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Executives

Kristian Talvitie - Senior Vice President of Investor Relations

Jim Heppelmann - President & Chief Executive Officer

Jeff Glidden - Executive Vice President & Chief Financial Officer

Barry Cohen - Executive Vice President of Strategy

Analysts

Sterling Auty – JP Morgan

Yun Kim – Gleacher

Blair Abernethy – Stifel Nicolaus

Steven Koenig – Longbow Research

Richard Davis – Canaccord

Ross Macmillan - Jefferies & Company

Ben Rose - Battle Road Research

Andrew Kaplan - Deutsche Bank

Parametric Technology Corporation (PMTC) Q1 2011 Earnings Call January 27, 2011 8:30 AM ET

Operator

Good morning ladies and gentlemen and welcome to PTC’s first quarter fiscal year 2011 results conference call. After brief comments by management we will go directly into question and answer session. If anyone should require assistance during the call please press star followed by the 0 on your touchtone phone. As a reminder ladies and gentlemen, this conference is being recorded. I would now like to introduce Mr. Kristian Talvitie, PTC’s Senior Vice President of Investor Relations. Please go ahead.

Kristian Talvitie

Good morning, good afternoon everyone. Before we get started I just want 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 most recent Form 10-K and Forms 10-Q on filed with the SEC.

All financial measures on this call are non-GAAP financial measures. A reconciliation between the non-GAAP measures and the comparable GAAP measures is located in the prepared remarks document on the investor relations page of our Web site at www.ptc.com.

Here today are Jim Heppelmann, President and CEO, Jeff Glidden, CFO, and Barry Cohen, EVP of Strategy. With that I’ll turn the call over to Jim.

Jim Heppelmann

Good. Thank you Kristian. Well, good morning to everybody. Good morning here from snowy Needham where we have a foot of fresh snow on the ground. But the PTC management team being very loyal and commitment all found a way to get to the office. I’d like to say we’re very pleased with what we think was a very strong first quarter and a very good start to our fiscal ’11 year.

We really see a good balance of revenue strength across almost all of our product lines, across our direct and indirect channels, across our different geographies and so forth. It was really pretty much solid across the board. We also saw a good continued momentum with Domino wins and we’ll talk about it. We saw pretty good progress in monetizing some of the previous Domino wins as well. So I’d like to start with some comments regarding the automotive industry in general and the win at Hyundai Kia Motors Company in particular.

So just to give you some background context, automotives is the biggest vertical within the manufacturing industry. That said, the automotive segment has been an historical strength of some of our competitors, Siemens and Dassault in particular, and relatively speaking PTC has been under represented in the automotive industry over the years. Now at the same time, we felt that with the competitive strength we have in PLM we ought to be able to fix that to our advantage. We should be better represented in the automotive industry.

So I think right now and really over the last six quarters or so we’re starting to see a lot of good progress of PTC taking share in this very important automotive segment. So if I look at the last 18 months or so, we’ve had competitive displacement wins, may of which we’ve announced at places like Volvo Truck, which is one of the world’s biggest truck companies, at Continental and as well separately at Schaeffler. And I think some of you know that Continental and Schaeffler are merging together to become the world’s biggest automotive supplier.

We had a very important win at Cummins, at Harley-Davidson, ArvinMeritor and a number of others. But really prior to this last quarter what we hadn’t succeeded in doing was penetrating one of the passenger vehicle automotive OEMs. And the passenger vehicle automotive OEMs are by far the biggest segment for enterprise PLM. Now we had some presence with CAD and power train and we had some presence with our Windchill software next to the CAD software we had sold. But in terms of enterprise PLM PTC really didn’t have a single automotive OEM account we could point to.

And of course that held us back because whenever we got in an engagement we didn’t have a good automotive OEM reference to use. So obviously we’re very pleased to announce what is a tremendous win at Hyundai Kia Motor Company. Now Hyundai Kia win, HKMC as we call it, is extremely important because HKMC is the envy of the automotive industry right now, particularly the OEMs. They are currently the fifth largest in the world and they are the fastest growing. So at current speed by next year the will be the fourth largest and passing Renault Nissan in the process.

So to put that in perspective, Hyundai Kia is bigger than Ford, than Daimler, Honda, BMW, Chrysler and a long list of others. This is a big, successful company and a big, important win that will be watched carefully by the entire automotive industry. So what happened at HKMC is that two years ago HKMC decided they really needed a better PLM strategy and they began a competitive benchmark process. PTC was represented as was Siemens, Dassault and SAP. The incumbent strategy that they were looking to upgrade was a Dassault Enovia strategy. So they went through a comprehensive request for proposal process and then separately they did many months of hands on software evaluation testing the software against the HKMC requirements at the HKMC sites.

