Industrial software company PTC's (PTC 0.22%) stock has dipped recently, and investors, initially at least, reacted negatively to the company's fiscal second-quarter earnings, which it released at the start of May. Is the trend likely to continue, or is now an excellent time to pick up stock in an exciting growth company?
PTC's recent big news
Investors usually pencil in assumptions for medium-term growth based on management's targets, and PTC's shareholders are no different. So when CEO Neil Barua (appointed in mid-February) told investors the business's most crucial metric would only grow by low double digits over the medium term, they grew concerned.
Management's previous medium-term guidance for its annual run rate (ARR) was mid-teens growth, and it can't be good news that the number is shrinking. PTC defines its ARR as "the annualized value of our portfolio of active subscription software, cloud, SaaS, and support contracts as of the end of the reporting period." Growing ARR is the key to generating long-term value and growing free cash flow (FCF).
Wall Street immediately picked up the negative news on ARR growth. Oppenheimer analyst Ken Wong told management, "We roughly estimate that maybe $100 million is coming out of ARR" on the earnings call. A few days later, a Mizuho analyst lowered the financial company's price target on the stock to $200 from $210 (retaining a buy rating) and noted the reduction in ARR guidance.
Does the medium-term ARR guidance change matter?
The obvious answer is that it does matter. Naturally, analysts asked why management felt now was the right time to lower the ARR even while maintaining FCF targets. Barua replied that he'd "looked at the fact of the current conditions of the market and felt it was the appropriate thing to do to make the midterm target toward that low double digits."
However, some context is necessary here.
First, Barua is relatively new in his role, and it's understandable if he wants to adjust expectations toward targets he believes the company can hit. One of the worst things an incoming CEO can do is start their tenure by missing headline guidance, and it makes more sense to underpromise and overdeliver than the other way around.
Second, management argued that even if ARR growth slowed, PTC could still meet its FCF targets by managing internal spending in line with ARR growth. While that's not great news in itself, it does demonstrate that cash flow will not decline significantly just because PTC is going through a weaker period of growth.
Third, like the previous CEO, Jim Heppelmann, Barua described the recent sales environment as sluggish. He argued that this was due to the challenges in securing the "large digital transformation deals that are seven, eight" figures. That's understandable in the current environment, in which industrial growth remains weak and susceptible to interest rate pressure.
That said, there's still a powerful secular growth story here related to the digital transformation taking place in the industrial sector and PTC's role in it.
Image source: Getty Images.
Why PTC stock is a buy
In addition, there was a lot more good than bad in the results. For example, going back to the first-quarter results from the end of January, I argued that PTC's implied guidance for ARR in the second quarter and the rest of the year left it facing a steep climb in ARR in the second half of the fiscal year to get there. For reference, the implied guidance suggested the first-half increase in ARR would be $79 million, leaving PTC to generate $162 million in the second half, a split of 33%/67%.
However, PTC outperformed management's expectations by generating a $96 million increase in ARR in the first half of its fiscal year, leaving it to generate $145 million in the second half, a split of 40%/60%. That's in line with recent years' metrics. All told, the results are a net positive.
The company's performance in the first half gives me more confidence in management's full-year outlook. Meanwhile, the reduction in medium-term ARR guidance is understandable and gives investors a small reset to expectations. That's a good thing, and the dip in the share price looks like a good buying opportunity for long-term investors.
