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Executives

Tim Fox

James E. Heppelmann - Chief Executive Officer, President and Member of National First Executive Advisory Board

Jeffrey D. Glidden - Chief Financial Officer and Executive Vice President

Analysts

Sterling P. Auty - JP Morgan Chase & Co, Research Division

Yun S. Kim - Janney Montgomery Scott LLC, Research Division

David E. Hynes - Canaccord Genuity, Research Division

Jay Vleeschhouwer - Griffin Securities, Inc., Research Division

Blair H. Abernethy - Stifel, Nicolaus & Co., Inc., Research Division

Perry Huang - Goldman Sachs Group Inc., Research Division

Steven R. Koenig - Wedbush Securities Inc., Research Division

Ross MacMillan - Jefferies & Company, Inc., Research Division

Ben Z. Rose - Battle Road Research Ltd.

Parametric Technology (PMTC) Q1 2013 Earnings Call January 24, 2013 8:30 AM ET

Operator

Good morning, ladies and gentlemen, and welcome to PTC's First Quarter Fiscal Year 2013 Results Conference Call. [Operator Instructions] As a reminder, ladies and gentlemen, this conference is being recorded.

And now I would like to introduce Tim Fox, PTC's Vice President of Investor Relations. Please go ahead.

Tim Fox

Thanks, Molly. Good morning, everyone. Thanks for joining us on our Q1 results and outlook call. Before we get started, I'd like to remind everybody that this call and Q&A session may include forward-looking statements regarding PTC's products or anticipated future operations or financial performance. Any such statements will be based on the current assumptions of PTC's management and are subject to risks and uncertainties that could cause actual events and results to differ materially. Information concerning these risks and uncertainties is contained in PTC's Form 8-K filed yesterday, in our most recent Form 10-K and forms 10-Q on file with the SEC.

All financial measures in this presentation are non-GAAP financial measures. A reconciliation between the non-GAAP measures and the comparable GAAP measures is located in our prepared remarks document on the Investor Relations page of our website at www.ptc.com.

With us this morning is Jim Heppelmann, Jeff Glidden and Barry Cohen. With that, I'd like to turn the call over to Jim.

James E. Heppelmann

Thank you, Tim. Good morning to all of you, and thank you for joining us here on the call this morning. When we spoke roughly 90 days ago on our last earnings call, Jeff and I discussed our belief that the negative trends in the worldwide manufacturing industry would create a challenging selling environment for us, particularly for larger deals. At that time, we also pledged our ongoing commitment to continue to push forward with our margin expansion and earnings growth strategies, somewhat irrespective of the revenue environment. That's largely how the quarter played out.

Our revenue in the quarter came in toward the middle of our guidance range, albeit with the mix more weighted towards Servigistics than we had predicted. We were diligent with spending all quarter, and this helped us to exceed the earnings guidance range. So continuing the trend of the last few quarters, we executed well on earnings, even while confronting strong headwinds in revenue.

One of the reports that we referenced in our prepared remarks suggest that the global manufacturing growth rate is now at the lowest we've seen since the 2009 global economic crisis. We've discussed in recent calls that there appears to be a reasonably strong correlation between our CAD and PLM license revenue and the larger trends in the manufacturing economy, and we saw this again in Q1.

The manufacturing environment in China was stable, and our performance there was solid. Similarly, the situation in the U.S. seems to be improving slowly, and our performance was relatively good there for the second consecutive quarter. Within Europe, the manufacturing environment has worsened considerably in the last 2 quarters as the German economy has slowed and perhaps even began to contract, and we see a corresponding significant slowdown in our European results. And Japan continued to be very difficult, though our license revenue was up relative to an easy year-over-year compare for that region.

On the positive side, most of the reports I've read lately are suggesting improved conditions in each of these regions as we move deeper into 2013, and then if these improvements materialize, that we would see a corresponding upswing in our growth rates. This is actually the pattern we've noted when comparing PTC organic license results to previous manufacturing industry economic cycles.

There were some very positive developments in our business within the quarter. The most positive is the momentum in our SLM business. Both our organic SLM business and our newly acquired Servigistics business posted strong license results. We would need more data points to say this with absolute conviction, but there is some building anecdotal evidence that suggests that the SLM business will hold up better in a tough economy as companies shift their attention from developing new products to generating more revenue and profit from aftermarket service for products already deployed.

I remember talking to a large truck manufacturing customer back in 2009 about how their new truck sales were down 70% but their spare parts sales had gone through the roof. Similarly, new development programs are hard to come by in our U.S. defense business, yet SLM opportunities abound as the agencies realize they need to keep the existing equipment operational because nothing new is being planned.

There are many reasons why we are excited about the longer-term SLM opportunity. First, there's a secular trend across many industries to expand deeper into the after sales service business and to think about a customer as a profitable ongoing relationship rather than a discrete transaction. Taken to the full extreme, you get products delivered as a service, which while it's still a nation phenomenon today, I see more and more examples of this strategy everyday.

The second key factor is that we have the opportunity to create a much more tangible and hard dollar value proposition in the SLM arena. It's always been somewhat of a challenge to monetize engineering productivity improvements, but having fewer expensive spare parts in inventory, coupled with fewer repairmen driving fewer trucks to chase down fewer warranty problems, is all readily measurable and goes directly to the bottom line.

Next, we find ourselves discussing this strong value proposition with a buyer that is a sales and service executive who generally owns a P&L responsibility and thus has the flexibility to invest dollars when confident in the return.