So PTC was pretty happy after this two years of competition last quarter to come away with a victory. Now just in the waning days of the quarter we started what’s a pretty typical phase I deployment. Now you’ll remember we’ve given you this monetization model that says most of our deployments start with a relatively small first phase where we’re trying to prove out the solution in the customer’s environment with actual users and actual data and actual production work processes. And when we’re successful with that then these things tend to expand and they expand again and again and again over time. We’ve taken you through that model.

So the actual win has relatively small revenues in this first phase and should get a lot larger over time. So in the press release and in our prepared remarks we talked quite a bit about this term contract accounting and how it caused a one-time 3-4 cent EPS hit that we’ll make up in the back part of the year. Now I’m not an accountant and many of you are not accountants so I’m going to try to give you a plain English explanation of why this happened and what it means for us. Okay. So we won the benchmark. Clearly HKMC believed PTC had the best solution relative to their requirements.

But at the same time their requirements are very aggressive. HKMC is a leader, not a follower. So they have very aggressive requirements. So they came back to us with a list of additional enhancements they’d like us to make to the solution. Now that’s not unusual at all for a large customer to give us a list of enhancements. And so let me add it’s particularly not unusual when you’re entering a new segment like we are with automotive OEMs for the first time. So PTC looked at these enhancements and we said the bulk of them look like good things to do to the product for the benefit of all of our customers, certainly all of our customers in the automotive industry.

So we said okay, we’re willing to incorporate those enhancement requests in the future product roadmaps and that’s something that we would - a conversation we would have with many customers. Now the difference is that Hyundai is a pretty good negotiator and they said we would like you to commit to those delivery timeframes and so forth in the contract. And so after some back and forth on that we agreed to do it. But the accounting treatment is once a commitment is made the deliverables must be delivered per this contract.

Then the cost of all that R&D work gets assigned to that one contract, okay? So when you take all this incremental R&D cost that would have just been run rate R&D and you assign it in one fell swoop to this one contract and you add those costs on top of the deployment costs of actually putting that phase I deployment in place, then you get into a situation where the costs of phase I when counted that way exceed the revenue of phase I. And then the accountants say okay, now you need to take the excess cost as a loss in the current time period. So the net effect of all of this is that we have taken 3-4 cents of R&D monies we would have spent in Q2, 3 and 4 and we have basically accrued that cost here in Q1.

So as we actually incur that cost in Qs 2, 3 and 4, it won’t show up because it’s already been more or less pre-paid. So it’s very important that you understand that these costs are not incremental to the PTC FY11 spending plan. It’s really just a reprioritization of existing resources and not incremental spending. So the 3-4 cents of cost is essentially like I said, a pre-payment for a front loading of costs that has no effect on the full year and therefore we left our EPS guidance unchanged for the year at $1.20-1.25.

Now I think what’s most important is that we don’t let this discussion around accounting sort of obfuscate the more important thing, which is that HKMC is a tremendous strategic win for PTC. It is the most important account we were pursuing here in fiscal ’11 and we won it. This is going to do a lot to reinforce our momentum. It will start an unbelievable number of new conversations in the automotive industry at all levels and it will further cement our claims of PLM leadership in the industry. So moving on to the rest of the customers, we were very successful in securing two other Domino accounts as well in the quarter.

So that puts us at a count of 22 versus a full year target of 30. So we’re doing very well against that target and we’re confident that in the end we will meet or potentially exceed that target of 30 Domino accounts. The other thing and Jeff will give you some detail, we’re seeing how Domino accounts previously won are contributing in a pretty meaningful way to the big deal pipeline now and about 1/3 of the big deals that came in in Q1 came from Domino accounts previously won. So our enterprise numbers I think overall look very solid though you all realize you need to look a little bit closer to see that because the enterprise numbers look much better when you take into account the very tough comparable from Q1 of last year when we had what was essentially a blow out quarter the blow out came from enterprise license revenue, which basically came in 20 million higher than our guidance and our expectations.

Okay. Now on top of all that I was very pleased, I think we all were, to see really pretty strong desktop strength and as well, solid SMB or reseller strength. And I attribute those two things to a combination of factors. Really on one hand, good economic rebound that has now worked its way down into the SMB segment and on the other hand, a lot of momentum and excitement around Creo. Creo has driven a much higher level of sales activity than we have seen previously in Mathcad for both the direct and the channel resources. There are many, many customers who want to hear about it, understand what it means, how is it different and better? It’s just driving a lot of activity and you’re seeing some of that fall through as revenue.

