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Executives

Jim Heppelmann – President, Chief Executive Officer

Jeff Glidden – Chief Financial Officer

James Hillier – Vice President, Investor Relations

Analysts

Raimo Lenschow – Barclays

Matt Hedberg – RBC Capital Markets

Steve Koenig – Wedbush

Ross MacMillan – Jefferies

Matt Williams – Evercore

Sterling Auty – JP Morgan

Jay Vleeschhouwer – Griffin Securities

Parametric Technology Corp. (PMTC) Q1 2014 Earnings Call January 23, 2014 8:30 AM ET

Operator

Good morning ladies and gentlemen. Welcome to PTC’s First Quarter Fiscal Year 2014 Results conference call. After brief comments by management, we will directly go to the question and answer session. If you should require assistance during the call, please press star followed by zero on your touchtone phone. As a reminder, ladies and gentlemen, this conference is being recorded.

I would now like to introduce James Hillier, PTC’s Vice President of Investor Relations. Please go ahead.

James Hillier

Thank you, Shirley. Good morning everyone and thank you for joining us on today’s Q1 results and outlook call. As a reminder, today’s call and Q&A session may include forward-looking statements regarding PTC’s products, our 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 most recent Form 10-K on file with the SEC.

Unless otherwise indicated, all financial measures in today’s call are non-GAAP financial measures. A reconciliation between the non-GAAP measures and the comparable GAAP measures is located in the Q1 2014 press release and prepared remarks documents on the Investor Relations page of our website at www.ptc.com.

With us on the call this morning is Jim Heppelmann, our President and CEO; Jeff Glidden, our CFO, and Barry Cohen, EVP of Strategy. With that, I’d like to turn the call over to Jim.

Jim Heppelmann

All right, thank you James Hillier. Good morning to all of you and thank you for joining us here on our first quarter of fiscal 2014 earnings call. We’re pleased that Q1 landed in a good place with license revenue coming in near the top of the guidance range despite a lack of mega-deals. As the revenue picture settled out following our preliminary announcement, we were pleased to see the service and support businesses both come in a little stronger than anticipated, so the net result was a total revenue picture that was above the top of the guidance range.

We continued to exhibit excellent discipline on spending in the quarter as expenses again came in lighter than anticipated, plus we made more progress on service margin expansion. The net result of all that was that EPS was well above the guidance range, so this past quarter we were able to demonstrate once again the earnings leverage we can achieve with our model as revenue picks up.

At the same time, in my view Q1 was not an easy quarter. As we discussed at our December 5 investor event, we had a strong pipeline going into the quarter such that we were able to land a good quarter even with close rates that were a bit softer than we like to see and with a few disappointments along the way. The takeaway is that there is solid interest in our software but it is our view that the economy is not yet hitting on all cylinders, which still colors our view of Q2 and the full year.

Taking a look at the business geographically, the Americas business had a solid quarter, especially given the comparison to the year-ago period, which included a mega-deal whereas this quarter did not. The European business is demonstrating good improvement with a return to growth. Japan performance was acceptable if you look at constant currency data, even though it doesn’t necessarily appear that way as reported due to significant year-over-year currency fluctuations. In China, we had a disappointing quarter, which seems consistent with a lot of other data points coming out of the technology industry.

Looking across our segments, we had another good CAD quarter, particularly in license sales. I think this reflects the momentum we’ve seen building with Creo now that the base is well into the migration process and passing the 50% tipping point. At this point, you’re in the minority if you’re not on Creo.

Contrary to the general experience of the CAD industry, the major upgrade from Pro/E to Creo has gone relatively flawlessly for customers because while we made major improvements to the functionality and the user experience of the product, we maintained a nearly perfect level of data compatibility. Customers come out of the upgrade generally in quite a good mood, which is helpful when talking about what they might do next.

The extended PLM business more or less followed the general revenue trend of the company and moved back into positive growth territory. In my view, the SLM business did relatively well but the year-over-year comparison is a bit unfair as we’re effectively comparing a seasonally weaker Q1 now to a seasonally stronger Q4 on the Servigistic side a year ago. Keep in mind, we acquired Servigistics a year ago at the start of what was our Q1 but their Q4. At this point, Servigistics has now switched to our fiscal calendar so they effectively had only three quarters in their fiscal 2013, and therefore this past quarter was a real Q1 for both Servigistics and PTC. That’s a one-time anomaly that will wash through the system, and if you look through that, the SLM business did relatively well.

The good news on revenue overall is that PTC has crossed back into positive territory in terms of constant currency organic growth, which is an important milestone in terms of our ability to deliver the plan in FY14 and beyond.

So overall, the economy remains a bit difficult and uncertain, but Q1 was a good quarter and it gave us a good start to the fiscal year, and we have a good pipeline coverage again going into Q2 and really for the balance of the year.

Changing gears, I couldn’t be happier with the reaction we received on the ThingWorx acquisition. Obviously the level of buzz around the Internet of Things is very high. Internet of Things was the theme at Salesforce’s most recent Dream Force event, and ThingWorx was featured in the Internet of Things track. Internet of Things was also the theme of the massive consumer electronics show in Las Vegas earlier this month.