To cap it off, the combination of PTC and Servigistics has now produced a clear leader in terms of SLM revenue, customers, expertise and technology. One can readily imagine that over the longer term, SLM could develop into a new core business for PTC. In any case, even stopping short of that, it's clear that our SLM business has good momentum even in this tough economy, and it is clear that the Servigistics acquisition is off to a strong start and will perform better than we had originally modeled, probably doing $80 million or more versus the $60 million to $70 million view that we shared most recently.

We also had a very positive quarter in terms of winning new domino-style accounts. To remind you, we have previously used that term to describe wins in competitive situations at very large accounts where PTC had no meaningful incumbent position. As you know, we chose to stop reporting the quarterly metric 1 year ago, but certainly, we did not stop pursuing or winning these big displacement opportunities.

The win we announced today at Embraer was one of the more notable domino wins we've seen. Embraer is the #3 manufacturer of commercial aircraft in the world behind Airbus and Boeing, and one of the fastest-growing. Embraer grew increasingly concerned in recent years about their incumbent PLM solution and proceeded to conduct the industry's deepest vendor analysis and benchmark since the full EADS company did so back in 2008. As we announced, the result was a decision to replace the incumbent PLM footprint with a full new PLM solution from PTC that also contained elements of our ALM and SLM solution sets. Incidentally, Embraer is a significant customer of Servigistics as well, and we see additional follow-on opportunities in the SLM area in subsequent quarters.

In addition to Embraer, there were several similar competitive wins in the quarter, many of which should provide revenue in Q2 and beyond.

Generally speaking, our ALM business also did well as a number of significant new orders came in for that part of our solution set as well.

So as you can see, there's a lot of promise in our business. For starters, there's the promise of leveraging our PLM and ALM strengths, as well as this Creo new product cycle, into a significantly stronger growth stories on the backs of an economy that is bottoming out and forecasted to start improving again, and the promise of a potential breakout in the SLM business as PTC leverages a leading position in a market bolstered by strong long-term industry trends is promising. But in light of this promise, we continue to believe that our 11% to 13% growth target's achievable in a better economic environment, even if it's out of reach here in 2013.

So coming full circle, our challenge is to balance this strong optimism about our longer-term prospects with the ongoing pessimism concerning the economic environment in the short term. Assuming that the economic situation will prove to be the stronger force in the short term, our guidance is built on a view that conditions will remain challenging for the balance of 2013, neither materially better nor worse than last quarter. So we will operate the near term as we have for the past few quarters, which is to say we will carefully watch our spending with an eye to achieving our $1.70 to $1.80 EPS range for the year, even with difficult revenue headwinds. And when the manufacturing economy eventually does pick up, we'll be ready to accelerate to the next level.

So with that, I'll turn it over to Jeff Glidden to review some of the financials in a little bit more detail.

Jeffrey D. Glidden

Thank you, Jim. First, a few comments on our Q1 results, and then I will discuss our outlook for Q2 and FY '13. Clearly, we are pleased with our Q1 earnings performance as non-GAAP gross margins increased to 72%; operating margin was 18.2%; and we delivered EPS of $0.36, which was above the high end of our guidance.

As Jim indicated, the highlight of the quarter was the acquisition of Servigistics, which was completed on October 2. We spent much of the quarter integrating Servigistics, and we're very pleased that this business contributed $27 million in revenue in the quarter.

A second highlight of the quarter was continued margin expansion on our services business as gross margins increased to 12.7%, up from 7.6% in the prior year.

Turning to the balance sheet. We ended the quarter with cash of $248 million. This is down from $490 million at the beginning of the quarter. Key uses of cash in the quarter included the acquisition of Servigistics for $222 million; the repurchase of PTC stocks, $16 million; and capital expenditures of $7 million.

Now looking ahead to our outlook for Q2 and FY '13. As cited by Jim, the macroeconomic environment continues to be very challenging due to the slowdown in global manufacturing. For FY '13, we expect revenue to increase by 7% to 9% to a range of $1,340,000,000 to $1,370,000,000, including license revenue of $360 million to $380 million, support revenue of approximately $660 million and services revenue of $320 million to $330 million. While we have lowered our FY '13 services revenue outlook by $10 million, we now expect services gross margin -- margins to be approximately 13% for the year.

As Jim said, we remain committed to expanding margins and driving profitability. We are targeting to expand our FY '13 margins to approximately 21.5%, with non-GAAP EPS in the range of $1.70 to $1.80.

As part of our plan to achieve the FY '13 margin targets, we have announced a reduction in staffing levels of approximately 4%. Those actions were initiated in October and January, and we expect these to be largely completed by the end of Q2. When completed, we expect a full quarter benefit to be approximately $9 million in our third quarter, with a partial benefit to be realized in Q2.

We expect total operating expenses in Q2 to be flat sequentially from the first quarter, primarily due to planned expense increases for sales commissions, marketing program spend and seasonal increases in U.S. payroll taxes.

For Q2, we expect revenue to be in the range of $305 million to $325 million, including license revenue of $70 million to $85 million. We expect to deliver non-GAAP EPS of $0.32 to $0.39.

In early January, Congress reinstated the R&D tax credit retroactively to January 1, 2012. This will provide a discrete tax benefit of approximately $3 million in our second quarter, resulting in a non-GAAP tax rate of 18% for Q2. We expect our non-GAAP tax rate to be approximately 23% in Q3 and Q4 and 22% for the full year.

And finally, a few comments on uses of cash for 2013. In addition to the acquisition of Servigistics, which was completed in Q1, we expect to repay some $120 million in debt and to repurchase between $55 million and $75 million in stock during the year.