So I’m pretty happy with the desktop side and I think we’re set up to have a pretty good year on the desktop front. So overall just reflecting on all this, I think we have a great start to the year. We’re ahead of plan on revenue. We’re actually on our plan for EPS after taking that 3-4 cent hit or I should say we feel like we’re 3-4 cents ahead just to be clear on that. We’re confident that our FY11 revenue and guidance remains achievable and we think we’re in a good place relative to our longer term plan for 20% sustainable revenue growth through 2014. So with that, I’ll turn it over to Jeff for a few brief comments.

Jeff Glidden

Great. Thank you very much Jim. I’m just going to give a little more color on some of the business metrics in the quarter. I’ll talk about cash and cash flow and then turn to our guidance for both Q2 and the balance of the year. As Jim cited, a terrific highlight of the quarter was the large deals and obviously 22 large customers generated 51 million in the quarter. This compares to 10 customers generating 50 million a year ago. So this really speaks to very much the increased breadth and depth of our business.

Last year obviously the average of the 10 customers was about $5 million each. That was reflective of a handful of very large deals that are very difficult to forecast and do give us the hard compare. I think the health of the businesses is really reflected very much in the 22 deals with an average of just over 2 million. That’s been a very consistent metric for us and I think that’s where we expect to be going forward. I think another key point is about 1/3 of these accounts were Domino’s and that’s just very important in building our annuity base, having the Domino’s not only being major wins in a current period but generating incremental revenue and a continuing revenue stream as we build these annuities, so a highlight there.

We’ve really talked about the direct enterprise revenue. That was 106 million or 40% of total and that compared to 111 million in FY10 for the same quarter. And as we have articulated, looked at about 20 million of upside in that prior period, our year over year growth excluding that upside of about 20 million would be 16% on enterprise and 36% year over year growth. Again, I think as we look at it, the pipeline of enterprise PLM opportunities is strong and growing. Jim has said we closed three Dominoes in the year in the first quarter and we feel very comfortable with the target and goal of 30 for the full year.

Highlights again were CAD, desktop and channel. So desktop CAD revenue was 146 million, up 8% year over year with license growth of 36%. Channel revenue was 77 million, up 7%, license growth of 26. This is really a continuing trend, very healthy for us. Both Q4 was up, Q1 again and I think it’s a reflection of both improving economics and really market customer and partner response to our Creo strategy. It’s been excellent. We were concerned as we went into the quarter that we might see some stall. We have seen the opposite. We have seen growth and strength in that, which reflects I think a very strong story and a very strong strategy in the Creo announcement.

Turning now to cash and cash flow, cash did decrease by $57 million in the quarter to 183. Recall that we had a litigation settlement of $48 million that was consummated at the end of - really at the beginning of Q1. That was paid out. So that’s a major piece of the decline in Q1. I would say the good news is Q2 is probably our strongest cash quarter. We expect cash to increase in Q2 by 77 million such that we’d end the quarter with 260 million of cash. And this is before any stock repurchases. So just on a cash basis we’d expect to close the current quarter with 260 million of cash.

For the full year cash flow from operations and I’m going to exclude the $48 million settlement, the cash flow from operations without the $48 million settlement would be 165 million. That’s a significant number for us. It’s great. It’s up year over year from FY10. We also plan to purchase $55 million worth of stock in the coming quarters and in the full year and we expect to end FY11 after $55 million worth of stock purchases at 275 million. So we’ve got a very strong balance sheet with excellent cash flow. I’ll just close with our guidance just reiterating our guidance assumes $1.37 US dollars to the euro.

This is consistent with both our simple average for 2010 and our guidance at the end of last year. So we’re holding to that. As you know, the euro has moved up and down fairly significantly within these periods but we feel right now we don’t forecast currency. We really just live with the flows up and down as they come. Guidance is based on this. So for Q2 we expect revenues to be 260-270 million. This would be year over year growth of 8-12% and non-GAAP EPS of 22 cents to 26 cents.

For the full year we expect revenue growth of 10-12% or 1,110,000,000 to 1,130,000,000 and non-GAAP EPS of $1.20-1.25. We thank you very much for your time and your interest and we’ll now open it up for your questions.

Question and Answer Session

Operator

If you would like to ask a question please press star, 1. You will be prompted to record your name. To withdraw that request you may press star, 2. Once again to ask a question you may press star, 1 on your touchtone phone. Our first question comes from Sterling Auty of JP Morgan.