We received a tremendous amount of positive press and media coverage about the acquisition itself. After the announcement, we put out an invitation to industry analysts to join a briefing where we could tell the story in a bit more detail. We ended up briefing 79 industry analysts either live or virtually, which is multiple times more analyst attention than we’ve ever experienced on any other topic. The industry analysts clearly understood what we are trying to do, and I think it makes a lot of sense to them. Denise Lund, a research director at IDC, summed it up when she wrote that this acquisition was one of the most exemplary strategic moves that IDC has seen.

Customers are excited too, and of course that’s even more important. I personally reached out to around a dozen executives of Fortune 500 companies to tell them about the acquisition and all were intrigued to the point of wanting an in-depth follow-up session to learn more. This isn’t just a tool we’re talking about; it’s a way to completely transform their business.

The product itself is really special. We just completed our normal integration summit and the broader group of PTC technical leaders, who were not part of the acquisition process, were seeing the product for the first time and they were drooling over the ThingWorx technology in terms of it’s architecture, it’s functionality, and it’s usability. The general theme across R&D, sales, services and marketing coming out of that summit was that we should push forward aggressively because this is one of those rare and special situations where we seem to be in the exact right place at the right time and with the right product.

I’m sure there will be many players with an Internet of Things angle, but our strategy of using the Internet of Things technology to build applications that transform the way products are created, operated and serviced is both highly valuable and it’s unmatched. I look forward to sharing more with you as this situation unfolds in the coming months and quarters.

With that, I’ll turn it over to our CFO, Jeff Glidden, for a financial review.

Jeff Glidden

Thank you. As Jim said, we’re pleased with our Q1 financial results. On January 30, we had announced that we expected to be near the high end of our revenue guidance range. As cited in our earnings release last night, we delivered revenue of $325 million with a $5 million in over-performance coming from services revenue. Our favorable revenue performance in Q1, coupled with lower spending, increased operating margins to 25%, and we delivered EPS of $0.50 for an increase of 37% year-over-year.

Turning to the balance sheet, we continue to have very good cash collections from our customers and generated $36 million in cash flow from operations. We ended the quarter with cash of $371 million as we had borrowed $110 million on our credit agreement to fund the acquisition of ThingWorx, which closed on December 30. So all in, we delivered strong financial results and completed a very strategic acquisition as we closed out the calendar year.

Now looking ahead to our outlook for Q2 and FY14, macro indicators suggest a modest recovery in the manufacturing economy is likely in 2014. Most expected the first turn to be driven by consumer spending, and we are hopeful that this will translate into higher levels of industrial output and spending later in the year. Given this background, we expect Q2 revenue to be in the range of $320 million to $330 million, and we expect to deliver non-GAAP EPS of $0.43 to $0.48. For the fiscal year of 2014, we expect revenue to be in the range of $1,330,000 to $1,345,000 and our non-GAAP EPS to be in the range of $2.03 to $2.13.

In Q2, we are planning to expand our credit facility from $450 million to a range of $750 million to $1 billion. We expect the terms to be substantially similar to our current facility with a maturity in 2019. During FY14, we also plan to repurchase $75 million in PTC stock and to repay $100 million of outstanding debt.

Again, we appreciate you joining us today, and with that I will turn the call back over to Jim Hillier.

James Hillier

Thank you Jeff. Shirley, can you begin the Q&A process, please?

Question and Answer Session

Operator

Thank you. [Operator instructions]

Our first question comes from Raimo Lenschow with Barclays. You may ask your question.

Raimo Lenschow – Barclays

Thank you, and congrats again on the quarter and a good start of the year. Just briefly, can you talk a little bit about a dynamic you see in the market. We saw your CAD/CAM business doing better in terms of license sales, actually with some very strong gold numbers, and PLM not quite working just yet. Can you talk how you see the dynamic evolving there? Is that in CAD/CAM or Creo, or is that economic recovery in there, and if it’s economic recovery, is that kind of a lag effect between CAD/CAM and PLM? Just help us understand the dynamic there a little bit. Thank you.

Jim Heppelmann

Yes, well first of all, good morning Raimo and thanks for joining us. It’s an interesting question because I think that you’re onto the right point, which is as it relates to PLM there is an economic effect. – you know, slow, modest improvement. As it relates to CAD, there’s both an economic effect and there’s a new product cycle on top of that, which is the Creo software and all the new capabilities that we can sell to a customer who goes through this upgrade process and comes out with a smile on their face. So I think that’s really why the Creo software is perhaps picking up faster.

The other thing that maybe we should point out in the year-over-year comp, last year in Q1 we mentioned we had this mega-deal, and it was pure PLM, so that also made the PLM comp look a little worse. If you either back that mega-deal out or kind of normalized it to be a normal big deal, then I think you’d have seen some pretty impressive growth levels in our PLM business year-over-year.

Raimo Lenschow – Barclays

Perfect, okay. And then just maybe one follow-up. If you look into your pipeline now, what’s the trend around mega-deals? Is that kind of something of the past, or do you see that kind of slowly coming back into the pipeline as people are feeling better about themselves? Is that something you still kind of hope you will see eventually, or is that something we should say goodbye to?

Jim Heppelmann

I don’t think you should say goodbye to them. I think we actually have a number of them that we have a bead on this year. I think we learned, I don’t know, six, seven, whatever quarters ago to be a little bit more cautious in how we plan them, how we would guide around them and so forth. So I think there are some mega-deals out there.

