October 26, 2015 - 5:48pm EST by
2015 2016
Price: 34.00 EPS $2.22 $1.15
Shares Out. (in M): 119 P/E 15.3 29.5
Market Cap (in $M): 4,040 P/FCF 13.0 19.9
Net Debt (in $M): 350 EBIT 301 161
TEV (in $M): 4,390 TEV/EBIT 14.5 27.3

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PTC, Inc. (“PTC” or “the Company”) is leading provider of product design and coordination software for discrete manufacturing processes.  PTC generates prolific free cash flow through its recurring maintenance stream, providing for a margin of safety through economic cycles.  The Company’s proven management team has multiple levers at its disposal to drive long-term shareholder value, including continued margin enhancement, improving top-line growth through its Internet of Things platform, and substantial share repurchases.  PTC is about to embark on an aggressive transition to subscription pricing, which we believe will improve visibility and result in a re-rating of the stock, and plans to provide more detail on the transition during its November 10th analyst day.  The transition, as more fully set forth below, is resulting in a near-term decline in EPS and EBIT (hence the high multiples above), but will create an additional 20-40% of lifetime value per customer in the long-run.   This should result in the company earning a steady and relatively protected $4.00 of after-tax free cash flow per share in four to five years (note: FY ends in Sept).

Business Description

Headquartered in Boston, MA, PTC is a leading provider of product design, workflow coordination and related software used in discrete manufacturing.  PTC’s mission is to help its 28,000+ customers – operating across automotive, electronics, general industrials, life sciences and aerospace/defense industries – to create, operate and service their products.  Based on FY2014 results, PTC generates approximately 40% of its revenue in North America, 40% in Europe and 20% in Asia-Pacific.

In terms of revenue sources, PTC generates 53% of its revenue from maintenance fees, 25% from license fees and 18% from professional services and consulting fees.  In a typical deal, PTC’s maintenance fees range from 18% to 25% of the upfront license fee.  The Company has exhibited consistent 90%+ renewal rates on maintenance contracts due to the central role that its software plays in the lifecycle of a product and the impracticality of switching to competing vendors.  PTC has started to embed low-single digit pricing escalators into its maintenance contracts over the last few years.  The remaining 4% of revenue is derived from subscription fees, which we expect to represent a much higher proportion of total revenue in the future as the Company more aggressively pursues a transition from the traditional license/maintenance model to subscription-based pricing.

Company and Product History

Samuel Giesberg, a University of Leningrad professor, founded PTC in 1985 as Parametric Technology Corporation (later shortened to PTC).  During the 1970s, Ginsberg had been involved with the early commercialization of computer-aided design (“CAD”) – systems used by product designers and engineers to create, analyze and modify physical properties of products.  Unlike other CAD systems at the time, PTC’s first product, Pro/ENGINEER, enabled a user to change one property while automatically changing associated properties.  The Company initially offered Pro/ENGINEER for a perpetual license fee of approximately $12,000 per seat, deployed across R&D teams ranging in size from a few to, in some cases, hundreds of designers.  By creating a more dynamic design environment, PTC established itself as a leading innovator.  The Company went public in 1989 and reigned as arguably the most successful CAD business throughout the 1990s, known for its high-end technical functionality and advancements in new techniques such as 3D design and modeling. 

CAD industry growth began to slow in the late 1990s, and competitors consolidated and invested heavily to gain ground against PTC.  Searching for a new avenue of growth, PTC recognized a need by customers to manage and coordinate expanding data sets created by CAD systems and, in early 1998, completed its largest acquisition to date of Computervision for $490 million.  PTC gained access to the product lifecycle management (“PLM”) market with Computervision’s Windchill product, as well as added its future CEO, Jim Heppelmann, to its staff.  PLM is sold on an enterprise-wide basis with perpetual license fees often in the millions of dollars, and serves to facilitate the sharing of critical product data across various departments, or with third-party suppliers/customers, engaged in the creation of a product. 

The early 2000s marked a humbling period for PTC, which had established a reputation for an aggressive, sales-centric culture and began losing market share due to underinvestment in CAD.  This resulted in the 2003 appointment of Heppelmann – a former mechanical engineer – as Chief Product Officer, who spearheaded a ramp-up in R&D expenditures, while the Company built-out its third-party sales channels.  By FY2008, PTC exceeded over $1 billion in revenue, with 60% comprised of PLM and adjacent products and the remainder from CAD.  Despite its greater product diversification, PTC’s exposure to global manufacturing during the 2008/2009 Great Recession caused license revenue to decline 36% in FY2009 (total revenue declined only 12%, reflecting the stability of the maintenance stream).  Management opted to retain the majority of the workforce rather than to embark on a major cost-cutting program which allowed the Company to quickly rebound in FY2010, spurred by a number of large PLM implementations. 