We thank you for your support, and I will now turn it over to -- back over to Tim Fox.

Tim Fox

Thanks, Jeff. Molly, we can open up the Q&A now.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question does come from Sterling Auty with JPMorgan.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

I want to dive into the demand characteristics around CAD and PLM. Let's actually start with PLM. We understand the economic environment that we're in, but -- especially around the large deals, what is it that customers are particularly saying? Are they worried about long implementation times and taking on a considerable project like that? Or what are some of the things that the customers want to see before they're ready to engage?

James E. Heppelmann

Yes, I mean, I think there's been a move toward smaller upfront commitments, "let's implement it a lot more and then purchase the bigger follow-on purchase." So I think some orders that maybe we envisioned were going to be a larger upfront deal turned into a small, "let's get started and when it's all live later, we'll purchase the balance of it." And that's not the conversation we had been having, but that's how the conversation shifted over time. So Sterling, that's a typical example of what we've been up against.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

Okay, and...

James E. Heppelmann

Let me just that net that out. That ends up being a delay tactic at the end of the day.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

Got you, got you. And could you contrast that with CAD, because I wonder how much the CAD demand might be more related to engineering headcount and hiring versus -- is PLM a headcount thing or more of a project-based?

James E. Heppelmann

Yes, Sterling, I think that's insightful on your part because I think that PLM is more of a project discussion. And with CAD, there are 2 sort of bottlenecks, if you will, that could hold back our CAD business. One is headcount, because new seeds really are generally tied to an expanding business, and there aren't so many expanding businesses right now. The other thing is in our Creo software, there's a lot of new capability in the Creo versions of the software that didn't exist in the Pro/ENGINEER versions of the software, but in order to get there, we need to get the customer to go through an upgrade. Now CAD upgrades are not huge projects, but they are projects that have to be planned and funded and scheduled and so forth. So the element of new modules tends to sit on the other side of a project that has to be done. And now we get into the discussion of when are we going to do that upgrade and might there be a delay in that, because the company is worried about dedicating resources to anything that they might view as discretionary.

Operator

Our next question is from Yun Kim, Janney Capital Markets.

Yun S. Kim - Janney Montgomery Scott LLC, Research Division

So can you guys go into the dynamics of your services business in terms of the quarter and what is implied in your outlook? Obviously, the -- for the quarter, the services revenue came in higher than your expectation, but your outlook for the year called for a lower service revenue. Is there any significant event that you're expecting that is causing this shift? Or is there like a large project or 2 that is shifting its implementation work from you guys to a third-party partner? I'm just trying to better understand how you can lower your services revenue for the year when you just showed upside in the quarter. And also, I guess, while we're at it, if you can just discuss the progress we're making in terms of creating the services partner ecosystem, which, obviously, is clearly implied in your services revenue guidance for the year.

Jeffrey D. Glidden

Yun, this is Jeff. I think you are spot on, and that is, our services partner program has been expanding nicely. I think we cited in the prepared remarks that our orders from our partners was up better than 50% year-over-year. So a very key piece of our strategy is to build out that ecosystem where we have traditionally done probably 80% of the services work related to PTC deployments. Our longer-term goal is for that to be approximately 50%, with our partners going from 20% to 50%. So that's long-term strategy. I think we're doing well and we're on that path. So the key here is for our partners to grow the services revenue and we to continue to do I think what's the key architectural and heavy-lifting projects and expand margins. So again, as we took the total revenue down, I think that's reflected in 2 things: maybe some softening demand on -- because of macro factors, but most importantly, partner ecosystem buildout with our margins continuing to expand nicely year-over-year.

James E. Heppelmann

Yun, it's Jim. If I could add a nuance. We tend to run with about 3 quarters of backlog in our services business. So as our license revenue slowed starting 4 quarters ago, we're now seeing some of that work its way through our system. And we could do more services revenue by changing the balance of what we do versus what partners do, but that's not our strategy. And I'd say from a management standpoint, we're not that concerned about services revenue because to get to the margins, we're talking about the upper-20s margins. We actually have to be doing a lot less services in our mix. So if the services revenue comes down by $10 million for the year, that causes little angst amongst the management team.

Yun S. Kim - Janney Montgomery Scott LLC, Research Division

Okay, great. So is it fair to characterize maybe this year as the inflection point in terms of your services strategy that you guys have been talking about could be potentially the back nine of the fiscal year '15 plan?

James E. Heppelmann

Yes, I mean, one way to look at it is if you were to overlay a graph of the growth of our organic services business with the growth of our partner bookings, it's pretty shocking. The partner bookings have a pretty steep slope, growing very fast, whereas our organic business is relatively flattish. And I think that, that really reflects the strategy we told you about, which is to dial back our involvement in the service ecosystem and largely begin to hand that off to other people. There's no way to get the upper-20s margins without doing that.

Yun S. Kim - Janney Montgomery Scott LLC, Research Division

Okay, great. And then if I can ask another question. Can you just talk about, Jim, in terms of how your sales organization is aligned today in terms of product lines? Clearly, your product portfolio has extended significantly over the past 2 years with the addition of MKS and Servigistics. Do you feel comfortable with the current alignment? Or do you feel that there may still need to be some sizable tweakings that you need, such as adding more sales engineers and whatnot? And do you feel comfortable that there are enough cross-selling of CAD, PLM and SLM going on in each major accounts?

