PTC's Subscription Stumble: An Autodesk Moment?

Update2 years ago
Solid Q3 results were overshadowed by a weaker outlook. The stock fell 14% after hours. Here's our take.
PTC, the design software company serving businesses primarily in the manufacturing industry, reported solid fiscal Q3 results on Wednesday, but lowered its forecast for the rest of the year. The stock fell 14% after hours.
We're going to dive deeper in this research update given the magnitude of the stock drop for what is an unfamiliar company for most.
Refresher on PTC: Transitioning to a SaaS Model
PTC sells software solutions for rapidly growing markets such as Internet of Things and Augmented Reality which are expected to grow 40%+ through 2021 as industrial companies increase their investments in device connectivity.
The company is undergoing a major transition right now. It's shifting to a higher-quality subscription revenue model (known as SaaS, or Software-as-a-Service), instead of a one-off "perpetual license" model.
Old Model: Customers buy a one-time software license from PTC with limited annual maintenance/support services. Sometimes a smaller upfront cost for customer, but choppier sales for PTC.
New Model: Customers pay PTC a recurring subscription fee (a la Netflix) for access to the latest and greatest software, always updated and accessible via the web. Sometimes a larger overall dollar commitment for customer, but more recurring sales for PTC.
We believe this "SaaS transition" should increase long-term profit margins to 30%+ while growing customer lifetime value -- both great things for the stock in the long run. However, these transitions take time, and they're bumpy, as these results proved.
What Happened in Q3
It was actually a solid quarter. The company reported $322M sales and $0.36 earnings per share (EPS), both in line with the management team's original forecast of $320-325M sales and $0.31-0.36 EPS. On that front, we were pleased.
"We delivered solid Q3 financial performance reflecting the strength of our subscription model," said the CEO. "Momentum in our growth business continues to be strong where we had five deals with bookings of over $1M, as customers increasingly leverage our IoT and AR offerings to enable digital transformation."
In other words, the SaaS transition went fairly well in Q3. Companies in fast-growing industries are retrofitting themselves with PTC's digital solutions, propelling higher sales and earnings for PTC.
However, as we know, stock prices reflect future cash flows, not yesterday's. Now onto what PTC is forecasting for the future.
Q4 Guidance: Fewer Whales and Customer Conversions
We believe the stock fell 14% after hours on "disappointing" revenue and earnings guidance for Q4 and the full year 2019.
The reason we used quotations there is because, in our view, the forecast was far from disappointing. PTC's management team expects only 1% lower sales and 3% lower earnings this year, compared to its forecast a few months ago.
And yet the stock is down 14%.
PTC's management gave two primary drivers for the lower forecast:
A slowdown in conversions of large volume customers from one-time licenses to subscription contracts
A lack of mega deals in what is typically PTC's strongest quarter (i.e. fewer "whale" customers)
We dug into the reasons for each of these drivers, and we believe they are unlikely to be permanent headwinds:
PTC plans to adjust its software offering to accommodate the large volume customers who don't think it's economical to switch to subscription contracts
We think its end markets are growing fast enough that more mega deals will enter the pipeline eventually
From the CEO: "The transition to a subscription business model plus operational changes we have made this year, which are important elements to our long-term success, have created some short-term headwinds in the business, but the balance of the business is performing well."
An Autodesk Moment?
This sharp stock drop for a SaaS transition company reminds us of Autodesk in late 2017.
Autodesk, which we think of as the "Microsoft Excel for designers," fell 16% after it gave a forecast for only 2% fewer new subscription customers for the full year 2017.
At the time, the company announced a restructuring plan to focus better on its subscription transition and navigate short-term headwinds. Some investors were fed up with the volatility and sold the stock. Others stayed put or bought more, understanding the nature of a subscription model transition.
Since then, the stock is up 60%.
We don't know for sure how PTC's transition will pan out, but we know there are plenty of examples of when drops like these turned out to be compelling entry points for long-term investors. Autodesk is a great example.
The Path Forward
It's never fun to see a stock down 14%, but as with many high-growth stocks, valuations can fall at even the slightest "miss" vs. a high bar of expectations.
Remember: a stock price (P) = earnings per share (E) x valuation (P/E ratio).
If a stock falls 14% but the earnings forecast only falls 3%, that implies the valuation fell 11%. So it seems the market is only willing to pay 11% less for PTC today than it was before the new forecast came out.
Us, on the other hand? We're happy to buy PTC's future earnings growth at an 11% cheaper price because we don't believe those growth prospects fell 11% overnight. The underlying business is producing a 16% return on invested capital (ROIC) and growing its earnings 30%+ per year. One quarter of a 3% lower earnings forecast due to short-term headwinds doesn't strike us as a long-term structural risk.
As we talked about in our Q2 Investor Letter, long-term stock returns are driven almost entirely by earnings growth, not valuation changes. Therefore, when the valuation of a great business falls sharply, it could be a wonderful time to buy tremendous future earnings growth at a substantial discount. We think that's the case here for PTC.
Perhaps more importantly, these SaaS transition stories are never a straight line upward. Autodesk, Adobe, and others have all had bumpy rides on the road to a subscription model, but the destination has always proven worth the volatility suffered to get there.
As of this writing, PTC was a portfolio holding of Titan Invest. This security may cease to be a portfolio holding at some point in the future.

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