Heppelmann, then President and COO, was well-positioned and qualified to assume the CEO role upon the retirement of Dick Harrison in May 2010.  During Heppelmann’s tenure as CEO, the Company’s equity value has more than doubled, as non-GAAP EPS exhibited a CAGR of 21.2% through FY2014.  The principal lever during this timeframe was improved operating efficiency, as non-GAAP operating income margin expanded from 15.6% in FY2010 to 25.1% in FY2014, while we estimate that revenue exhibited a mid-single digit organic CAGR through a tepid manufacturing recovery.  PTC’s ability to achieve this bottom-line growth is impressive in the context of significant investments made to bolster legacy products for long-term growth.  PTC introduced a new suite of easier-to-use CAD products under the Creo brand in 2010, and has continually added enhancements to its core PLM product, Windchill – positioning it well in a now stable competitive environment, where the four largest providers (PTC, Autodesk, Dassault and Siemens) control roughly three quarters of both the CAD and PLM markets with only minor shifts in market share.  PTC’s big bet, however, has been in an exciting new market, the Internet of Things (“IoT”).

IoT is a term used to describe the connectivity of products – washing machines, jet engines, headphones, etc. – with the internet and with each other.  Effectively, IoT is turning these everyday products into “smart” products, catalyzed by the confluence of technological advancements in processing power, cloud computing and ubiquitous wireless internet.  The value proposition of IoT is rooted in the ability to capture and analyze troves of data collected from products, used to inform business decisions and improve the performance of products.  Companies can now embed sensors in industrial machinery, for instance, to collect data on the frequency of mechanical failures and trigger an automatic maintenance call, and may choose to strengthen certain structural components in future models.  As a result of this game-changing value proposition, Gartner estimates that the IoT services market will grow at a 30% CAGR to $263 billion by 2020. 

Given PTC’s history as a pioneer in helping companies make products, its next play is to help companies connect these products.  In pursuit of that vision, PTC acquired two of the most well-regarded and complementary companies in the space – ThingWorx and Axeda – to assemble a leading IoT enablement platform.  PTC’s IoT value proposition is to provide the back-end “plumbing”, priced ratably on a per-device basis, to enable companies to build new IoT applications seamlessly and with less development effort.  Adding IoT to PTC’s existing product portfolio should create a valuable feedback loop to the users of its CAD and PLM software, as they can now incorporate firsthand insights (rather than relying on anecdotes from end users) about product performance into the design of future products.  While its IoT acquisitions were completed at high multiples of current revenue, PTC’s capacity to cross-sell into 28,000+ existing customers supports the opportunity to capitalize on this long-term growth trend. 

Investment Thesis

While PTC has amassed a strong product portfolio and consistent operational execution, it faces a series of transitions and transient headwinds – chief among them, its transition to a subscription model – that we believe create a compelling opportunity for long-term investors.  At its November 2014 investor day, management presented the early components of what it now, in hindsight, refers to as “phase 1” of its transition to subscription, marked by a wait-and-see approach that left investors confused about both the path and end-state of PTC’s business model.  The retirement of the Company’s CFO, Jeff Glidden, exacerbated uncertainty until his replacement, Andy Miller, joined the Company in February 2015. 

The transition from a transitional license/maintenance model to subscription pricing causes a near-term “dip” in the P&L, but pays-off handsomely over the long-term.  Increasingly, CIOs prefer to pay for software on a ratable basis, and this has driven an industry-wide shift to subscription pricing, wherein the customer pays higher ongoing fees in lieu of the initial license fee.  While the software vendor foregoes the upfront fee, it can earn a greater lifetime value as long as the customer continues to renew.  Typically, the “breakeven point” (i.e., when cumulative revenue is greater in a subscription model versus the traditional model) is three to four years.  The subscription model is also more predictable from quarter-to-quarter than the traditional model, as effectively all revenue is ratable (with the exception of professional services fees).

On top of PTC’s subscription transition, the combination of unfavorable foreign exchange movements and softening global manufacturing trends resulted in a Q3 FY2015 top-line miss and full-year guide-down, causing PTC’s stock price to decline approximately 20% from its 52-week high of $42.53 per share.  Still, PTC managed to deliver Q3 non-GAAP EPS of $0.53 per share, versus prior guidance of $0.47 to $0.50 per share, due to ongoing cost cutting efforts and a slightly lower tax rate, and we estimate that on a constant currency, transition-adjusted basis that non-GAAP EPS grew over 20% YoY.  Nonetheless, we believe the confluence of the aforementioned forces combine to understate PTC’s long-term growth profile and earnings power. 