Sterling Auty

Yeah. Thanks. Good morning guys from snowy New York. We’re suffering right along with you. Let’s start with the contract with Hyundai. So I want to make sure I understand there was no revenue that was actually recognized in the quarter. Was that also because of the way that the contract was constructed?

Jim Heppelmann

Jeff, you want to take that?

Jeff Glidden

Sterling, I’ll take that one. So we signed this contract really late in December and so it’s really basically the structure here is contract accounting. And we’ll be recognizing revenue on a percentage completion basis. So as we sign the contract we’re into deployment now. We’ll begin recognizing revenue and the revenue stream really in Q2 and beyond. Based on contract accounting what we did is an estimate of all the costs to complete this and what we booked in the first quarter was the excess of cost to complete versus the contract value for phase I. So phase I revenues will start being accrued in the second quarter.

Jim Heppelmann

So just to add a little color to that, because we were doing this percent complete contract accounting we are not able to extract out the license revenue and recognize that as we would do in a traditional deal. And then if you say well, what percent complete did we get to? Well, the answer is zero. We just started in the waning days of the quarter. So that’s really the story there.

Sterling Auty

I think there are a lot of us that follow other companies that use this in other segments so I don’t think it’ll be that foreign. But maybe one clarification - is this completely unusual for you guys to use percentage completion? Or have you done that with any of the other Domino deals?

Jeff Glidden

It’s a rare occasion. I think we have done this on a couple of occasions where we have made commitments and where the service is the vast majority of it we would use 81/1 or contract accounting. So it’s very consistent with past practices. That said, 97/2 or software revenue rack is the vast majority, 95-98% of our business is software revenue rack.

Jim Heppelmann

Yeah. What is very unusual is for us to make commitments around product development. Now normally a customer gives us some requirements, we look at those requirements and we say sounds good. We’ll try to work it into our future product roadmap but we’re not committed to it. So even if we normally would do a percent complete you wouldn’t really see it that much. What’s strange here is we made the product enhancement commitment and that brought in all of this cost from future periods in one big lump, which is why it looks strange. I have not seen that happen prior at PTC.

Sterling Auty

Got you. One of the other items that we saw and I got questions from investors is also looking at the license revenue as a whole kind of towards the lower end of the guidance range. If you had used 97/2 if you didn’t have the commitments, is there any quantification that you can give us as to what license revenue might have looked like? And then the follow on to that is would you get all of that license revenue during fiscal 2011 under the percentage completion for this phase I or does it stretch it out even longer than that?

Jeff Glidden

So let me pick up on this. It wouldn’t - we’re under contract accounting and just let me say that the license piece of this is a small number of licenses up front and that is in phase I. We expect that to broaden significantly in phases II and III. So there will be significant amounts of additional revenue recognized in future periods on phases II and III once we complete phase I. So it’s a very small amount of license that would have been in this and that’s common, not uncommon for our Domino programs where there will be a lot of services up front to get a deployment complete and then we see a rapid expansion of license seats after that.

Jim Heppelmann

Yeah. And this phase I does not fully complete within this fiscal year. It’s more like targeted at calendar year.

Jeff Glidden

Correct. Yeah.

Sterling Auty

Okay. And last question and I’ll get back in the queue just to keep beating the dead horse. In terms of the expenses that you were forced to recognize were 100% of those expenses in the R&D line or when I look at the costs of services and I look at the services margin?

Jeff Glidden

It’s in services so there’s about $5 million in services that’s recognized there because that’s a services contract. And it did have a 2% percentage point impact on gross margins in the quarter as well as on the bottom line it had the 3-4 cents. But that really bridges I think what was a very good quarter in overall margin, good services margins excluding the HKMC deal.

Jim Heppelmann

So again, just to be perfectly clear what essentially happened to a large degree is future R&D costs got characterized as current period services costs. That’s what you’re going to see happen here over time. Higher services costs now means lower R&D costs later.

Sterling Auty

Got it. All right. Thank you guys.

Operator

Our next question comes from Yun Kim of Gleacher.

Yun Kim

Thank you. So I think Sterling did a good job of asking all the right questions regarding the Hyundai Kia contract accounting deal so I’ll just go on to something else. It looks like you mentioned the desktop CAD business had a very good quarter. How do you account for such a strong business in front of a major release coming up, Creo product, in about six months? And then also you hear some put through effect that’s happening from some large PLM wins that you had last year basically Windchill driving some pro-E sales right now. Thanks.

Jim Heppelmann

Okay. You had a couple questions there. I think again the desktop CAD number was strong for two main reasons. One is there were some large deals that contained desktop CAD. Those were probably more a function of renewals that came up and got renegotiated than any special connection to Windchill or anything else or Creo. And then there was just good, robust strength in the SMB channel where most of the new buying behavior happened.