James E. Heppelmann

Okay, maybe I'll just step-through a quick description of our sales model as it exists today at a high-level. I won't get into all the details. But there is, of course, the reseller channel that deals with the smaller accounts, that tends to be mostly CAD, but with a growing element of PLM. They are largely not participating in the ALM or SLM business, nor are we encouraging them to at this point. If you then move up into the direct sales space, there's a couple of developments that have happened over the last couple of quarters. One is that we integrated the MKS sales force and the PTC sales force together. In the first year following that acquisition, we kept those sales forces separate. And we probably think in retrospect with the benefit of hindsight, we maybe kept them separate for too long because it interfered with the building of revenue synergies. So over the past couple of quarters, we sort of dissolved the ALM sales force and the PLM sales force together such that there's only one sales organization. Some of those specialists became overlays, at least for a while they'll remain in that configuration because they have specialty knowledge that we can leverage. And then on the SLM side, particularly with Servigistics, we took a different strategy, which is we said, "because we're already in the SLM business and having SLM conversations with the very same customers, we should move quickly to integrate that because it would be counterproductive to have 2 SLM sales force from PTC talking to the very same buyer at the very same company." And that went pretty well actually. In the quarter, those 2 sales forces worked well together. The Servigistics sales force will continue to penetrate new accounts with the Servigistics products, but the PTC sales force has also begun to be able to position not only the PTC SLM products but the Servigistics SLM products together. So it's not big change, it's just a little bit, absorbing these 2 acquisitions, taking the next step and final step really with ALM and taking the first step with the acquisition we just closed in the quarter.

Operator

Our next question is from Richard Davis with Canaccord.

David E. Hynes - Canaccord Genuity, Research Division

It's actually DJ on the call for Richard. Jeff, maybe one for you. Can you help us with the seasonality in the Servigistics business?

Jeffrey D. Glidden

It's a good question. We're 1 quarter into it. It was their fiscal year end so that's their fourth quarter and it's the calendar year end. So I'm not sure we have -- we don't really have much history in that. I would expect we'll put them onto our programs. The fiscal year-end drive will then be instead of the calendar quarter 4, it will be calendar quarter 3. I would expect like our seasonality, Q1 and Q2, calendar Q1 would normally be a little bit -- would be lower than last quarter. We'll just have to see how it comes. And I think we feel very good, as Jim said, most importantly about the pipeline and the opportunity ahead. The seasonality, I'm not sure we have good data on yet, but I would say, we're very encouraged with the activity levels and really the team. I mean, the integration has gone well, strong people, strong team and a good start.

James E. Heppelmann

Yes, but -- DJ, it's Jim. Let me -- I think you're on to something there that we should elaborate on for a minute, which is, let's all remember that was their Q4. So we shouldn't assume that it gets bigger and better as we go throughout the year. We should think of that as their Q4, and now we're going to do their Q1, 2 and 3 in the back part of our year. But that said, the pipeline really is promising. So that's why we said okay 60 to 70 clearly doesn't make sense. It's going to be 80 or more. I think we feel like there's going to be at least 80. We don't know how much more. That would depend how effective we are together at converting both their SLM pipeline and our SLM pipeline into revenue in the next 3 quarters. There is more than adequate pipeline to deliver a pretty good SLM year. But it's new stuff, and we're not ready yet to get too confident in what the conversion ratios might be in the next 3 quarters.

David E. Hynes - Canaccord Genuity, Research Division

Right. And then on sales headcount, you talked about the 4% restructuring, I guess, and there's the second tranche that came in January. I mean, how do you think about kind of where we end the year with quota-carrying reps? How tight is the leash there? If you can continue to see kind of productivity declines, would there be another tranche, or how do you think about managing that going forward?

James E. Heppelmann

Okay, well, it's Jim here. So my view is that we'll keep sales headcount relatively flat, as we have for the last couple of quarters. I don't see us adding capacity because I feel like we have ample capacity. It's really a productivity discussion at this point. I also don't see us taking away any significant amount of sales capacity unless things got materially worse than we hear -- we see them at this point in time. So I think steady as she goes, more or less with sales capacity trying to get these people more productive and work on close rates, and a better economy would help a lot with that.

David E. Hynes - Canaccord Genuity, Research Division

Yes, and then one last one, I guess. Have you or would you guys ever consider a lease pricing option? I realize you guys are managing the business for operating margins now, and there would be a headwind to march your targets. But would smaller upfront license commitments help you guys push some of these large deals that may be getting pushed out now across the finish line? How do you think about that?

James E. Heppelmann

First of all, we do, do some lease deals now when customers want that. I think, though, the bigger problem is the commitment. Customers are trying to delay the commitment. Whether that commitment takes one form or another, it's still a commitment. And I think what they're saying is, "let's get the project started, make progress and see if we can postpone the commitment to the capital outlay or OpEx outlay to a later point when we're actually sure the economy looks better." So it could help a little, but I don't think it would be a breakthrough in our business. I don't think we would just take off of that. Tim is reminding me that I should say that Servigistics also does have a cloud SaaS model for a certain percentage of their revenue. So they offer it both ways, on premise or in the cloud, buy it upfront as a capital asset or take it as a service as you go. And that business is doing okay, pretty well actually. But they're also selling a lot of on-premise stuff.

Operator

Our next question is from Jay Vleeschhouwer, Griffin Securities.

Jay Vleeschhouwer - Griffin Securities, Inc., Research Division

First question concerns your guidance for maintenance revenue for the year. You're retaining the $660 million, but in light of the erosion of the license forecast coupled with the comments you made about Europe, is that a number you're still confident in? As best we can tell, Europe alone accounts for about 40% of your maintenance, and so, wouldn't it stand to reason that you might start to see some erosion in that base of business?

