PTC Inc. (PTC) Earnings Call Transcript & Summary

Good afternoon, and thank you for joining us, everyone. My name is Elizabeth Porter. I'm an analyst on the Morgan Stanley Software U.S. equity research team. I'm really pleased to have with us today PTC CFO, Kristian Talvitie. We are doing audience Q&A. So mic will go around. And with that, Kristian, thank you so much for being with us.

Great. Thank you for having me, especially on this important day. I'm sure you know what the significance of December 6 is.

Go on.

It's Finnish Independence Day.

Finnish Independence Day. Well, happy Finnish Independence Day everyone.

Everybody knew that, right?

Awesome. So Kristian, just to kick it off. You guys just had your Q4. You just reported at an Investor Day and disclosed a lot of new information that I'm looking forward to discussing in our chat. But just for those in the audience that may not be as familiar with the PTC story, can you just give us a quick overview of kind of who your customers are and kind of why do they turn to PTC for help?

Yes, sure, briefly. So PTC is a software company. We deal primarily in CAD, computer-aided design and PLM, product life cycle management software. We're about 6,500 employees and about $2 billion in revenue. It is a 30-plus-year-old software business that's gone through a lot of evolution over that time. Some of that evolution has included expanding the definition of PLM into SLM, service life cycle management, ALM, application life cycle management, as well as just leveraging more broadly the engineering data that's created in CAD, in other parts of the organization with kind of core PLM or product life cycle management. One of the other important aspects of the company's evolution over the past few years has also been transitioning from a perpetual license business model to a subscription business model. That was a transition that we went through from about '15 to about 2019. And still largely on-prem subscription, and that brings with it some nuances in terms of financial metrics. But that transition was completed as we headed into 2020. I think super important from a top line and bottom line stability perspective, and then lastly, the next phase of our evolution is actually migrating from or evolving from an on-premise provider to a SaaS provider, which is something that in our part of the software universe, the technical software space has definitely been a laggard in migrating to SaaS unlike other places like CRM or even ERP where it's more common. So we're now embarking on that journey as well, which we think will provide some tailwind to growth really for a decade here as we transition our customer base and continue to add new customers.

Great. And then just going back to kind of the core CAD and PLM business. I think growth there has been better than expected in the last 2 or 3 years now? And how do we pick apart some of those dynamics? And also like what you're seeing today? Did you see some sort of benefit from a COVID pull forward? Or was it digital transformation really driving this renewed customer interest and demand over the last couple of years? And then kind of more recently, what are you seeing today as it relates to macro and your customer conversations?

Yes, sure. So a couple of things. I think that the market growth rates for CAD have been pretty steady for quite a long time in the kind of mid to upper middle single digits. And for PLM in the high single digit, maybe low double-digit range, PTC over the past few years has been outpacing that growth into -- partially due to the subscription business model transition that we went through. If you go back a couple of Investor Days, we did a pretty deep dissertation on the differences between subscription and perpetual models and how subscription models actually, over time, will grow faster. And because our markets are largely perpetual, we have some benefit from that as well as some competitive -- some competitive share shift that's also coming our way. So all in all, we think the growth rates have been in line with better than market growth rates. We think it's more sustainable than pull forward and you touched on this concept of digital transformation. And really, kind of one guy's opinion here, but I think that is what's driving a lot of this investment. And digital transformation, in general, is more of a journey than a destination. And for the part of the enterprise that we serve, PLM is really the backbone of digital transformation. So said differently, if you were to think about a system of record for financial information, you would probably think ERP, if you were to think system of record for customer information, you would think CRM. And what we're seeing now increasingly is when our customers are thinking about system of record for product, they're thinking about PLM. So we actually think it's this kind of digital transformation trend that has been accelerating in this journey that customers are going on that's driving some of that growth. And then obviously, the transition to SaaS, which we're in early innings, but that will also continue to provide some tailwind as well.