And there Creo is helping us a lot because as you remember, the Creo story on one hand is very interesting. On the other hand it’s fully upward compatible from the existing stuff. So excitement about Creo even though it’s not delivered today, actually does translate into a purchase of what’s available today because it’s upward compatible. So I think that what’s happened is the number of conversations that we get included in has increased dramatically as a result of Creo and all the marketing that we have done around that.

Yun Kim

Okay. Great. Thanks. And also Jim, you mentioned about 1/3 of the large deals were follow on deals from existing Domino accounts. Is that where we can expect the level to kind of trend for a while? Or do you expect that level to pick up or maybe even dip a little bit? How consistent would that level be going forward?

Jim Heppelmann

Well, just to be completely honest with you, I don’t have that data in front of me for prior period so I can’t comment as to the trend. That feels to me to be probably relatively normal, maybe increasing a bit over time. Kristian tells me it’s been increasing over time. But I don’t have the data for prior periods sitting here to compare it to.

Jeff Glidden

Yeah. Just as a general view I think we’re building these annuity accounts. The Domino wins are terrific and then our clear goal is that they generate not just a deal up front but a continuing stream of revenue over three, five, many, many years. So I would expect as we build the annuity accounts we’ll see more of that Domino revenue flowing through as well.

Jim Heppelmann

And I think just to again add some more color, clearly we have taken you guys through this Domino monetization model. This has most of these Dominoes are not up front big purchases. Occasionally they are but that’s the exception rather than the rule. So the rest of them become small engagements up front dominated by services revenue. And over time they translate into more and more license revenue and then a building stream of maintenance. And if I look at this portfolio of the 22 Domino wins to date, they are all more or less on that exact path with the exception of a few that gave us big orders up front.

Yun Kim

Okay. Great. And then I just want to make sure the closure rate on these follow on Domino deals are much higher than the initial contract, right? That’s probably a fair assumption?

Jim Heppelmann

Yes.

Yun Kim

Okay. Great. And then Jeff, there was a pretty sizeable sequential jump on deferred revenue in the quarter. Is that all maintenance renewal or was there some pick up in the consulting work or even some license revenue?

Jeff Glidden

You know that is the maintenance renewal. It’s a big, big Q1 event, which is terrific and that’s what also drives the very significant increase in cash flow in Q2.

Yun Kim

Okay. Great. And then the final question from me - can you give us an update on the interest level of large system integrators as far as working with you in terms of signing the next big PLM deals? Are there more site consultants being trained on Windchill? If you can share with us any specific plan that you have to get these large system integrators to ramp up. Thanks.

Barry Cohen

Well, this is Barry here. One thing we have done now is we have created a model for what the service economy needs to look like in 2014. And we have assigned it as a goal to the service organization so we have really resolved the strategic issue going forward where we’re going to be ramping up the SI community with a lot greater investment and support in the years coming. And we’re seeing that to be very well received by the SIs out there. So we’ll expect our economy to grow significantly over the next three to four years.

Yun Kim

Okay. Great and congratulations on the signing of that Kia Hyundai deal. Thanks.

Jim Heppelmann

Thank you. Just before we move on if we could keep questions to one question and one follow up, that’d be great. Thanks.

Operator

Our next question comes from Blair Abernethy of Stifel Nicolaus.

Blair Abernethy

Thanks. Can you hear me guys?

Jim Heppelmann

Yes.

Blair Abernethy

Just on the Domino wins to date, the 22, Jim, I’m wondering if you can just help us out a bit in terms of characterizing the backlog on licenses. If you look at the group of 22 now how much of them could you bucketize as sort of in the first phase versus a second phase versus a final phase of implementation?

Jim Heppelmann

Yeah. Well, I think we began the program, began talking to you guys about Domino accounts in mid-2009 or so. So you could say that the earliest wins are what, six, seven quarters under our belt? And the latest wins of course are days under our belt. So I think that says that all of these accounts are somewhat in their early days because this is a multi-, multi-year phenomenon that takes to run this course. And quite frankly we’ve never actually had one run its course. So we’re not sure when they do end.

It just becomes an engagement where we become a strategic partner and we continue to do incremental business with them year after year. But just trying to get back to your question, I think that I would characterize all of them as having ample additional opportunity from where we now stand and most of them as starting to be pretty meaningful.

Barry Cohen

I would add that when you may see the final phase, in actuality we don’t think of having any final phase because one is the roll out of Windchill and PLM but there is also the expanding footprint of PLM. I think most of you heard and saw how we’re expanding into the service market within our accounts with our Sys Arbortext offering. And so we see these as really sort of never ending annuities.