We believe PTC represents an asymmetric risk/reward opportunity at the current price based on the following:

1)       Highly recurring maintenance stream affords margin of safety:  PTC's maintenance fees, renewed at 90%+ annually due to the integral role of the Company's products, solid competitive positioning and difficulty for customers to rip-and-replace, provides a source of dependable cash flows irrespective of managerial missteps or macroeconomic pressures.  Our conversations with customers highlight their reluctance to switch CAD and PLM software due to the cost, time and distraction of porting data and designs to a new vendor platform and retraining users.


2)       Plentiful value creation levers available to high-quality management team:  PTC's proven management team has ample opportunity to create shareholder value.


a)       Leverage IoT opportunity to drive long-term growth:  We believe that PTC has the potential to accelerate organic revenue growth to double-digit rates within our investment timeframe as its IoT platform, expected to grow revenue at 30%+, becomes a larger portion of the total business.  To date, PTC has exhibited early successes in IoT, having won approximately 200 customers, with momentum building as the Company has achieved thought-leader status in the industry (see The Internet of Everything in the November 2014 Harvard Business Review – co-authored by Jim Heppelmann and Michael Porter). 


b)      Continue operating margin enhancement:  Since Heppelmann assumed the CEO role, PTC’s non-GAAP operating margin has expanded 950 basis points through FY2014 to 25.1%.  Still, the Company’s operating margins remain below the peer levels in the low/mid 30% range. Management’s target of 28-30% by FY2018 is largely predicated on a well-defined plan to continue shifting less profitable consulting services work to resellers and systems integrators, and we think that more upside in PTC’s margins may exist by optimizing pricing strategies.


c)       Utilize prolific free cash flow to repurchase stock:  PTC has generated a cumulative $842 million of after-tax free cash flow over the last five years with a free cash flow margin of 20.6% in FY2014, giving management firepower to invest organically, pursue M&A and return cash to shareholders.  In August 2014, PTC announced a new capital allocation strategy to return 40% of free cash flow to shareholders and an authorization to repurchase $600 million worth of its shares through FY2017.


3)       Transition to subscription a catalyst to stock re-rating:  Despite its negative near-term impact to the P&L, PTC’s transition to a subscription model will make its business more predictable in the long run, which should result in a higher valuation multiple.  Since the February 2015 arrival of new CFO Andy Miller, who previously served as VP of Finance and Chief Accounting Officer of Autodesk (a business having thus far successfully navigated a subscription transition and broader product pricing optimization), the Company has kicked its transition planning process into high gear, dedicating approximately 200 people to the effort.  While we await the unveiling of subscription transition “phase 2” at the Company’s November 10th analyst day, we expect a significantly more aggressive transition, both in magnitude and timing, than previously presented by management.  Having observed a number of prior model transitions, we believe that PTC has learned from, and will capitalize on, the mistakes made by the “first movers”.


4)       Potential takeout candidate:  We believe that PTC’s high quality product portfolio, reputation for high-end technical proficiency, and long-standing relationships with major automotive, aerospace and industrial customers make the Company a coveted asset to a number of larger software vendors as well as industrial companies.  While we are not privy to any potential transactions, there has been previous speculation of PTC as a takeover target, in whole or in part, for Autodesk and SAP, and more recently, GE, due to its well-publicized interest in IoT.

At the current price of approximately $34 per share, PTC is available at a 7.7% FY2015 after-tax free cash flow yield to equity (excluding one-time restructuring and severance costs), which we believe is a compelling valuation for a high quality business with an embedded “call option” on potentially explosive revenue growth and profitability from the IoT platform.  As we think is necessary with any subscription-based business model, we focus predominantly on a free cash flow metric, which includes the change in balance sheet deferred revenue, as PTC typically collects fees for subscription contracts on an annual upfront basis.  Focusing instead on P&L-based metrics such as EBITDA and EPS multiples, in our view, masks the value of subscription fees booked near the end of the fiscal year, and make a business like PTC look unjustifiably expensive. 


If PTC executes on its long-term transition and growth plan – which we think, in spite of near-term macro and currency headwinds, it should be able to do – we estimate the Company will generate over $4.00 per share of after-tax free cash flow by FY2019.  At the same time, even in a pronounced economic downturn, its earnings power should be insulated by the recurring nature of its sticky CAD and PLM businesses, as well as management’s continued measures to drive costs out of the business, providing a margin of safety against permanent capital impairment.

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.


Transition to subscription model

IoT growth

Capital allocation


Upcoming analyst day (which encompasses communication of the above)

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