We expect to close some of them, but I think we’re being relatively conservative because they could push, they could get downsized, what have you. But there’s a couple handfuls that we’ve got our eye on.

Raimo Lenschow – Barclays

Perfect. Okay, thank you.

Operator

Thank you. Our next question comes from Matt Hedberg with RBC Capital Markets. You may ask your question.

Matt Hedberg – RBC Capital Markets

Yes, thanks for taking my questions, and I’ll echo my congratulations on the great start to the year. On your fourth quarter call, you talked about implementing solutions that require shorter sales cycles, less services – so I guess said differently, more out-of-the-box functionality. Can you give us an update on that initiative?

Jim Heppelmann

Yes, in fact that was the major focus of our sales kickoff back in early October, so we have rolled that out. It’s kind of working it’s way through the system. It takes a while because we don’t sell those solutions into they get baked into a sales cycle and so forth, so that all takes a while; but I think we’ve done a good job in moving that into the water supply, training people that this is how you should position it, here’s the value, here’s the services program that would go along with it, here’s the pricing, et cetera. So I think we’re making good progress but it really takes a while for that to kind of kick in and transform the actual deals we’re doing.

Matt Hedberg – RBC Capital Markets

That’s great. And then I guess on SLM, it was down for the first time in over a year – obviously a very difficult comp. Comps do remain difficult throughout the entire year, and I think in your prepared remarks you talked about achieving strong SLM growth this year, but that’s a business that grew, I think north of 120% last year. What sort of growth are you assuming in that business this year?

Jeff Glidden

So to comment on last year’s growth, recognize a significant portion of that was related to the Servigistics acquisition, so organically the growth was probably in the 20’s. So I think as we look at that business, we see the market growing probably in the mid-teens to 20%, and we think we can outgrow the market. So I think we feel very good. The pipeline is building. The level of activity both on the core products—and I think now with the Internet of Things, with ThingWorx, there’s a big, big play that I think is ahead of us to really accelerate that business based on what we’ve done with—what we think we can do with ThingWorx.

Jim Heppelmann

Yes, maybe I could add, Matt, if you were to look at the license revenue sort of quarter-to-quarter over the last eight quarters, you would see that this quarter—like, let’s compare Q1 of ’14 to Q2 or Q3 of ’13 where we didn’t have that anomaly, and you’re looking at really strong license growth. So I think if you back out that anomaly, this was not a bad quarter, certainly on the license front which is obviously the thing that matters most.

Matt Hedberg – RBC Capital Markets

That’s great, guys. Thanks again.

Operator

Thank you. Again, if you have a question, press star, one. Our next question comes for Steve Koenig with Wedbush. You may ask your question.

Steve Koenig – Wedbush

Good morning. Thanks for taking my questions. I’d like to ask you guys if you can give us a bit more color on the weak close rates, maybe some granularity either geo, product, deal side – any particular areas – and what’s behind this. And then if you don’t mind, I’ve got one follow-up.

Jim Heppelmann

Yes, I think if you remember when we had the investor day, we talked about pipeline coverage and that we actually have pretty good pipeline coverage, so I think our guidance contemplated the idea that we could have a weak close rate and therefore still deliver a good number, because quite frankly, if you had applied a strong close rate to a strong pipeline, you’d have calculated stronger numbers than we did. So I think we were ready for that.

Now, where did it come from? I mean, all over. Probably the worst place was China, where I think deals pushed; but I think elsewhere—you know, I think some companies are starting to feel good about the economy and they’re starting to spend money. Other companies were saying, let’s close out this year without spending that money to make our numbers look a little better. So I think it’s kind of all over, to be fair.

Steve Koenig – Wedbush

Okay, great. Thanks Jim. And then I guess for the follow-up here, I’d like to ask you guys on ThingWorx, could you give us a bit more, maybe just some thoughts now on what the revenue synergy is with PLM, and to your earlier point, how could it accelerate SLM? More generally, what’s the impact on the business beyond the $5 million to $7 million immediately in ThingWorx revenue?

Jim Heppelmann

Yes, I think at the end of the day, ThingWorx is really interesting independently, but we’re going to use it to rework everything else we have to make that more interesting too. Let me try a quick a pass through PLM-ALM-SLM.

Let’s start with SLM, because that’s the most obvious use case. The way you would service a product that you are in daily communication with and know everything about, it’s quite different than the way you’d service a product you haven’t seen in five years and have no clue what it’s status or current configuration, or how it was used or anything else. So how would you change things? Well, in the service world, you would try to move from a reactive break-fix mode to a proactive preventative medicine-type of mode. You’d try to prevent things from breaking as opposed to fix them after the fact.

The second thing is when it is time to fix something or even make a preventative intervention, let’s say, you go there knowing exactly what needs to be done. Now, I don’t know, if you’ve ever been in your own home and your oven doesn’t work and you call the repair main, he comes out, he looks at it and he says, okay, now I know what oven you have. I have an idea what’s wrong with it, so I’ll be back tomorrow with all the parts. That means you’ve got to pay the guy to have spent two days, make two trips, everything. That’s just a really expensive service call. If he could have actually called you up and said, hey, I’m going to come out and do something to your oven to prevent a problem, and he shows up with everything.