Blair Abernethy

Okay. Great. And then on the win with Hyundai, if we look past this and say okay, what other automotive OEMs are out there looking to do a major overhaul as well at this point? Do you have - are there other ones in your pipe now?

Jim Heppelmann

You know, I don’t want to predict that we’re going to close another one soon. I think what’s going to happen is we’re going to start being taken seriously in the evaluations that they do. General Motors ran into evaluation last year and they didn’t include us in the evaluation. And I was a bit dumbfounded and actually flew out there and asked them why, why would you not include the leader? And they said you’re not a player in automotive.

And so okay then, it is what it is. That’s no longer true. General Motors watches extremely closely what’s happening at Hyundai and now I don’t want to speak specifically for General Motors but in companies like that they’re wondering if they haven’t maybe been leap frogged because Hyundai didn’t follow their strategy. They leapt ahead with a new strategy with the now current market leader. And I think a lot of these automotive companies move from defending what they’re doing to questioning what they’re doing.

But now we’ve got to start the sales cycles that take some time to run. So I don’t think it’s going to make an immediate difference. But in terms of working our way increasingly into this industry in the coming years, it’s huge.

Blair Abernethy

Okay. Great. Thank you.

Operator

Our next question comes from Steve Koenig of Longbow Research.

Steve Koenig

Hi guys.

Jeff Glidden

Hey Steve. Good morning.

Steve Koenig

I’m good. Thank you. First question and then one follow up - you’ve given a pretty in depth explanation of the contract accounting, which was helpful. Can you direct that however specifically to Q2 and talk about the dynamics there, the guidance being a little below the Street on EPS? And was it all the Hyundai deal where basically it looks like you’re now going to be matching your costs with your revenue so margins on those resources and the other annuities will be low? Or are there additional items in Q2 that would have affected that guidance? And then I do have one follow up.

Jeff Glidden

Okay Steve so relative to Hyundai we won’t provide specific revenue and margin guidance. But I would suffice to say that it’s baked into our plan and our forecast and it has a very small effect going forward. The dollars we took in Q1 one, helped to mitigate that and it’ll be percentage completion. Again, the uptick that we would expect would be as we move from phase I to phase II with license revenue. So I would say it’s a small effect.

As we look at the balance of the year we’re really looking at trends that I think are very important and that would be continued margin expansion. We’ll be building and continuing to invest in sales capacity to drive growth because we feel very comfortable and very confident in the market opportunity ahead. We’ll be watching and expecting that our R&D expenses will continue to trend downward over time.

And as I think we have cited before, our R&D expenses historically were in the 16% range. We essentially increased that significantly over the last two years into the 20% range. We’re trending down now 19-18% this quarter. We’d expect over time that will normalize. So I think we’ve built in a number of programs. We’ve got some investments in services that we spoke about last quarter that occurred in the first half of this year that will get better margins for us on the services side in Q3 and Q4.

So I think most of the programs that we funded we feel very good about and you’ll start seeing the small effects of that in Q2 and more as we step up through Q3 and Q4.

Steve Koenig

Okay. Great. That’s very helpful. Then just turning to my follow up, I’m wondering on the PLM side you did have a tough compare this quarter. Last year you all spoke about growing Windchill, growing PLM I should say, 20% year on year and growing licenses at potentially 30-40% pace. Do you still see that pace as achievable this year?

Jim Heppelmann

Well, I think we definitely believe we’re going to hit the 20% overall growth. And I think it will take license growth in the 20-25% range you’re talking about - I’m sorry. More in the upper 30s range that you’re talking about. Now keep in mind we had 72% license growth last year in Windchill. So we see ourselves scaling back to sort of half the license growth rate we had the previous year, attributing some of that previous year license growth to economic recovery and soft comps from the previous year and so forth. So I think we feel like that 20% growth for Windchill this year is completely doable and we have the pipeline to support doing it.

Steve Koenig

Great. Thanks a lot Jim. Thanks Jeff.

Operator

Our next question is from Richard Davis of Canaccord.

Richard Davis

Thanks very much. So the question I have as much as I like talking about accounting is by my reckoning if you barely allocate expenses to CAD and PLM Windchill is somewhere between I guess breakeven and low single digit operating margins. And if you look at every other software company that generates, if you cut your revenues roughly in half, $300-400 million, they all have 20% operating margins. So it’s awesome that Windchill’s growing but why are the margins low? How do they get better and when do they get up to industry average? And how do you think about that because if you’re able to pull that off then it could be an awfully interesting story here?