Jeffrey D. Glidden

Yes, Jay, this is Jeff. We feel pretty good about our maintenance business. I think we're -- all the metrics we look at, our tax rates and in particular, renewal rates have been very, very good. And we also have sort of the seasonal pattern, as you know, that in the -- we have big renewals that occur in January, so the deferred revenue number comes down slightly at the end of Q1 and then it comes back up again. So I would say we watch it closely. We feel pretty good about the metrics, and I think we're quite comfortable with the outlook. Clearly, if things change on the license side, that does have an impact on maintenance, so we'll watch that closely.

James E. Heppelmann

Yes, Jay, it's Jim here, too. So a couple other comments. One is back in the 2009 global economic crisis, we saw a very little drop-off in maintenance renewal rates, and we feel like that situation was much more Draconian than this one. And then the second thing is, as you know, maintenance follows some distance behind license, so the lower license we might see in 2013 becomes more of a maintenance discussion in 2014 than a maintenance discussion in 2013, so that's another factor. And of course, there's the currency factor as well.

James E. Heppelmann

And, Jay, just to pick up on the currency. For the quarter, our average euro rate was $1.29, and as we look right now, it's $1.33. So that's what we provided in the guidance. But that has a positive benefit sequentially on the maintenance business as well. But the metrics that are underlying that are really the keys, and we watch those closely, as you know.

Jay Vleeschhouwer - Griffin Securities, Inc., Research Division

Right. A couple of things as well. How are you thinking about the Creo 3.0 launch later this year and the apparently imminent launch of PDM Essentials, Windchill Light, so to say, as possible revenue events for this year?

James E. Heppelmann

Yes, I think they're factored into the guidance we're talking about here. I don't see either one of them as major events, to be frank. I think Creo 3.0, the issue with Creo is we need to get the customer base upgraded, and that's happening actively as we speak. It's moving along. But we're still in the first quarter of that, let's say, and I think Creo 2.0 is a pretty good product that people are upgrading to get their hands on. Creo 3.0 is just more of that, but I don't think it's a disruption or a step-function different than Creo 2.0 in terms of its ability to generate revenue. PDM Essentials, there's a lot of pull for that from our channel, and I think that the channel is pretty excited about that. The deal there, though, is the channel has already been doing pretty well with PLM. So that's icing on a pretty good piece of cake they already have. So I can't imagine that the growth rate in the channel would double because it's actually been really high for a long period of time now.

Jay Vleeschhouwer - Griffin Securities, Inc., Research Division

Speaking of the channel, let me ask you about the changes that you made nearly 1 year ago with respect to the mid-market direct transition when you pulled some accounts in the channel and added to your mid-market direct efforts. Now that this is 1 year later, how would you describe those efforts? Have you, in fact, been able to generate new business the channel hadn't necessarily been able to do with those accounts or otherwise close on deals that had already been in the channel's pipeline?

Jeffrey D. Glidden

Yes, well if I look at our channel performance, it's not that impressive, relatively flattish in quarters of late. But I would attribute that more to the economic environment and the difficulty that smaller companies have in this environment, more so than to any organizational changes or coverage strategies that PTC had. On the other side, I think that the PTC sales force in the mid-market has generated some decent amount of revenue and a lot of pipeline because we have such better coverage in that area than we used to have. The channel was a little reticent to go into, let's say, a PLM deal at a medium-sized company because it would get very complex, the sales cycles would be long, they weren't sure they could win it, et cetera, so a lot of those deals they passed on. And now we have much better coverage. So I think that, that move, if I have to be judgmental about it, I think it was a good move. And it has probably created a net benefit for us, though I don't have enough data to prove that conclusively yet.

Jay Vleeschhouwer - Griffin Securities, Inc., Research Division

And then lastly, could you talk about pricing pressure in the CAD market? As best we can discern from the last number of quarters or years' worth of data about your CAD business and competitors who are converting that to ASPs, it does look as though there's been some broad pressure, particularly in the last year. Could you talk about them?

Jeffrey D. Glidden

Yes, I think we're selling largely to our installed base. They're used to our products. There's not big displacements. I think we're always conscious, larger orders get better discounting typically. That said, we're not seeing that many of the larger orders. So I think we watch discounting, Jay. I'm not sure I can share with you any particular metrics, but we are aware as we get -- as we see the economy slow, there's usually some additional pressure on that, but it's probably as much as anything driven by large accounts as well. That's typically where the bigger discounting is, but we're seeing some additional discounting to drive closure rates, probably in the mid-market as well or in the average market.

Operator

Our next question is Blair Abernethy, Stifel.

Blair H. Abernethy - Stifel, Nicolaus & Co., Inc., Research Division

Just a follow-up on Jay's maintenance -- around the maintenance side of things, first off. The -- given December and January through now, what are your renewal rates looking like on a percentage basis versus 1 year ago? And also, have you been able to affect any kind of pricing increases?

Jeffrey D. Glidden

Yes, I'll take a couple of these, Blair. The renewal rates have been very solid, very consistent year-over-year with the one caveat we said before being China is lower and we have, I think, some programs that we're driving in China to make that -- to move that up. But typically, our renewal rates are in the -- depending on geos, in the 80s to 90%, and in many cases, better than 95%. So we're seeing those continue, and again, we look at that -- both that metric plus the change in deferred, and we have a big renewal period in this quarter. And that's the January timeframe, and we're seeing those roll in. Relative to pricing, we're increasingly putting CPI indexes into our maintenance contracts and agreements, and that has a long-term benefit. And in the short term, we're seeing customers accept that and understand that it's -- a CPI adder is an appropriate thing. In the past, we didn't do that, so we're seeing some opportunities, I think, to get -- build longer-term pricing benefits in that.

