Value Investors Club / PTC INC (PTC)

Description

Company Overview:

PTC Inc. (PTC) is a legacy software company that has created a smoke-and-mirror growth story using creative accounting, unconventional definitions, and a variety of non-GAAP metrics. PTC is primarily known for their Computer-Aided Design (CAD) and Product Lifecycle Management (PLM) solutions though they also have Application Lifecycle Management (ALM), Service Lifecycle Management (SLM), and Internet of Things (IoT) divisions. PTC sells into a variety of end markets but is heavily focused on manufacturing, specifically within the automotive, technology, aerospace, and industrial segments. PTC is currently in the midst of a business model transition that is shifting focus from a perpetual license model to a subscription based model, following the path of many software peers. Unlike others who have fully transitioned to a subscription-only model, PTC is pursuing a hybrid license/subscription model but may look to discontinue licenses altogether at some indeterminate point in the future.

Key summary of the short thesis:

PTC is misrepresenting the business model transition using an inflated bookings figure, various non-GAAP metrics, and faulty assumptions
Inflated metrics have given the illusion of stronger growth and operating performance than PTC has actually delivered
Wall Street analysts do not appreciate or even acknowledge the downside risks associated with the business model transition
PTC is a massive roll up that has destroyed immense amounts of shareholder capital; since Jim Heppelmann took over as CEO, PTC has spent ~$1.1 billion on acquisitions with no meaningful contribution to revenue
The IoT platform has been created entirely through acquisitions and is producing weak organic growth that must accelerate dramatically to meet expectations
In each of the past five years, management has taken restructuring charges that have failed to reduce operating expenses and are likely emblematic of aggressive expense allocation and/or earnings management

For better or worse, Wall Street is willing to pay a much higher multiple for subscription based businesses. In many cases, this enthusiasm is well deserved. When paired with proper execution, companies like Adobe have demonstrated that the license-to-subscription transition can result in a financially attractive and highly scalable model. Legacy software companies that look to embark on this transition typically encounter a near term operating trough that arises from ongoing expense recognition while deferring new subscription revenues. For the enterprising management team, this creates a short-lived window of opportunity where creative accounting and unique definitions can be used to construct a growth story where there is none.

Segment Overview:

Solutions Group: comprised of legacy low growth CAD, PLM, ALM, and SLM businesses; depending on the business unit, competition includes Dassault, Siemens, Autodesk, Oracle, SAP, IBM, and HP.

Technology Platform Group: this is the “high growth” IoT division which has been created via acquisitions. The IoT space is immensely complex and highly fragmented with many verticals. Competitors include Samsung, IBM, General Electric, Amazon, Microsoft, Cisco, Oracle, SAP, and many others.

Business Model Transition:

Bookings are the primary metric by which investors are evaluating PTC and the ongoing business model transition. Bookings include both license and subscription bookings, applying an unconventional 2x multiplier to subscription ACV as an “apples-to-apples” comparison to perpetual licenses bookings. PTC states that they arrived at this conversion factor by "considering a number of variables including pricing, support, length of term, and renewal rates." As a result, all the metrics that include subscription bookings at a 2x multiple are also inflated. One of these metrics is subscription bookings as a percentage of total bookings, where PTC has guided to a 90% long term target of subscription bookings mix. PTC has also guided to a long term non-GAAP operating margin of 30% (non-GAAP operating margins typically ranged from 15-25% prior to the business model transition coming in at ~15% in FY 2016). Non-GAAP operating income includes stock compensation, adjustments for acquisitions, amortization of intangible assets, and restructuring charges. These additions increased operating income from ($37mm) to $173mm in 2016.

As a part of this transition, PTC is in the process of converting support revenue into subscription revenue. PTC has publicly stated that support contracts are typically converted into subscriptions at a 25-50% premium with ONLY the incremental amount included in the bookings figure (subsequently multiplied by 2x). My field research indicates that customers are only willing to pay this "increase" because they are either renewing with fewer seats or receiving concessions on upgrades. Based on my modeling under an array of different assumptions, I believe PTC may be including the entire conversion amount in the bookings figure. If accurate, this constitutes a serious misrepresentation of the subscription transition and further invalidates the growth story.

As far as LTV metrics are concerned, PTC has indicated the break-even point for subscription conversions is 4 years and results in 30-40% higher revenue over 7-8 years (assuming subscription and maintenance is priced at 45% and 20% of license fees, respectively). However, churn rates and seat counts have not been contemplated which can dramatically impact break-even points. By way of example, assuming 10% license churn, 5% subscription churn, and 20% fewer subscription seats, my calculations yield a break-even point of 7 years.

