlighted in Aging Gracefully.

Triple Threat

PTC (NSDQ: PTC) brought the first commercial computer-aided design (CAD) product to market about 30 years-ago and the first web-enabled product life-cycle management (PLM) solution in the late 1990s. The company’s Solutions Group accounts for about 90 percent of its annual revenue and involves three core capabilities:

  • CAD: The Creo product enables clients to create conceptual and detailed two-dimensional and three-dimensional designs, analyze them, perform engineering calculations, and develop and test virtual prototypes.
  • PLM: The Windchill suite helps engineering departments manage and collaborate on product design by providing a central repository for pertinent information—for example, CAD models and various forms of documentation. This environment includes supply-chain management solutions to optimize sourcing and procurement of parts and materials, allowing for automated cost modeling and insights into balancing expense and quality.
  • Service Life-Cycle Management (SLM): These solutions help manufacturers improve their service efficiency by managing maintenance cycles and spare parts more efficiently through algorithms. Arbortext provides an environment for creating technical and service documentation.

These core businesses stand to benefit from the ongoing transition of its CAD, PLM and SLM customer base from perpetual licenses to a subscription model.

At the end of PTC’s fiscal year ended Sept. 30, 2016, SaaS accounted for about 56 percent of the company’s revenue; management’s guidance calls for this proportion to reach 68 percent in the 2017 fiscal year and 85 percent in 2018.

Most of these conversions come from customers that prefer the flexibility to scale up and scale down the number of subscriptions in response to business conditions, though PTC’s plan to phase out perpetual licenses in North America and Western Europe in 2018 undoubtedly helps.

Execution in these business lines has also improved, with PTC’s CAD sales growing at an above-market rate over the past four quarters and PLM revenue at an annual rate of 6 to 8 percent.

Some of this momentum reflects efforts to add channel partners, but the introduction of innovative new features has also helped.

For example, management identified that only 25 percent of its customers had deployed its PLM solutions outside of the engineer department. Accordingly, the company developed simplified dashboards for downstream, non-technical users to access data critical to their responsibilities and decision-making processes. This Navigator product has generated $23 million of new bookings over the past five quarters and continues to gain traction.

More important, we expect PTC’s leading capabilities related to the internet of things and augmented reality to drive impressive revenue growth in coming years and make its legacy products even more compelling. Management estimates that this business could grow by 30 to 40 percent annually and become as large as the CAD market over the next four to five years.

Accelerating adoption of machine-to-machine communications reflects the profusion of inexpensive sensors, data storage and processing capacity, as well as strategic goals among manufacturers:

  • Reducing factory downtime, improving product quality, and boosting profit margins by utilizing sensors and predictive analytics to optimize maintenance and service schedules; and
  • Transitioning from selling a product to selling a product that generates recurring revenue through a service component. Research outfit IDC forecasts that by 2018, 40 percent of the largest discrete manufacturers will have rolled out a product that’s sold as a service. And 70 percent of this customer-base will ship web-connected products in 2017.

PTC’s ThingWorx platform has emerged as one of the leading software solutions for manufacturers and other industrial companies seeking to make the most of the big data generated by smart, connected products.

This system pulls data from PTC’s CAD and PLM software as well as offerings from rival developers—Autodesk’s (NSDQ: ADSK) AutoCAD products, for example—and inputs from Amazon.com’s (NSDQ: AMZN) AWS, Microsoft Corp’s (NSDQ: MSFT) Azure and SAP’s HANA.

More important, ThingWorx enables non-hardcore programmers to build applications that process, sort and analyze the data generated by the connected factory and product to enhance the efficiency of manufacturing facilities and predictive maintenance on their output. Given the reams of data generated and the number of apps that can be created, this software can reduce the time and cost of taking full advantage of the internet of things.

ThingWorx has gained impressive traction with industry heavyweights. In September 2015, PTC announced a partnership with General Electric (NYSE: GE) whereby customers in its “brilliant manufacturing” program would use ThingWorx to build their capabilities in the internet of things.

At the time, General Electric’s Predix infrastructure had its own capacity to build apps, but this cumbersome solution required much more time and wasn’t as intuitive as PTC’s software; the industrial giant ultimately opted to deploy ThingWorx internally and sell the product to new and existing Predix customers. Buy-in from General Electric validates ThingWorx as an industry-leading solution and creates a massive growth opportunity for PTC.

And earlier this year, PTC announced that consulting firm Deloitte will leverage its industry expertise to build internet of things apps for various verticals on the ThingWorx platform.

In PTC’s fiscal third quarter ended June 30, 2017, the company’s internet of things revenue climbed 28 percent from year-ago levels and bookings have consistently grown by 30 to 40 percent. Expansions of existing customer relationships have started to account for a larger amount of ThingWorx bookings, resulting in larger deals as clients grow more comfortable with the software and its capabilities.

The success of ThingWorx also helps to reinvigorate PTC’s CAD offerings by feeding live data from connected devices to conduct statistics-based analyses or physics-based simulations.

PTC has also invested heavily in its augmented- and virtual-reality capabilities. With Vuforia Studio, engineering teams around the globe can analyze a product in a virtual room while viewing real-time data on its performance and writing notes in the air around the product. Other applications include authoring and publishing augmented reality experiences that serve as product manuals and/or service guides.

Despite PTC’s successes and the promise of ThingWorx, the stock sold off after the company’s bookings in Japan—a market where perpetual licenses still predominate and customer relationships are critical—fell $11 million short of expectations, resulting in overall bookings coming in $10 million below the midpoint of management’s guidance range.

Management attributed this shortfall to the promotion of its head salesperson in Japan to a new role in October 2016; the company has reinstated the former leader in this position, which should help to right the ship in coming quarters.

Still early in its profit cycle, PTC rates a buy up to $56 per share for aggressive investors seeking leverage to accelerating adoption of the internet of things.

Peter Staas is managing editor of Conrad’s Utility Investor and Energy & Income Advisor.

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