James E. Heppelmann

We did also adjust some of our PLM pricing, but mostly in North America, at the beginning of our fiscal year. And by taking our product pricing up a little bit, that flows through into maintenance renewals as they renew, but that takes a while. But I think that there's some opportunity to do that more broadly. We've done it so far selectively.

Blair H. Abernethy - Stifel, Nicolaus & Co., Inc., Research Division

Okay, great. And then on the Creo adoption in the base, Creo 1.0, Creo 2.0, and the direct modeling products. I wonder, Jim, if you can kind of give us an update of how that's going in the base.

James E. Heppelmann

Yes, I mean, I think if you look at where we are with the upgrade, which is sort of the gates that need to open to sell this stuff, we're somewhere around 20%, give or take, in the number of customers who have upgraded. And you might remember we said by the end of the year, we would expect that to be more like 50% to 60%. So there's a lot of upgrades happening as we discuss right now. And until a customer upgrades, you can't really put that software to work because it's on the other side of the upgrade. But that said, we have a fairly high closure rate of the new flexible modeling, direct modeling technology, amongst the customers who have upgraded. So if you look at the sales, the penetration rate for customers who upgraded is pretty high. And therefore, we're pretty confident that there's a sizable opportunity ahead of us. It will just take a little more time to kind of fully materialize.

Operator

Our next question is from Perry Huang, Goldman Sachs.

Perry Huang - Goldman Sachs Group Inc., Research Division

I wanted to ask a question about the weakness in global manufacturing, is there any more color you can provide around this? For example, in terms of linearity, did you see a deceleration in customer demand at the end of the quarter, or is it pretty steady over the course of the quarter in terms of customers making smaller purchases?

James E. Heppelmann

Yes, so Perry, first I'll point out that Tim, in our prepared remarks, gave you a URL that takes you to our Investor web page where we actually posted a couple of the reports that we've been reading that we think provide some objective third-party views of what are going on. I encourage you to take a look at them. What those reports say, generally, I said in my comments, is the U.S., relatively positive picture, balanced -- more than counterbalanced by situation in Europe getting a lot worse. China, kind of steady as she goes, but at half the growth rate we had a couple of years ago. And then China -- I'm sorry, Japan, really dismal picture. So that's the environment we're up against, and you'll see that in the data if you look at it. I don't think it changed materially within the quarter. I think we had a view that it could be difficult. Probably, when we were talking to you 90 days ago, we maybe thought the U.S. environment would get a lot better because I think most people had pretty good odds that this fiscal cliff problem would be solved. But when our quarter closed on December 28, that problem was raging full intensity still. So there was no sort of good news that came out of that, maybe there will subsequently, although I think that the closure on that issue is a little muddy and maybe it's still not fully closed. So there was no good development, nothing that caused close rates to get better, but I don't think they neither fell apart late in the quarter.

Perry Huang - Goldman Sachs Group Inc., Research Division

Got you. That's helpful. And then just as a follow-up, around Japan. Again last quarter, you talked about the disruption to your business due to the territorial dispute with China. I guess, how was demand with Japanese auto manufacturers this quarter? I think in your prepared remarks you mentioned the CAD business in Japan was pretty strong, but you also saw lower deal activity -- large deal activity.

James E. Heppelmann

Yes. Keep in mind that -- and you'll actually read this in this report and it does talk about this territorial dispute and it concludes that the Japanese economy in the -- 1 quarter ago declined 4.6% quarter-over-quarter -- or I guess it was year-over-year in 1 quarter. So it went from a pretty good story to a terrible one in 1 quarter. The quarter that followed that, according to other data points I triangulated on, was flat with that, but the general trend is improving. So it feels like Japan is working its way out of some kind of a flash crisis around the trade dispute. But I think that because this flash crisis came on so fast and so deep, people just sort of panicked and stopped. They stopped spending money. And I think now that some of the emotions are working their way through, it's trending back toward business as usual. But we've had a number of deals that we expected to get 2 quarters ago and didn't, and then they float into last quarter and the situation didn't get any better. But we sense some softening, and we would say we probably think those deals will come if not this quarter then next, as the situation gets better. There's customers who want to buy what we have and have negotiated and so forth. They just need approvals to proceed.

Operator

Our next question is from Steve Koenig with Wedbush.

Steven R. Koenig - Wedbush Securities Inc., Research Division

I'm curious to know about -- maybe you could delve into your SLM business. My perception is, you've got kind of 3 distinct groupings of products: one, Arbortext; the other, the acquired Servigistics products; and then thirdly, your initiative on the service information system. Can you maybe just touch on what are the product and selling synergies between those various initiatives here going forward? And also, what are the potential synergies with the CAD PLM business?