So trying to get to the punch line here, the way we do field service would change. The way we do spare parts planning would change. The way that we do what we call knowledge management – knowledge management is the process of going from a problem to a solution. The way we do that would change, because we would bring in al the data from the product into the process of determining what’s the root cause of the problem and therefore what should we do to solve it. So there are three or four really obvious high-value use cases in SLM.

If I move to ALM quickly, you know, the really obvious high-value use case is to be able to maintain the software that’s in that connected product. I mean, if you have an automobile right now and you have a software problem—and by the way, half of the problems with automobiles right now are software problems, literally. If you have a software problem and your car is not connected, you need to bring that car to the dealer and they are going to treat it just like you have a crankshaft problem. They’re going to take the car out of your hands and they’re going to use it for a couple hours. You’re going to get a temporary car or sit in the lobby and have a donut – whatever. But they’re going to fix it in the dumbest way possible.

In the new world, they’re just going to push a button or click on an icon and that software is going to be pushed down into your product and implemented, and that’s not just fantasy. I mean, that’s the way Tesla upgrades an entire fleet of automobiles all at once. It’s really incredible. So that’s coming, and that’s really Internet of Things meets ALM, which is you’re doing active management of the software in the entire fleet of products, understanding what problems there are, what security issues there may be. You’re pushing patches down, just like what happens in a data center. You know, you start to think of the car as a computer in the data center, as opposed to some remote, distant chunk of iron.

In PLM, the best use cases, I think are in two areas. One is, let’s say, in requirements management to understand how does the customer actually use this product. That’s pretty informative, and today people, they start out with requirements which are sort of like a hypothesis of how the product will be used, but it’s very hard, short of putting some people, let’s say, in some kind of a laboratory, sterile environment where you monitor them. It’s hard to know what they actually do with your products. But with the Internet of Things, you’re gathering data. You know how it was used, how many hours per day, how many duty cycles, at what levels of speed and performance and whatever.

A second great PLM example would be quality management. If you think of the way that products are developed today, you have these requirements, you go through an engineering process. You maybe even product a limited production run and you test the heck out of these products because you’re never going to see them again. But what if you actually were going to continue to see them every day and you could do continuous testing? What that means is that when you went beyond the limited production run and the problems start to show up because maybe the customer is actually using it a little different than you thought they would, you’re seeing that and you’re seeing what the problems are. You’re fixing these problems quickly before you replicate them hundreds or thousands of times and then produce hundreds of thousands of warranty issues you’re going to have to deal with later. So quality management – you know, one of our solution areas is windshield quality solutions. I think that’s another great place where we’re going to be able to use this data.

So I mean, that’s all really exciting, and then the customers say if I had an Internet of Things platform where I could build all the applications that are unique to my world and then park next to that on the same platform all the applications that PTC has for SLM, ALM, PLM – my God, I would have this incredibly powerful platform and I would really think about doing things differently in my business. That’s where it’s getting really exciting.

Steve Koenig – Wedbush

Great. Thanks a lot for the color, Jim.

Operator

Thank you. Our next question comes from Ross MacMillan with Jefferies. You may ask your question.

Ross MacMillan – Jefferies

Thanks a lot, and my congratulations as well on the quarter. I just wanted to go back, Jim, on the pipeline and your approach to thinking about close rates and thinking about large deals. It certainly sounds like although the close rates were not what you would have liked to have seen, you still arrived at the high end of your license revenue range, so it strikes me that you’re taking a relatively prudent approach to close rate assumptions. I’m just curious – as you think about either Q2 or the rest of the year, what are your assumptions around close rates? Are they sort of similar to Q1? Are they incrementally more cautious? Are they incrementally a little bit more optimistic?

And then just on large deals, how do you actually think about mega-deals in your forecasts now? Are they in the forecast but at very low probability? Are they in there at all? I’m just curious as to how we should think about that as well. Thanks.

Jim Heppelmann

Okay – I’m just taking a note here on the same question. If I think about the close rates, when you were here on December 5, as I remember, we showed you a coverage rate that was greater than three-to-one. For every dollar that we’re trying to do in our plan, our guidance, we have at least $3 in the pipeline. I think I also told you at some point here that last year we closed 32% of the pipeline, so I think our plan and our guidance for the year probably actually contemplates we close less than 32% of the pipeline. Now there are some really big deals in that pipeline, and they are huge swing factors, which is sort of leading into the second part of your question.

So I mean, I think our view on the economy, it has not really changed yet. There are some promising signs. Q4 actually was—felt like a pretty easy quarter compared to Q1, so I think we’re still conservative and feel like that’s the right place to be right now until things are more consistently positive. So somewhat conservative close rate assumptions in that pipeline, in part because of the mega-deals.

Now, if we go to the mega-deal second question, in the context of a given quarter, we watch a mega-deal separately and we generally have learned our lesson not to have a forecast that predicates a mega-deal being done. In fact, one of our board members, Ron Zambonini, gave me a good lesson one day when he said, Jim, there’s no such thing as a 90% deal. They go from 70% to 100, so don’t ever think of something being 90% sure. It’s either done or it’s only 70% sure because as long as it’s not done, there is actually a longer list of problems that could come out than you’re probably thinking of or aware of. So think of it that way, and that’s a little bit the approach we’ve been taking as we forecast in a given quarter.