PTC stopped disclosing active seats after experiencing rapid deceleration in each business unit with the introduction of the subscription offering. PTC takes the position that seat counts are no longer a relevant metric during the transition. As an example, PLM had experienced out-sized support-to-subscription conversions and experienced rapidly decelerating YoY growth of active seats (note the deceleration in FY 2015). This suggests that the subscription transition is actively reducing seat counts and likely invalidates the four year break-even period.

IoT Hype Story:

The other aspect of the growth story is the IoT division which has been pieced together entirely through acquisitions for total consideration of over half a billion dollars.

PTC has acquired five IoT related companies thus far, namely:

ThingWorx: application development platform
Axeda: M2M connectivity software
ColdLight: predictive analytics/machine learning
Vuforia: augmented reality
Kepware: industrial automation software

Wall Street analysts are expecting IoT to grow organically at ~40% and to contribute the majority of bookings growth in upcoming years (with sell side analysts forecasting double digit top line growth within 2-3 years). Adjusting for acquisitions, I estimate that organic IoT revenue growth was ~9% in FY 2016, meaningfully below PTC’s long term 40% growth target.

PTC originally indicated that new logo count would be one of the primary metrics for the ThingWorx platform. PTC added 290 logos in FY 2015 and an additional 275 logos in FY 2016, indicating that logo growth decelerated in FY 2016 despite the introduction of a freemium model for ThingWorx in April 2016. PTC no longer discloses this metric either, stating that it is no longer relevant to the IoT effort. My field research further indicates that management has experienced difficulties integrating these acquisitions and has struggled to understand the underlying technology (Axeda and ColdLight in particular), focusing instead on customer lists.

Restructuring Charges:

PTC has recorded a total of $225mm of restructuring charges in the past five fiscal years, 98% focused on severance and reducing headcount by 2,266 (equating to turnover of ~1/3 of the entire PTC workforce).

While PTC has implemented widespread layoffs, these restructuring charges are highly suspect. The 2016 restructuring plan was originally estimated at $40-50mm, increased several times, and eventually totaled $76mm. This amount was ~98% focused on severance packages and was projected to save ~$17mm annually. This means that PTC is spending over 4x the annual cost savings to terminate these employees and paying $93k per employee in severance costs. In conversations with the company, PTC was unable to articulate if offices had been closed, leases exited, or even verifying those amounts, instead commenting that it was focused on reinvestment and reallocating resources into high growth areas.

Despite five consecutive years of restructuring charges, PTC has failed to reduce total headcount or operating expenses in any meaningful way. Excluding restructuring charges, PTC has guided to flat operating expenses due to "overall investment" and "certain cost increases" that will offset cost reductions from restructuring. This will represent yet another year with no expense reductions despite an outstanding restructuring accrual of $36.6mm. At what point are restructuring charges part of the normal course of business?

Bribery and Fraud Lawsuits:

On February 16th, 2016 PTC settled with the DOJ as a result of repeated FCPA violations in which PTC China subsidiaries were bribing foreign customers in order to secure business. The DOJ found that PTC had internally investigated the issue and intentionally withheld information from the DOJ in its investigation until the fraud was uncovered, suggesting direct involvement of management. The DOJ also found evidence of deficient internal controls that failed to detect bribery and misallocation of expenses (totaling ~$1mm plus an additional $250k of gifts). These bribes resulted in +$13mm of revenue to PTC and $28mm of penalties in the form of disgorgement, interest, and fines.

Similarly, GE Capital accused PTC in 2007 of participating in a scheme with Toshiba and resellers to finance fraudulent software sales. GE accused PTC of orchestrating fraudulent, unauthorized software shipments and falsifying supporting documentation that defrauded GE Capital. PTC settled the case in Oct 2010 for ~$48mm in cash.

Other Issues:

Employee reviews are fairly mixed; consistent feedback includes excessive restructurings and layoffs, visible favoritism and nepotism within the organization, and underpaid employees. Also worth noting that changes were made retroactively to 2013-2014 performance based equity awards (due to obfuscation from ongoing business model transition) such that the CEO was awarded ~$5mm of stock (plus ~$3.6mm to other executives) that would not have otherwise been earned and subsequently paid.

PTC guided to GAAP EPS of $0.51-0.58 for FY 2017 only to revise this guidance down the next week to $0.21-0.32 after “inadvertently omitting” interest expense from their internal calculations. Beyond the embarrassment of having to file an 8-K for this miss, the omission in PTC's guidance does not exactly inspire confidence that PTC maintains effective internal controls or that management truly has a firm handle on the underlying GAAP reporting. PTC subsequently took this guidance down to $0.06-0.09 after reporting Q1 numbers.

