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2 Colossal Growth Stocks to Buy Before the Big Bull Rally

Motley Fool - Tue Oct 17, 2023

Industrial software company PTC(NASDAQ: PTC) and ON Semiconductor(NASDAQ: ON) have one thing in common. They are companies whose underlying growth prospects are improving, but the improvement isn't quite seen in their headline numbers yet. They represent precisely the types of stocks investors should look at right now. Here's why.

PTC, a software company that's the future of manufacturing

PTC's software is the future of manufacturing and design in the industrial sector. It's a future built on adopting a so-called "digital thread" that runs through and connects every aspect of a product lifecycle. This digital thread starts with its computer-aided design (CAD) software as a product is designed. It runs through its product lifecycle management (PLM) software as the product is manufactured, used, serviced, and disposed of. Meanwhile, manufacturing and servicing are enhanced using the Internet of Things (IoT) and augmented reality (AR) software.

The "digital thread" allows users to collate and gather a mass of data to continually and iteratively improve design and manufacturing in a closed loop. One example includes how a product can be digitally redesigned (CAD) if the data gathered by PLM and IoT shows that its manufacture can be made more productive with a redesign, or even more accessible to service with a change in design or production.

In common with many other software companies, PTC has transitioned toward selling its solutions on a subscription basis instead of an on-premise license basis. The shift results in a relative slowdown in revenue growth compared to growth in its annual run rate (ARR) of subscription, cloud, and support contracts. This can immediately be seen in the disparity between its full-year revenue, ARR, and free cash flow (FCF) growth guidance on the third-quarter earnings call in July.

PTC Metric

Full-Year Guidance

Revenue

8% to 10%

Organic ARR at constant currency

13%

ARR at current currency

23% to 24%

Free cash flow

41%

Data source: PTC presentations.

Wall Street analysts expect the strong trends in its underlying growth to continue in the next couple of years as its ARR drops down into increased FCF generation. For example, the Wall Street consensus calls for revenue growth of 12.1% and 12.8% in 2024 and 2025, compared to FCF growth of 19.8% and 22.2% over the same period. Trading on 25 times its estimated 2024 FCF of $701 million, PTC looks like a good value for growth investors.

ON Semiconductor is targeting desirable end markets

It's no secret that the semiconductor industry is highly cyclical. When the economy is expanding, manufacturers order semiconductors in anticipation of a production ramp. That's why semiconductor sales are typically seen as a critical leading indicator of the economy. While that's great on an economic upswing, it's not so good on the downswing, as the first thing manufacturers will cut when sales start to slow is semiconductor orders.

The latter is precisely what's happened this year as a combination of interest rate hikes have pressured consumer spending and, in turn, consumer discretionary spending on things like consumer electronics and automotives. In addition, there's been a natural correction from previous years' heavy spending on consumer products due to stay-at-home measures.

But here's the thing. ON Semiconductor focuses on growing its revenue in end markets with secular growth drivers and moving away from more cyclically exposed end markets.

The company's end markets are defined in terms of automotive (40.4% of 2022 revenue), industrial (27.5%), and "other" (32.1%). The "other" is where most traditional highly cyclical end markets (graphics cards, consumer electronics, white goods, smartphones, gaming systems, etc.) are lumped together. As you might expect this year, it's having a tough time.

A driver charging an electric car.

Image source: Getty Images.

Returning to the second quarter, management said its automotive revenue was above $1 billion and grew 35%, and its industrial revenue was $609 million and grew 5%. I've interpolated these figures to produce the following rough guide to what's going on with its sales this year. Still, note that management continues to exit non-core businesses. CFO Thad Trent noted the company had exited its "more than $100 million" in year-to-date revenue "and nearly $400 million since the start of our transformation." These figures will make the decline in "other" sales look worse.

Still, there's no way of avoiding the fact that the company is growing in its targeted end markets while it works through a cyclical decline in its "other" revenue in 2023.

Second Quarter

Revenue

Year-Over-Year Growth

Management Estimated 2022-2027 Compound Annual Growth Rate

Automotive

~$1 billion

35%

19%

Industrial

$0.6 billion

5%

10%

Other

~0.5 billion

~(35)%

-4%

Total

$2.1 billion

Flat

10% to 12%

Data source: ON Semiconductor presentations. Author's analysis.

Long-term growth in its automotive and industrial end markets will come from its power and sensing solutions sales into secular growth trends like electric vehicle (EV) investment, advanced driver assistance systems (ADAS), industrial automation, machine vision, robotics, smart buildings/infrastructure, and EV charging.

By way of example, the company signed long-term supply agreements with Magna (eDrive systems for EVs), and BorgWarner (power modules for EVs) earlier this year.

While its automotive and industrial end markets aren't entirely free of cyclicality, they also have long-term secular growth drivers, which means ON Semiconductor can increase its content on its products and grow in line with its customers' top-line growth.

It all adds up to a company transitioning toward significant growth in the coming years.

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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends BorgWarner, Magna International, ON Semiconductor, and PTC. The Motley Fool has a disclosure policy.

Paid Post: Content produced by Motley Fool. The Globe and Mail was not involved, and material was not reviewed prior to publication.

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