Ross MacMillan – Jefferies

That’s really helpful. And then maybe just one quick follow-up. Great job on costs again, and I noticed your headcount in sales were down sequentially again, but you’re also saying that you’re going to be adding 20 to 30 reps as a position for fiscal ’15 and beyond. I think you’ve taken that into account in your guidance. I still calculate that you’re running maybe 10 to 15% below the productivity level of 2011, so I’m just trying to understand the thought process about beginning to hire again into direct sales capacity versus just allowing that productivity to move higher before that hiring starts, if that makes sense.

Jim Heppelmann

Can I hit the first part, Jeff, and maybe you can comment on productivity.

Jeff Glidden

Sure, yes.

Jim Heppelmann

Just so you understand, the main reason we’re hiring more sales people right now is we’ve simply fallen under our plan. Everybody has been busy – they were busy with sales kickoff, now they’re all excited about ThingWorx and so forth, and there’s a certain amount of attrition that happens kind of on a natural, consistent basis. I don’t believe it’s abnormally high at all right now, but it’s just we’ve fallen behind in hiring. So we’ve sort of attrited down to a place we don’t want to be at.

That happened to be helpful to the quarterly results last quarter, but I don’t think it’s helpful to running the business for the balance of the year or into next year, so that’s the main reason right now we’re adding headcount. It’s not that there’s some great, big growth spurt we’re planning for. It’s more that we’re simply below plan actually for fiscal FY14.

Jeff Glidden

And Ross, I’d just add that at our investor day, I think Bob Ranaldi did a great job just kind of laying out his key initiatives, and the focus has been clearly on building capacity and driving productivity. So they are related and we are going to drive productivity for the existing group, and we are going to build more capacity for the future. So both of those are really at the top of his list, and I think we’re driving those as hard as we both need to and should.

Jim Heppelmann

But just to verify a point you made, of course all of that hiring assumption is in the guidance that we’ll give you for the quarter and the year, and that we have given you.

Ross MacMillan – Jefferies

That’s perfect. Thanks so much for the color. Thank you.

Operator

Thank you. Our next question comes from Matt Williams with Evercore. You may ask your question.

Matt Williams – Evercore

Thanks so much. Good morning guys. Congrats on the quarter. I just wanted to spend a little bit more on the Internet of Things opportunity, and realizing it’s still very early days, I think here. But when you’re talking to customers, do they have the people and processes in place to really sort of take advantage of all the advances in connectivity and the amount of data that’s now flowing through these products? And I guess to that end, how does ThingWorx enable them to sort of capitalize on that data and, I guess, maybe just briefly relative to the competition that’s out there, how well positioned do you think you guys are?

Jim Heppelmann

It’s a great question, Matt, and good morning to you. I think right now there is a lot of people thinking about Internet of Things, talking about Internet of Things, getting that a-ha moment about the Internet of Things. That said, they’ve never done it before; however, I would tell you they are prioritizing it very, very high. I mean, there’s a Fortune 100 customer I visited in December, and he said the bad news is our earnings performance wasn’t quite what we wanted it to be this year, so we didn’t get much IT money at all for 2014. The good news is there was one $45 million project that was funded, which was Internet of Things. And that’s a little bit how I feel, is everybody is saying, we’ve got to go figure this out and we’ve better get moving. So it’s prioritized very high; that said, they’re not sure exactly what to do.

So what happens is if you go try to build an Internet of Things application the old fashioned way – you grab yourself a compiler and an integrated development environment, IDE-type tool and you start writing code, oh my God, it’s a slog. In comes ThingWorx and you watch one demo of that product and you say, I would literally be 10 times more productive using that approach to build this. It just makes these visions so much more real, so much faster. It’s rapid prototyping, it’s highly graphical, et cetera.

So I think that right now, ThingWorx helps in the most important way possible, which is it lowers the barrier to entry to building an Internet of Things application, literally by a factor of 10. And even when we go to companies that are already doing something, and there are a fair number of those, they look at ThingWorx and say, wow, we’ve got to switch because the way we’re doing it is just silly compared to that, so tell me more. That’s the kind of conversation we’re having right now. It’s, as you can tell from my tone here, really very exciting.

Matt Williams – Evercore

Great. That’s very helpful. Maybe just a quick follow-up if I could, and sort of switching gears a little bit to the CAD business, but in the past you’ve talked about some of the increased functionality and modules attached to Creo, and I’m just wondering – obviously the results have been much better in that business the last two quarters. Are you seeing the sort of adoption and the type of traction within some of the modules and increased functionality in that business that you expected?

Jim Heppelmann

Yes. In fact, the new stuff has a much higher growth rate than the old stuff, so I think when you look at the license number that we had this quarter in CAD, for instance—and I should point that out. That’s against a weak comp from last year, so I don’t want you to think that’s the new normal; but nonetheless, it was a good quarter. If you look at where did the goodness come from, this proportion and amount of the goodness in that good quarter came from the new stuff. We’ve seen people move through that upgrade process, like I said, pretty happy how that went. Users love the new software. You know, they’re in a good mood at that point to take a serious look at all this new stuff, and then many of them end up writing a purchase order.

Matt Williams – Evercore

Great. Thanks so much.

Operator

Thank you. Again if you’d like to ask a question, just press star, one. Our next question comes from Sterling Auty with JP Morgan. You may ask your question.