Okay. And when we think about kind of SaaS transitions, one of the benefits is that you do have a more resilient model on the top line versus perpetual. And that aside, I think that investors do worry about, is PTC a cyclical business and try to point to PMI numbers and see how those move around? But PTC has shown to be more resilient in kind of a macro downturn in part because of that subscription model. So can you just expand on kind of the resiliency of the top line revenue? And then also, explain kind of what you've done on the cost side of the equation too, to be relatively resilient?

Yes. There's a lot packed in there. So first, I'll say just quick definitionally for PTC, the 2 metrics that we use to gauge our performance by what we call ARR or annual run rate, it's effectively the active book of contracts, the annual value of the active book of contracts at any -- at the end of any given period and then free cash flow. And you'll notice that we don't really talk a lot about revenue per se because of -- because we're largely an on-premise subscription company, our revenue recognition is impacted sometimes in funny ways by ASC 606 or I think what our friends in the room here would call IFRS 15. And so because of that, we've moved to ARR, which, again, I think is for us, a pretty close proxy for billings and then free cash flow as opposed to looking at operating income or EPS. And now to get to the [ mid ] of your question on the resiliency piece, I think that's right. And we did see in 2020, for example, in the couple of darkest most uncertain quarters. We did see some bookings decline year-over-year. However, the ARR that we had actually continued to grow at double digits throughout 2020. And as a consequence, our billings were coming in, our cash was coming in, and we were actually able to still deliver stable free cash flow, which is in stark contrast, if I went back to the last time we saw that kind of bookings decline would have been in 2009 and there, we saw perpetual license revenue down a little over 30% for the full year. And frankly, what that translated into was our top line revenue at that time was down by about 12%. Free cash flow was impacted, earnings were impacted, right? So the differences in the business model have been very stark, proved to be very resilient in the face of turbulence. And frankly, I think that's good for investors, but it's also great for our customers because we can continue to still invest in the business despite some more of this macro uncertainty, we can feel a little bit better about doing that, which brings me to my last point about your -- or the last point of your question, which is around what we've done on the cost side to prepare ourselves for a storm. And I'd say it's really a factor of kind of 2 or 3 different things. One, in general, I think PTC has, over the years, earned the reputation of being a pretty disciplined when it comes to managing cost structure -- when it comes to managing cost structure and managing investments. So that mentality and mindset continues. Additionally, last year, our fiscal year ended September 30. So our -- we just started our fiscal '23 right now in October. But last year, in fiscal '22, there were a couple of things that happened. At the beginning of the year or the end of fiscal '21, we announced a restructuring program to help realign the business to prepare for this SaaS journey that we're now embarking on and kind of undoing some of the legacy perpetual functional silos that have existed and building up a more, we call it, standard kind of SaaS business model. So in the course of doing that, we did take some cost out of certain areas, and we're actually able to invest in other areas, like continuing to invest in DevOps, our SaaS platform and so on, while reducing kind of redundant costs elsewhere. And then towards the end of the year, we also did some portfolio rebalancing -- portfolio rebalancing to better align our spending with what we now expect the kind of medium-term growth rates for our IoT and AR businesses to be. And as a consequence of that, what we ended up doing was closing about 500 open recs that we had planned for next year and moving folks around internally into different roles to meet the demand that way. And frankly, the net impact of both of those things has been the restructuring that we did probably added about 300 basis points of margin improvement. And the rebalancing that I just talked about will also add another kind of 400-ish basis points of improvement as we look at setting ourselves up for fiscal '23. And of course, just given the macro environment in general, we are taking a cautious stance on spending and hiring. We actually still have folks that we plan on hiring throughout the year. We have investments that we're planning on making, but we are kind of taking it day by day. So I think it's a pretty good setup for fiscal '23.

Yes. And I wanted to dig a little bit more into the IoT and AR business that you just mentioned, doing a bit of a restructuring there. So what happened in those businesses? And what are your goals for those looking forward?