Jeff Glidden

So Richard, this is Jeff Glidden. We understand the question and where we really start with this is looking at the revenue growth and then the mix of product and services that are within that. And as we have articulated in many of these accounts and in our Windchill business, a large, significant portion of that revenue is services, which has a lower margin mix relative to license and maintenance.

So I think there is both within existing accounts and over time we start with the heavy services mix. We watch license revenue grow at a more rapid rate. That will drive maintenance and as that overall mix improves that moves gross margins from today probably in the 60% range up into the 70% range itself. So that alone and I think that’s another piece of the way we manage the business, these strategic channel partners and other really consultants are an important piece of building that ecosystem to provide that level of service and support to our customers.

So I think you’ll see continued mix shift that is very favorable for us on the gross margin line. We’re also today as you know, investing significant amounts of money particularly in R&D to leap frog others with the Windchill program. As I’ve just said, those will moderate over time so you’ll see leverage on the operating expense side as well. The combination of that will put us into what I think will be industry targets for that Windchill business. So it’s both growth and gross margin expansion and operating margin expansion for the Windchill business.

Richard Davis

So is it fair or logical to conclude that the R&D payoff would be to more productize Windchill such that therefore future deployments whether that’s a year from now, two years or what have you, are less service intensive? In other words, you have to do less up front effort or is this a system that requires links to so many different back end systems that it’s unlikely that you can fully productize the business?

Jim Heppelmann

No. I think you’re exactly right. That’s exactly what we’ve been working on for some time now and continue to work on is try to eliminate or let’s say minimize the amount of services and customization work and so forth. It’s never going to go to zero. That’s impossible. But I think people think in terms of a multiplier from license to service revenue. That multiplier has dropped dramatically over the last few years.

And we’re trying on a go forward basis to give a bigger portion of that services need to a services economy above and beyond PTC. You know, if you really go back to what Jeff said, it’s all about the mix in Windchill. And our goal is to grow license revenue the fastest and to sort of grow maintenance revenue at a pretty good clip as well and to actually throttle back the services growth. And again, two parts to throttling back. One is throttle back the demand and then number two is throttle up the supply of the third party ecosystem.

And if we do that then as we grow we grow to an increasingly more interesting mix. And then you’ll also get some benefits of scale that the R&D as a percent of revenue for example can drop. And I think we’ll get some benefits of leadership, what I call economies of leadership, which means we’ll have shorter sales cycle, higher productivity, better pricing power - all those good things as well. So I think all that stuff together is really about fixing the mix and I think it’s going to make Windchill very interesting going forward.

Richard Davis

Got it. Thanks.

Operator

Our next question comes from Ross MacMillan of Jefferies.

Ross MacMillan

Thanks a lot. Jeff, I just wanted to go back just so I fully understand on the contract accounting, it sounds like you match revenues and costs over the remainder of the contract. But you took costs in excess of that in the first quarter. And I guess my question is does that imply that you actually have higher costs for fiscal ’11 than you would have previously expected because you effectively committed to say I don’t know, two years of R&D or three years of R&D and it’s getting stuck into fiscal ’11? Is that the right way to think about it?

Jeff Glidden

The first part on the accounting is correct. The second part is not correct. That is this is funded through our existing spending programs and plans. So it’s not we will not have incremental expense in the year. We’ll have some different pocketing of it. We’ll have more recorded in services and we’ll have a lower level of R&D over the course of the year. But it’s really a function of it’s already as Jim said, it’s baked into our expense plans. And therefore despite this impact in Q1 we’re comfortable with maintaining our EPS guidance for the balance of the year.

Ross MacMillan

Okay. That’s clear. Thanks.

Jim Heppelmann

Keep in mind that timeframe of performance for phase I is pretty short. So this is not a multi-year thing. It’s really a calendar year thing.

Ross MacMillan

And I just wanted to be clear on one other point in the contract. It didn’t sound - if this had not been contract accounting it didn’t sound like there was a material amount of license revenue associated with phase I. And so if it had been 97/2 accounting would there be much delta let’s say to the license revenue taken in the first quarter?

Jeff Glidden

We didn’t break that out and we won’t. I’ll just say it’s a small amount of license revenue in the phase I, which will be followed by significant amounts of license revenue as we anticipate in phases II and III.

Jim Heppelmann

Yeah. Had that happened, we would have had a little more license revenue and we would add 3-4 cents more EPS this quarter. And we’d have had higher services margins and all that type of stuff.