Sterling Auty – JP Morgan

Yes, thanks. Jim, I wanted to also follow up on in the commentary you just had on ThingWorx. I guess it was my impression that ThingWorx was kind of the data capture, data management application that sits on top of it, not necessarily the embedded functionality that goes in the product, whether it’s a washing machine or a refrigerator or a car, or something else. So my question is when you talk about it’s 10 times quicker, are you saying just to build out that capability? And I’m also wondering when you guys looked at the competitive landscape, is there a common embedded module, if you will, or embedded technology or a company that’s doing that side of the Internet of Things?

Jim Heppelmann

Yes, okay. There’s a series of interesting questions there, Sterling. I’ll do my best to hit them. First of all, what ThingWorx really is two things. It is a platform to run—a runtime platform for Internet of Things applications, and then secondarily it’s a highly productive development environment to create those runtime applications. So if you’re looking at a product and you say, if I connected it, there is five different applications I could envision, how would I create those five applications and run them? The answer is with ThingWorx, you create the five very quickly, and with ThingWorx you run all five and serve them up to the user community. So that’s fundamentally what it does – it’s listening to these data streams that are coming off products and issuing commands to the products and so forth.

If you—maybe I’ll give an example of a fundamental application here in a minute, but then the second question you were asking is, is there any ThingWorx embedded in the actual product? And there is a module for doing that so that you can have a certain amount of smartness actually—a certain amount of application smartness running inside the product itself without always having to go back to the cloud. But that’s kind of optional. That’s not required. It’s called an edge server – you know, it lives out there at the edge in the device itself as opposed to a cloud server which lives back in the cloud. Bu that’s optional, and there’s a lot of cases where people won’t use that.

ThingWorx also has a machine—the machine connectivity capability, so if there’s a question what protocols and so forth do you use to get the data from the sensor on the machine to the cloud, ThingWorx does that. Some customers already have that infrastructure, and that’s okay too because ThingWorx really is kind of agnostic as to where the information is coming from and how did it get there. In fact, it doesn’t really care if it’s coming from a sensor on a remote device or SAP. The question is how to put it all together quickly into an application.

Let me give you a fun example of a ThingWorx application that’s actually outside our space but I think it helps give a sense of what’s possible here. They created with a partner a parking application in San Francisco, kind of a city pilot project, I guess. The idea was they put sensors in all of these street-side parking spots that simply indicated to a smart parking meter nearby the spot is occupied or it is not. That’s all it knows – yes or no. But that smart parking meter then is connected to the Internet, so I don’t know – maybe it’s Bluetooth to the parking meter, the parking meter somehow connected to the Internet, and that data comes up to the cloud.

So there’s two really interesting things you could do. First, you can create an application for drivers that they run on their Android or iPhone device that says, I’m here – where are all the closest open parking spots? That’s actually pretty useful because you don’t just have to circle block after block after block looking for one. You just kind of go to where they are. And then to fund this, they created the application for the meter maid to say, where are all the expired meters? Because if this street has one expired meter and that street has nine, I’m going to that street because I can write the most amount of tickets and generate the most amount of revenue. Everybody wins from a simple little Internet of Things application that has nothing to do with PTC but ThingWorx would go after that opportunity, again because if you’re going to build an application for a meter maid and an application for a driver, you’re going to need to figure out how to do it, and ThingWorx is the perfect answer.

On the competitive front, we don’t think there’s anything like it. That’s one of the reasons we had to pay a decent price for the product, is it’s pretty special. So other things will come along, I’m sure, but at this point in time, we’re out in front. We’re going to move fast. We’re going to invest a lot in this business, and we’re going to try to develop a really solid leadership position.

Sterling Auty – JP Morgan

Got you. And maybe one follow-up for Jeff. When you look at the margin side, both in the quarter and I heard your comments about the sales heads, but would you say that we’re at a point where the savings from the restructuring that you’ve done over the last 18 months are just kind of rolling forward, or what additional efficiencies and cost savings moves are you making that maybe are not headcount, even at this point, that’s going to drive that incremental margin from here?

Jeff Glidden

Sure. So obviously the things that we did last year help set us up very much for ’14, and we’ve explained that, I think, in a positive way, so we’re starting with a lower cost base. That also gives us more room to hire the additional sales capacity, things like that we’ve talked about.

The margin story – let’s go to gross margin first. We’re on that path. We are ahead of plan, and that’s positive. I think as we cited here, I think we’re in the mid-15% range. Our longer term goal is 20%, so we still have things to do and we’re working on that, so we’ll continue to drive that. I think we’d be pretty comfortable – our guidance was to get to 15% for the year. I think there’s upside in that, so we’ll continue to work it.

On the spending side, we recently hired a VP of purchasing that I think is at the early stages of helping us find other opportunities and ways just to save money on things we’re already doing. So I think you know the diligence that the finance team, the management team, Christian and his team put together on this where we’re effectively looking for 10 basis points here, 50 there. So the good news is we’ve made good progress, Sterling. The even better news is there’s more ahead, so it’s really looking at spending areas and all areas, what’s critical and not, driving gross margin and driving productivity really in all areas.