Yes. So I mean, those businesses grew at a combined pace of about 19% last year. So actually still faster than PTC's overall growth rate, which was last year, 15% organic, 16%, including an acquisition that we had done. So those businesses were clearly accretive to the overall growth rate. At the same time, that growth rate is lower than if we went back 3 or 4 years and said, what do we think those markets could grow at. We would have said, geez, something with a 3 handle on it, 30% plus, and we had been investing accordingly, given a variety of factors, including market readiness, which is also impacted by -- frankly, by COVID and the lack of ability to get on site and other things, the evolving product maturity as well. I think that we've come to take a position that we think these products will grow in the 15% to 20% range. And as a consequence, we should be investing in them accordingly, not investing in them to grow 30% when they're going to grow 15% to 20%. And so that was really part of that rebalancing. Still think they're great technologies. I think there's lots of opportunity to create value for our customers by helping them deploy IoT and augmented reality technology in an industrial setting. It's just that the pace of that right now feels like it's in that 15% to 20% range.

Got it. Yes. Still very optimistic on those businesses, but it will just take longer for those to nurture. Just another one on the SaaS transition. You mentioned that as customers move over to SaaS, you see them spending more. So what is the typical top line and gross margin improvement you see when a customer moves from on-premise to SaaS? And how do you expect the gross margin to develop over time just as SaaS becomes a bigger piece of the overall business?

Yes, it's a great question. So first, I guess, maybe I'd say just to clarify, I think that the customers are actually going to spend less in aggregate. They're just going to spend more with PTC as a SaaS vendor. So in general, I think it's a good move from a cost perspective for customers. I think it's a great move from advancing technology, enabling collaboration, faster time to market for us, they're always on the latest version, better security, blah, blah, blah, all the benefits you would expect from SaaS. So I think all of that is true. In terms of the move and the impact on margins, again, I would want to remind everybody that when we went from a perpetual model to the subscription model, that's when we went through what sometimes we refer to as the valley of death, which is a bit morbid. And I try to call it paradise valley, but my boss prefers valley of death, which is really when you see a trough in your revenue and frankly, in your free cash flow, but your spending staying the same because you're migrating your billing model. And so we did that already from 2015 to 2019. So we're through that piece. And now as we transition to SaaS, it's actually all only incremental, the growth. And then from a margin perspective, and I'm going to use round numbers to keep it super simple. If -- for $1 of on-premise software that we have today, we're getting, I'll call it, 90% for the purposes of this discussion, but a little bit north of 90% gross margin on that software, depending what software it actually is, which program and a couple of other variables, but it's in the low 90s range, generally. Whereas with subscription -- or sorry, excuse me, with SaaS, what we're really seeing is that, that $1 is going to turn into $2 of spend with PTC but it will be instead of $1, a $0.90 or euro. It will be $2 at -- in the beginning, probably somewhere closer to 60 -- mid-60s percent margin. And over time, as the platform continues to evolve, we think we're going to get to about a 70% gross margin. So the gross margin on those specific contracts is a little bit lower, but the gross profit dollars conversely are higher. And just lastly, if you looked at our mix of business between on-premise and SaaS, then what I would tell you is you'd actually have to look out a number of years. And because we expect both of those lines of business to continue to grow the -- and frankly, we expect our professional services business to continue to shrink over time as we move more and more of that to partners. The net impact on PTC's gross margin should actually be negligible. It should be 81%, maybe see a point, if we're super successful and the SaaS transition goes way faster than we think, maybe you'd see another point of gross margin degradation, but it would come with all that incremental gross profit.

Got it. I'm going to ask another question and then turn it over to the audience. So I wanted to hit on ServiceMax, which is the largest kind of acquisition that you guys have announced. And if we think about kind of your main competitors in the environment in CAD and PLM, they don't offer similar kind of field services management. So this seems like something kind of new. So how does ServiceMax really fit into PTC's vision and strategy?