James E. Heppelmann

Yes. Okay, well, you're fairly close, Steve, in characterizing how we think about it, because there is the traditional Arbortext stuff we acquired way back in 2005. That was about creating technical documentation, think manuals. Then before we acquired Servigistics, PTC began to expand that strategy and we began to use the term SLM for a better connected into engineering view of that. We realized at the end of the day that manuals aren't really the be all, end all. They're actually a fairly poor way to deliver information to downstream constituents. They're the encyclopedias that we stopped using once we got Google. So PTC moved on to this strategy that we called service information system or ultimately called it service lifecycle management, which is what we ought to be doing is building a bridge whereby you take the engineering building material, which you get out of CAD and PLM, and you take the CAD information and you work on that information, restructure it into things like online parts catalogs that use 3D information to help you find the right part and online or on a mobile device technical information that again uses 3D information to help you understand how to repair the machine and to lead you to the part you need. So think of that -- I used this example, before, we were making maps and then we evolved to a moving map GPS strategy. And that's the Caterpillar project, for example, for those of you who have heard Caterpillar talk about that. That's the moving map GPS. But again, the input to that is CAD and PLM data. Now it turns out where Servigistics starts, the first thing that they're really good at, best in the world at, is parts planning, which is okay, this product that have to be serviced, what are the parts that you might have to carry as spares and how many of such spares should you carry and where should you carry them? Should you carry them centralized, should you carry them distributed out to dealerships and in what quantities and so forth, because remember they're very expensive physical assets, so figuring out the right quantities of the various spare parts in the right locations has profound implications for your carrying costs of spare part inventories. So they really pick up at that point with spare parts and then they take it from there and what should the service technician do when he gets in the truck today, what should happen at the service bay, on and on downstream from there. So there's a thread that links all of this stuff together in a very meaningful way, and it makes a lot of sense to think about products and services as a continuum. And more and more, it gets blurred. More and more companies are blurring the 2 together and saying the product is a service. We're seeing examples, for example, of a medical device equipment, think CAT Scans x-rays. Instead of selling the equipment and selling a service contract to keep it running, now people are saying, "I'll put the equipment in your hospital and I'll charge you for each time you do a scan with it. I'll charge you per scan." And therefore, it's up to me to think about that product as a service. You're just paying for the results of the product, not for the asset and the carrying cost. So anyway, this one continuum here, and it makes all kinds of sense for PTC to be in the SLM business. If you're to think about SLM, optimizing the service processes and you say, "what's the best angle to come at this from?" Well, the CRM guys say, "we know everything about the customer," and the MRP guys say, "well, we have the logistics and financial backbone." And PTC says, "we know everything about the product." And quite frankly, if you have to chose between those, I like our position best. I think we're in a very good strategic position to connect this continuum from what other requirements of the product, down to how do we keep that thing operating efficiently at the customer side. I think it's a great strategy.

Steven R. Koenig - Wedbush Securities Inc., Research Division

Great. That's helpful, Jim. I'm wondering if you can characterize, say, how much of your traditional, your non-Servigistics SLM revenue is coming from Caterpillar or more -- or maybe more broadly speaking, from more dynamic online-generated content as opposed to traditional manuals.

James E. Heppelmann

Yes. So I think if you think about that, we have in the thousands of customers who use the Arbortext technology to create manuals. And those deal sizes were pretty small. That was a very tactical approach, a better way to write manuals, but people didn't place that much value on that. When we moved to the moving map, GPS, the price tag gets at least an extra digit, maybe 2. So what happened is from a much smaller quantity of deals, the Caterpillar-type deals, we're generating tremendous amount of revenue, which also speaks to the magnitude of this opportunity. I think that we found a way to make every Arbortext deal a hundred times bigger. And that said, it's newer technology. And the products, the organization, everything has to mature a little bit to really, really see this thing take off. But it's delivering so much more value to the customer when we take this approach.

Operator

Our next question is from Ross MacMillan with Jefferies.

Ross MacMillan - Jefferies & Company, Inc., Research Division

Three quick questions, if I could. Just the first one, I think when you'd laid out the guidance for the December quarter, you talked about the midpoint of the license range having 1 megadeal in there, and that's what you had, but we also had upside in the Servigistics business. So I'm just curious, as you reflect on the December quarter, what particular product area on license was the biggest, if you will, underperformer? It strikes me it's probably CAD and probably Europe-centric CAD, but I'd just love to get your take.

James E. Heppelmann

Yes, I think Europe-centric CAD is close to where I would throw the dart, as well.

Ross MacMillan - Jefferies & Company, Inc., Research Division

.Okay, great. And then on the Servigistics business, it obviously outperformed your expectation. And you mentioned earlier on this call, you maybe would shift that back to a model whereby their fiscal year was aligned with your fiscal year. Does that happen now, like, immediately or -- I'm just curious as to how that plays out because, obviously, it looks as if that business was still running on a calendar fiscal year through the first quarter of consolidation.

James E. Heppelmann

Yes. What happens there, Ross, is if you were a Servigistics sales rep, you've been working on a sales plan that was 4 quarters long and you don't want PTC to come in and say, "Guess what, there is no fourth quarter." So what happened when we acquired the company, we say, "For you Servigistics tales reps, it is still fourth quarter. Meaning, you can hit your accelerators and so forth that you've been building toward all year long." What happens for the Servigistics sales force is there is no Q1. They now rejoin PTC in Q2, and we're all on a Q2, Q3, Q4 plan going forward. And they would then have targets that are sort of prorated for a 3-quarter year. But at this point, they're part of the PTC team, and we're moving forward. I can also tell you I was down in Atlanta at the Servigistics headquarters last week, and these guys are number one, on fire, but number two, so excited to be with PTC. I mean, they feel like there couldn't possibly ever been a better place for that company to ultimately land than to a company who has a big but complementary strategy and then huge assets in terms of this customer base that is upstream but extremely strategic to try and to deliver SLM. So anyway, it's pretty exciting. Sales reps, I think, are pretty happy. They had a good Q4, and now they're just on a 3-quarter prorated year going forward.