Jim Heppelmann

I think, Sterling and everybody else, you should take note though that we have a plan to increase our operating margin for the full year by 300 basis points. In Q1, we were up by 700 basis points, so there were some kind of one-time anomalies in Q1 that you should realize we didn’t ever intend to carry through the full year. I mean, we’re not—our guidance doesn’t reflect that we’re going to try to raise the annual operating margin by 700 basis points – it’s 300 basis points is the target, and clearly we’re ahead of that target in Q1.

Jeff Glidden

Yes, so I would just add and say it gives us some confidence in the 25 points for this year, and clearly what we’ll do this year is also set ourselves up for improving it again in ’15, ’16 and ’17, with a long-term goal to push into the high-20’s to 30%. So I think we’ve made—we’ve committed, we’ve delivered, and we’ll continue to do that.

Sterling Auty – JP Morgan

Got it. Thank you.

James Hillier

Thanks Sterling. Operator, I think we have time for one more question.

Operator

Thank you. Our final question then comes from Jay Vleeschhouwer with Griffin Securities. You may ask your question.

Jay Vleeschhouwer – Griffin Securities

Thank you. Good morning. Jim, Jeff, at the analyst meeting last month, you mentioned that yours is an 80% installed base revenue business. I think, Jeff, you made that comment. Could you talk about how that proportion of installed base versus new business has progressed over the last number of years, and more importantly, how are you thinking about that over the next number of years in terms of your long-term goals? Do you expect a material change in that mix of installed based proportionality?

And then secondly for Jim, could you give us an overview of how you’re seeing conditions in end markets right now, particularly your position in markets of industrial equipment and aero and auto? And one question I’d like to ask about auto as well is we’re seeing what seems to be some improving momentum by the automotive companies in terms of investing in your type of technology, and there seems to be some of what I would call ferment among a number of the automotive companies in terms of selections and new investment. So if hypothetically there were to be some large new selections in auto, let’s say among any Japanese or German or French car companies, could you talk about the kinds of resources or investments that you might need to invest to support such a large, Hyundai-like deal or something like that to occur for you? Then a follow-up at ThingWorx.

Jim Heppelmann

Yes, okay. I hope I got all this listed here. So on the installed base percentage, yes, I think you’re right – we’re 80, maybe 85% of our revenues come from customers we already know, looking backwards – you know, when you look in the rear-view mirror. When you look out the windshield, I think a brand-new picture is developing.

If you think about we had CAD and we’ve got quite a nice base, and then we had PLM and the natural way to sell PLM is to attach it to CAD. That’s kind of how the business ran for the last decade. But when you start talking about ALM, SLM, Internet of Things, who cares what your CAD and PLM system is? Now, it’s useful, very useful for us to go in there and explain to these customers why SLM and PLM have some good synergy, you maybe ought to buy them both from us if you already have PLM. But if you remember the Renault use case, I mean, let’s be fair – Renault loves Dassault for CAD and PLM, but they bought our SLM because they need SLM. There’s a great value proposition and Dassault doesn’t have it, so end of discussion – let’s go.

So I think that it’s one of the themes that we talked about at our investor day – with every passing day, we look more different from Dassault and from Siemens. They’ve kind of stayed in that world of CAD, PLM, maybe gone a little deeper in 3D in the case of Dassault, maybe a little deeper into manufacturing in the case of Siemens. But as we went to ALM, then to SLM, then to IOT, they’re not following us and I don’t know why, but it’s great because that gives us ways to penetrate every account. We don’t say, well, they use somebody else’s CAD so drive on by. We say pull in and go right up to the top of the company and talk about transforming their whole business before they’re out of business. That’s a pretty interesting discussion at a very high level. It tends to be around securitization and the impact of new technologies like IOT and so forth.

I think it’s kind of interesting – somebody pointed out to me a day or so ago that one of our competitors had a job listing on their website for an IOT expert to develop a strategy around IOT that might lead to R&D or M&A-type projects. I just thought it was kind of funny – we’re deep into this and they’re saying, I wonder what that is, maybe we should hire somebody to go look at it. It just sort of speaks a little bit to I think what’s happening out there, and it’s very exciting for us.

Okay, second question, I think was verticals. I think the only notable thing—I’ve got to find that data her.

Jeff Glidden

Yes, I can probably jump in and Jim can add some color. If we look at verticals generally, we saw increases in really core industrial, high tech and electronics, and med devices. I’d describe automotive as roughly steady. It wasn’t up significantly in the quarter, but it’s been pretty steady at a higher rate than it was perhaps a year or two ago. The only area really of softness would be in the federal market, which would be as expected. I’d also say aerospace was lower this quarter than it was a year-ago quarter because of a large mega-deal that did close, but excepting that I’d say fundamentally that was also a pretty good business for us. But softness in federal, and the strength we just described, and steady in automotive.

Jay Vleeschhouwer – Griffin Securities

Okay. I had that question about possibility of a large deal in auto, but we can take that offline.

Jim Heppelmann

No, no – let me just address it at least at a certain level, because as you were asking the question, I wanted to ask you, are you talking about CAD deals? Are you talking about PLM deals?

Jay Vleeschhouwer – Griffin Securities

Yes, it’s more of a traditional business kind of question, Jim. It’s not the new stuff.