Ross MacMillan

That’s great. And then could you just remind us of the phasing on Creo? There are I think as you move to the new product introduction there are two elements. Can you just remind us A, when we should expect to see those two elements and B, if you will, can you explain those two elements and how they kind of relate to let’s say the existing install base today? Is the second phase for example really all incremental new functionality and phase I is really going to satisfy if you will an upgrade path for the majority of the base? Thanks.

Jim Heppelmann

Yeah. So actually we talked about before key capabilities, any mode modeling, any data as options, any roll outs and what’s the other one - any bottom assembly. So three of those are sort of meat and potato things that have much meaning for everybody. Those three are in the first release, which remains scheduled for the June timeframe so Q3. The next thing, the any bottom assembly, this is a more sophisticated concept that requires changes to Pro-E, Creo and to Windchill as well to change the way the two together do assembly model.

And so this is in the phase II release, which is a bit further out. But it’s also not something that will have an immediate impact anyway because it’s a more compelling but bigger change for a company to make. So I think if you’re thinking about it from a revenue standpoint, that really comes down to our release 1 in the June timeframe. That’s what 98% of the customers plan to upgrade to, etcetera or anyway that they’re excited about let’s say.

Ross MacMillan

That’s very helpful. Thanks a lot.

Operator

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

Ben Rose

Good morning. Just a couple of quick questions - Jim, what is your sense of how long the first phase will last with HKMC? I’m sorry if you did mention that. I didn’t catch that. And also could you give us a sense of how other verticals look to you over the next six to nine months ex automotive?

Jim Heppelmann

Yeah. So the first one is easy. That’s essentially a calendar year contract. I mean that’s not contract but a calendar year plan that we have with HKMC. So if we execute per the plan it’ll be wrapping up come January of 2012. On the second question about the verticals I mean you guys can help me here because it’s just anecdotal information I would have. If I think where have we seen a lot of strength, two areas stand out for me kind of looking back at the past few quarters. One is automotive.

In fact, I think we had 27% total revenue growth in the automotive vertical in 2010 over 2009. That’s surprising to everybody. And it probably is superior to either of our competitors who would call that their home field advantage and that’s before the HKMC win. So I think that’s one. The second is retail. We’re seeing a lot of these big box style retail companies buying PLM and PTC has an exceptionally high win rate in that vertical. And there is a lot of green field opportunity so we’re seeing a tremendous amount of activity in that vertical.

That said, I don’t see any of them as being laggards. I just see all of them as feeling pretty healthy and two of them sort of being more outstanding than that.

Ben Rose

Okay. Thank you.

Operator

Our final question comes from Andrew Kaplan of Deutsche Bank.

Andrew Kaplan

Hi. Congratulations on the Hyundai win. That’s a huge win. Just a quick question on that - you said it’s a one-year execution basically. The plan is to execute their changes that they’re requesting within a year. Can you shed some light on the economics if you don’t execute within that timeframe? That’s my first question. Second question is you took a $57 million decrease in cash position because of a litigation settlement. Any other large looming litigations that are out there that you can comment on?

Jeff Glidden

Okay. So this is Jeff. I’ll just speak to the Hyundai program. This is just phase I so there are some incentives and some contract clauses that we really need to execute and deliver this in the year. We expect this. We’ll get that done and we’re accounting for it as such. The real key for us is not any issues on this side on phase I. It’s about how do we get to phase II and phase III because this is like an iceberg. We see what we see in phase I, which is a small deployment and maybe a few hundred seats of Windchill.

Over time we think this is thousands of seats of Windchill and so that really represents the opportunity. So I think the vast majority of the opportunity is ahead of us with tremendous upside as we go forward on this. Your second question was litigation. We have put this behind us. The good thing having and by the way it was $48 million was the net effect of that litigation settlement. I think that’s behind us and that’s a good thing.

I’d reiterate that we expect very strong growth in cash in Q2 as well as the balance of the year and there are no - we fully disclose any risks or litigation out there and I think this settlement is terrific to have behind us and there is nothing else of that ilk ahead of us.

Andrew Kaplan

Thank you.

Operator

At this time there are no other questions.

Jim Heppelmann

Okay. Great. Well, that’s been a lot of good discussion and I’m confident actually through the discussion here that you guys see the HKMC win for what it is, which is a tremendous victory with some very short-term accounting discussion. But soon enough that will be behind us and PTC will continue to execute what I think looks like a great year. And I think that’s the second great year in a five-year great program and we’re well on track for both of them. So I’d like to thank everybody for joining us and well look forward to talking to you all in about 90 more days. Thanks a lot.

Operator

This does conclude today’s conference call. You may disconnect your phones at this time.

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