PTC is also subject to currency risks as ~2/3 of their revenue is overseas vs. ~1/2 of their expenses. PTC uses forward contracts to hedge currency risk; according to details in the most recent 10-K, a €0.10/USD movement will result in a $8mm impact to operating income while a ¥10/USD movement will result in a $7mm impact to operating income. While difficult to properly evaluate the ongoing hedging program and currency risks to PTC, foreign exchange movements are likely to be a headwind for PTC in a strong dollar environment. Additionally, PTC maintains very little cash in the US with only about ~10% of the total held domestically.

PTC must comply with leverage ratios (4x total leverage, 3x senior leverage) and an FCCR (3.5x coverage) on its senior revolver. PTC has noted in 2016 conference calls that share repurchases have been suspended in order to maintain compliance with financial covenants. Depending on what assumptions are modeled, PTC could potentially trip these covenants in 2017. Even without violations, these covenants will likely impede PTC's ability to resume share repurchases in the near term.

Valuation:

Sell side coverage of PTC is overwhelmingly positive, predicated largely upon 1) the business model transition which drives higher revenue and operating margins over time and 2) the IoT investment which is expected to grow at a ~40% CAGR through FY 2021. Many sell side analysts are projecting an acceleration to double digit growth by FY 2019, disregarding restructuring charges and focusing entirely on non-GAAP metrics in their analysis. Additionally, the assumptions and downside risks do not seem to be well understood; as noted previously, introducing any churn or overall reduction in seats could meaningfully extend the break-even period for new subscription seats. Analysts also seem to be overlooking the reclassification of maintenance revenue into the subscription bucket.

While PTC has generally beat bookings targets, they have not fared well against GAAP metrics and management has been using the ongoing business model transition as a means to obscure financial performance. Management originally guided to an operating trough in FY 2018, however this timeline was accelerated on the Q4 2016 earnings call with the indication that PTC has already experienced the trough. Guidance implies that restructuring charges will abate in FY 2017 and that investors could expect non-GAAP operating margins to improve going forward. Despite this, management has guided to flat top line growth and a very slight increase in non-GAAP operating margins.

The peer group (same that appears in sell side reports) trades at 13x EV/EBITDA. Note, however, that this peer group has higher revenue growth and vastly superior EBIT margins than PTC. As such, it is fair that PTC should trade at a discount to the average, particularly with high quality names like Adobe included in the table.

PTC should trade at 10-12x EBITDA as a low to no growth legacy software company and should not be given any credit for the business model transition or success in the IoT segment until they can demonstrate real progress with either initiative. Guidance for 2017 essentially assumes a return to normalized operating metrics prior to the subscription transition (EBITDA margins ranged 19-20% in FY 2011-2013). Applying a 10-12x multiple to EBITDA (including stock based compensation) on an enterprise value basis yields a share price of $14.79-18.61 implying 65-73% downside from current price levels. The inability to return to historical operating margins, illegitimate restructuring charges, or inconsistencies with reported bookings figures could present further downside.

Risks and Mitigation:

Significant Revenue Traction: While investors expect 40% growth in the IoT segment, organic growth rates are currently ~9%. My field research indicates that PTC has experienced execution and integration issues with IoT acquisitions and, as noted above, PTC may be including the entire conversion amount in the reported bookings figure which would further impair the growth story.
Successful SaaS Transition: PTC is misrepresenting this transition by focusing on non-GAAP metrics and deemphasizing the downside risks with pricing, underlying LTV assumptions, as well as the overall execution of this transition.
Acceleration of Legacy Business: The CAD and PLM markets are established markets with formidable competitors. In fact, PTC was once a dominant force in the CAD market and has ceded share to competitors. According to industry reports, Dassault and Siemens alone control 2/3 of the CAD market and about 1/3 of the PLM market (PLM is more fragmented than CAD). PTC is also reallocating resources to the IoT segment and cutting both sales and R&D headcount in the legacy CAD/PLM businesses. My research indicates that competitors are aggressively building out functionality in 3D modeling and PLM capabilities.
Acquisition Risk: The market's notion seems to be that someone would likely be acquiring PTC for its IoT business. This risk is mitigated by the fact that the IoT business is a fraction of PTC's overall business and has yet to experience explosive organic growth. The IoT sector is also highly fragmented with many verticals and competitors. Participants are also susceptible to technological disruption and, based on my research, PTC lacks the structural ability to react to any disruption from technological innovation given their propensity to acquire, rather than develop, new technologies with a long history of poor execution.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Potential catalysts include the following:

No improvement in operating margins (after management's acceleration of the operating trough)
Lagging growth or outright failure in the IoT segment
Deterioration of core business and continued restructuring charges

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			2017	2018
Price:	53.80	EPS	0	0
Shares Out. (in M):	116	P/E	0	0
Market Cap (in $M):	6,220	P/FCF	0	0
Net Debt (in $M):	728	EBIT	0	0
TEV (in $M):	6,725	TEV/EBIT	0	0
Borrow Cost:	Available 0-15% cost