Jim Heppelmann

Yes, okay. So I think that there are some customers out there who are thinking particularly about PLM. That’s what’s most interesting to us, so I think Hyundai did switch to our technology. Our position in Volkswagen has grown stronger. All of the Volkswagen truck families are headed our way – Scania, MAN. As you know, Volvo came our way. So we’ve been chipping away at that, and Embraer is another example of a big (indiscernible) Dassault customer who came our way. So I think that people see a notable difference in the strength of our PLM technology versus what they might get from their CAD vendor, assuming it’s somebody else, and that creates opportunities for us.

Now, those things are slow to develop and mature and so forth, but no doubt having an SLM, ALM and IOT strategy is pretty interesting to these guys because keep in mind, software, it isn’t a point in time, it’s a journey. So when you buy enterprise software, you’re kind of asking two questions. One question is right now, who has the best stuff? And the second question is, how will it evolve over time, and over time will it become more interesting to me because they’re headed in the same direction that we are, or is it going to become less interesting because I’m going places that that vendor doesn’t intend to follow.

If you’re talking to an automotive company and it’s all about manufacturing efficiency and/or it’s all about 3D, that’s one story. But if you’re talking to them about cars becoming smart, they’re becoming connected, you’re going to transform the way you create, operate and service them, that’s a very differentiated story. So I think that’s useful for us, but you know, this stuff takes time and we’ll continue to sort of harvest those opportunities when we get a chance to go compete for them.

Jay Vleeschhouwer – Griffin Securities

Okay. The ThingWorx question is when we think about the broader context of what we saw, for example, at CES a few weeks ago and your comments about smart products and connected products and so forth, in addition to which you’re expanding your credit line, could you talk about how you’re thinking about investing in or partnering in the non-traditional, non-mechanical, non-apps development world? Do you think you need to have something a bit complementary that is outside of what you already have in ALM and CAD, and now with ThingWorx, to fully round out the picture either in terms of owning something untraditional for you in the portfolio, or how are you thinking about at least partnering with established companies in that world?

Jim Heppelmann

Yes, I think if we take ThingWorx and IOT first, ThingWorx has an ecosystem strategy. They have sort of an app store kind of concept – I’m not going to call it an app store – but for example, if you want to create an application that talks to your products but it also talks to your ERP system and to your Philips Hue light bulbs, so every time there’s a problem on the shop floor the lights in your office blink, well, it’d be nice to have a pre-developed connector to the Philips Hue light bulbs and a pre-developed connector to the SAP system and a pre-developed connector to some kind of a system that would issue alerts through text messages, and how about a system that looks at the weather and so forth. That’s the kind of thing that ThingWorx does, so they’re building a nice ecosystem of, let’s say, Lego blocks, building blocks of technology, a building block, for example, that would connect to a Philips Hue light bulb – you know, just being fun with it. That’s a literal example, though, of one that exists. SAP would be another one, Salesforce.com might be another one. You can quickly put these Lego blocks together into all kinds of interesting applications.

You know, Google acquired Nest for a lot of money, and Nest is a smart connected thermostat and there is limited amount of applications. If you asked what else might you do with the data you could get from a Nest thermostat and/or the controls you could send to it and so forth, and how might you mash that together with other things? Let’s say Google wants to go to smart homes, from smart thermostats to smart homes – maybe they don’t. This is a hypothetical example. Probably the tools the Nest guys used to develop that one application really are kind of old-fashioned tools – they grabbed a copy of Eclipse and they grabbed Java and they grabbed an Oracle database, and away they went. We’re going to go show them ThingWorx and they’re going to say, you know what? If you go from one application to 100, you’re going to need a whole different approach here, and this idea of a platform, a series of pre-built connectors—and oh, by the way, applications like ALM, PLM, SLM, that’s a very interesting approach to combine the best of what’s proprietary to us and the best of stuff we’d just like to buy from somebody else and reuse.

So I think that that ecosystem idea is very important there, and of course as we look at CAD and PLM, the acquisition opportunities are less numerous. As we move to ALM, then to SLM, then to IOT, they continue to just explode, so I think we’ll continue to try to cherry pick those most important pieces of technology that we want to own and have right in our technology stack as well.

Jay Vleeschhouwer – Griffin Securities

Thanks Jim.

Operator

Thank you. At this time, I’ll turn the call back over to the speakers.

James Hillier

Thank you, Operator.

Jim Heppelmann

Okay, so maybe just to close it out here, thank you all again for spending your time with us here this morning. I think we feel like this was a good quarter. We’re, as you see, being prudent, not to get ahead of ourselves, but yet at the same time there’s some really interesting things developing here. There is evidence that the economy might get better. I wouldn’t say it is better, but the vector is a good one. We’re in a good place now with our business model – you know, 25% operating margins makes things really interesting when revenue grows, as you’ve seen the last two quarters. I think from a growth standpoint, we’ve got the Creo product cycle – we’re seeing some impact from that. We have SLM. Now we have IOT. I think the people sitting here around the table on this call here at the PTC side really have never felt better about the future of PTC, so I hope some of that is coming through. We’re trying to balance that with sort of a prudent, let’s be careful, not get ahead of ourselves sort of attitude as we guide you through the balance of the year.

Okay, with that, thank you very much and appreciate the time you spent with us today. Bye bye.

Operator

Thank you. This does conclude today’s conference. We thank you for your participation. At this time, you may disconnect your lines.

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