Yes. Super great question, and it is our largest acquisition. We expect to close it here, hopefully, in early January. It's a great business. And if you go back to what I was -- at the very beginning of the intro, and I was saying that part of the way that PTC has evolved over the year is by kind of expanding the definition of PLM to include things like SLM and ALM, that SLM service life cycle management is really a part of our vision of PLM. And so we think that ServiceMax actually fits really nicely into that part of the portfolio that we already have with other assets like Arbortext that does technical documentation or Servigistics that does kind of spare parts optimization. And then this is really helping with field service optimization, particularly for complex assets that are deployed in the field by these companies. So we actually think that it's going to fit in strategically great. We think that over the long term, there are going to be some pretty interesting product synergies. Again, if we think about leveraging that product master data and how that can be distributed now in this case, into the hands of a service technician in the field, leveraging some of that core engineering data, augmenting it with technical documentation that's also tied back to this core engineering data and supporting that with spare parts optimization. So when they get on the scene, they have the right documentation, they've got the right tools. They've got the right parts to be able to address the problem once and efficiently while they're there. So from that sense, strategic fit, super interesting and from a financial fit, we said at our Investor Day, it's going to be accretive to growth. It's going to add from a ARR perspective somewhere in the vicinity of $175 million by the end of the year. And we think it will be also accretive to free cash flow. So we think we'll take our free cash flow guidance up by $5 million in fiscal '23 as a result of this. And that's, of course, after deal costs, after incremental interest costs. And I guess just the last point I would make on that is, yes, it's a sizable acquisition. We're going to leverage our revolving credit facility as well as take out a term loan in order to finance it. It should take our leverage up over 3x for I don't know, a couple of quarters, and we're going to really focus on paying that down as rapidly as possible. So I think after 2 or 3 quarters, we'll be back under 3x levered, but still focused on getting this thing paid off in short order and really trying to get the strategic synergies out of it.

Great. Do we have any audience questions here? Here, in the second row.

1917. That was the year. Yes, for Finnish Independence. And that's what you were going to ask, right?

No, it's related. Thank you. No, just thank you for the presentation. I really enjoy the questions and stuff. Two questions. Basically, one is concerning the product, which is follow-on and the first one is basically about distribution. I mean, if the U.S. now has taken this attitude with China, that everything that is critical technology that will enhance the military capability could be an issue. We have seen that for Cadence. We have seen that for Synopsys and other companies that basically provide infrastructure software for the development of systems. You have defense clients and you are used for the design of military systems as well, and you have sales in China. So how are you going to handle that?

Yes. It's a -- it's a great question. On the one hand, I would say, yes, we do have customers that have aerospace and defense customers, even U.S. government, various branches are customers. That's all true. And yes, we do have business in China at this point. However, our China exposure is about 5% of the overall business. So we will have to watch and see how it evolves, how the overall situation evolves. We've been impacted already by previous administration's decisions around U.S. interactions with China, and we've lost a couple of our larger customers in China that found themselves on a list. So we'll have to continue to watch and monitor.

Because it has a good factor growth. Basically, it was growing double digits. So it is growing double digit.

It's still small number.

It's small, but it's growing fast. The second part of my question is concerning your comment concerning the PLM, I mean Windchill, which was your core business, and it was the kind of disrupting technology at that time when you actually launched it. But you have now -- I mean, if you make the analogy, yes, SAPs, ERP and Salesforce's CRM, it's 1 system for many verticals, but it's only 1 system. You have Windchill and you also have another 5 or 6 different PLM systems in addition of Windchill. So why do you have so many and you have to maintain code bases for all of those or are those basically specialize on verticals. Can you [ expound ] me through that for me?

Yes. I'm not sure that I would say we have that many PLM systems. We got Windchill. We did acquire a company called Arena. But then some of the other things that I was referring to, like SLM and ALM, that's really an expansion of what we would call closed-loop life cycle management of an expansion of the definition of PLM. So again, the core -- the core PLM application is Windchill.

Is Windchill. Okay. Got it.

That actually brings us up to our time. So Kristian, thank you so much for sharing your insights with us today.

Great. Thanks very much for having me, and I appreciate the questions and the support, everybody. Thank you.