Ross MacMillan - Jefferies & Company, Inc., Research Division

That's helpful. And then just on -- maybe one for Jeff on costs. You, obviously, are doing a good job on controlling operating expenses and driving higher gross margins on services. I think you said you expected OpEx to be around flat sequentially because of some of the onetime costs around marketing, comp plans, et cetera. But you also said, I think, the full impact from the 4% headcount reduction would be about $9 million on a run rate, and that wouldn't be realized until Q3. So just putting these pieces together, it feels like we should be about flat into Q2 and then down sequentially into Q3 as you get that full benefit, is that correct? And then secondly...

Jeffrey D. Glidden

I think we'd be down slightly in Q3. We're still -- we are very good at moderating and planning the expense controls and tightening them up as you cited. We do have planned PTC, that occurs in June. That's a key program every year. I think right now, we would say clearly we're expecting to be flat sequentially in Q2. I would say down slightly in Q3 would be a good expectation. As we sit, we could -- and again, at the end of this next quarter, we'll give you better direction on that. But I think that's a -- we'll have a step down, and I'd say it's a moderate step down, in Q3, in part because of some of the other programs we have underway. But we'll reserve the right to tighten it up if that's appropriate.

Ross MacMillan - Jefferies & Company, Inc., Research Division

That's helpful. And then the last one I had was just on capacity and productivity. It sounds like you feel very comfortable with the capacity you have, and until you get productivity moving higher, there's no immediate need to hire more reps. Just curious, should I think about that productivity dynamic being one where you probably wouldn't really start to aggressively hire until you got back to sort of prior levels of normalized productivity per rep, so in other words, 1 quarter of improved productivity doesn't necessarily mean you start to hire?

James E. Heppelmann

Yes. Maybe the way to think about that, first of all, if you look at the sales capacity we now have versus what we had 6, 8 quarters ago, you have to remember a certain amount of that was acquired, but a fair amount of it was hired. At the level of organic results right now, we have excess capacity, more than we need. So part of the reason productivity went down is because we injected a lot of capacity, and there's the math formula that says if you do that in the short-term, productivity will go down. And then the second thing is, of course, the economy got a lot worse over the last 4 quarters. So those 2 have been pressures on productivity. I think that time cures the first one and a better economy cures the second one. Both of those should develop, I believe, in the coming quarters. For us, though, we need to remember that it takes a while to ramp people, so we can't wait and tell we're at capacity limits to start bringing on new capacity or there'll be a gap. But I also feel like -- it's probably, in my mind, at least 4 quarters away before we would begin to expand capacity, even if the trends look positive.

Operator

Our next question comes from Ben Rose, Battle Road Research.

Ben Z. Rose - Battle Road Research Ltd.

Jim, a question -- I guess, the first question, a question on Germany. In your discussions with customers, are you seeing an actual pullback in new product development, or is it just a pullback in the spending on PLM tools?

James E. Heppelmann

Well, if I back up first to the macro view of Europe, the European debt crisis is not a new story. But the new part of the story is that it began to affect Germany pretty significantly in the last 2 quarters. So I think in previous discussions, we said that our business was mostly in Central Europe, Germany and right around there; secondarily in the Nordics; third, in U.K. and France; and distant fourth, Southern Europe. But in the last 2 quarters, the problem, which seemed to be outside of Germany, suddenly is also inside of Germany. So I think right now, these companies are just being conversative. I don't think they're canceling their new products. They're just trying to tighten their belt a little bit and not spend money until they understand is this thing going to get better or is it going to get worse. And again, I go out and look at the projections I can find, most people think it's bottomed out and it is and will get better, and therefore, it will be a fairly short-term phenomenon. But we'll have to wait and see, I think, what actually happens.

Ben Z. Rose - Battle Road Research Ltd.

And then on the Embraer deal, are there additional opportunities in their supplier base? Are you serving that supplier base now? Or is that potentially new opportunity for you as well? .

James E. Heppelmann

It would be a mixture. There are a number of larger aerospace suppliers that we have relationships with and then there's a few we don't. For example, we're not that big in the aircraft engines business, and maybe there will be opportunities there. But that really was a fantastic win. Another example of somebody going to the nth degree to validate a decision and coming up with an answer that says, "You know what, we should throw the stuff we have out the door because it's a problem compared to what we could be doing with PTC." And I'll point out, we don't exactly have a strong business in Brazil. We have a limited organization. I mean, you can kind of count them on your fingers and toes. And so for us to win this business, we also had to convince them that even if we're not the biggest company in Brazil, our technology is so strong, the gap is so different, that it's worth going down this path with us. So it's a big, huge win for PTC.

Operator

Thank you, I'd like to turn the meeting back to the leaders. This does conclude the question-and-answer session.

Tim Fox

Well, thank you for your questions. Just as an advertising here, we have some upcoming investor events. We're going to be on the West Coast in February, first at the Stifel Nicolaus on the 7th, followed by Goldman's Internet technology conference on February 12. And then early March, we'll be attending the Wedbush transformational technologies conference in New York. So hopefully, we'll see you at some of those events. With that, I'll turn it back over to Jim for closing remarks.

James E. Heppelmann

Okay. Thanks, Tim. So thanks a lot, everybody, for joining us this morning. There were some really great, insightful questions, and it tells me that you guys are listening closely here. I appreciate that.

So with Q1 behind us, we're confident in our ability to drive profitability and we're confident in our growth opportunities for the longer-term. So with that, I want to thank you for your continued support and the time you're investing here this morning. And I look forward to talking to you again next quarter, if I don't happen to see you before then. Thank you.

Operator

Thank you for participating in today's conference. You may disconnect at this time.

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