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Executives

Jeffrey Glidden - Chief Financial Officer and Executive Vice President

James Heppelmann - Chief Executive Officer, President, Director and Member of National FIRST Executive Advisory Board

Barry Cohen - Executive Vice President of Strategy

Kristian Talvitie -

Analysts

Richard Davis - Canaccord Genuity

Sterling Auty - JP Morgan Chase & Co

Yun Kim - Gleacher & Company, Inc.

Ross MacMillan - Jefferies & Company, Inc.

Ben Rose - Battle Road Research Ltd.

Jay Vleeschhouwer - Merrill Lynch

Michael Olson - Piper Jaffray Companies

Steven Koenig - Longbow Research LLC

Parametric Technology (PMTC) Q2 2011 Earnings Call April 28, 2011 8:30 AM ET

Operator

Good morning, ladies and gentlemen, and welcome to PTC's Second Quarter Fiscal Year 2011 Results Conference Call. [Operator Instructions] As a reminder, ladies and gentlemen, this conference is being recorded. I would now like to introduce Kristian Talvitie, PTC's Senior Vice President of Financial Planning and Investor Relations. Please go ahead.

Kristian Talvitie

Thank you. Good morning, good afternoon, everyone. Thanks for joining us on our Q2 results and outlook call. Before we get started, I'd like to remind everybody that this call and Q&A session may include forward-looking statements regarding PTC's products or anticipated future operations or financial performance.

Any such statements will be based on the current assumption of PTC's management and are subject to risks and uncertainties that could cause actual events and result to differ materially.

Information concerning these risks and uncertainties are contained in PTC's most recent Form 10-K and Forms 10-Q on file with the SEC.

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

With us today on the call is Jim Heppelmann, Jeff Glidden and Barry Cohen. And with that, I'd like to turn the call over to Jim.

James Heppelmann

Thanks, Kristian. Good morning, and thanks for joining us, everybody. Let me start by saying that, I think, all in all, Q2 was a very strong quarter. I won't tell you it was a perfect quarter, but I will say that I'm very excited about the underlying strength of our business that was demonstrated. While we posted a quarter that was ahead of our plan and at the top of our guidance range, we can still see some relatively obvious ways we can make the business even stronger going forward. We feel there's room for improvement, and with that, the potential of even stronger performance in the future.

Let me start by reminding you that since 2009, I've been saying that the primary measure of our success is our ability to deliver on this 20% earnings growth per year through 2014. So against that draw, Q2 represents another good quarter under our belt. And with very strong performance from our maintenance business and with surging demand for our Creo CAD solutions, we're confident that we'll deliver the 20% to 25% earnings growth that we've been guiding till here in fiscal 2011. So factoring in the 25% earnings growth that we had last year, finishing 2011 in this guidance range would put us well ahead of the required pace at the 40% mark of that 5-year plan, with strong momentum going forward.

I talked to you a number of times about how our 20% earnings growth plan is rooted in 4 factors, being growth, leadership, efficiency and predictability. So I'd like to reflect back on Q2 and actually the first half of fiscal 2011 from the perspective of that framework.

In the area of growth, we said we'd like to increase our organic growth rates into the low teens and drive toward a 13% growth CAGR over the timeframe of this 5-year plan. We remain confident that we have strong growth prospects with our Windchill PLM and our Arbortext SIS, or Service Information System business, and similarly with our license revenue. But to get to the low teens overall, we said we needed to increase the growth rates of CAD and the growth rates of our Maintenance business, both of which have been growth laggard in recent years.

So over the past 2 years, we put in place a number of initiatives to drive growth in these areas, including our Creo strategy for CAD, and a series of new business policies and operational improvements in our Maintenance business. Quite frankly, the success we've now demonstrated in those areas has surpassed my expectations. So the biggest challenge we have at the moment is balancing the various growth opportunities against our capacity.

As you know, we have the same sales force selling both Creo and Windchill, and the strong demand we've seen for Creo in the first half, clearly takes selling cycles away from Windchill, suggesting we should be thinking about and probably working on remedies to what may currently be a capacity limitation to our growth opportunity.

On the leadership front, we had another good quarter securing domino accounts that we've been using to demonstrate our ability to take market share in tough competitive environments. So included amongst the 3 accounts was our first true Creo domino, which was a large Japanese electronics company who decided to sweep out a mix of the Sol and Siemens tools in favor of an across-the-board standardization on Creo.

A second account was a significant European industrial company who replaced an SAP PLM strategy. And the third was TJX, a local and large retailer here in Boston, who has multiple store brands, and starting with a long list of 15 vendors and ultimately selected PTC from the short list that included Siemens and the Sol. So we have good momentum there, and we feel we're well on track for our goal of 30 dominos by year end.

On the efficiency front, we've made a lot of progress with big improvements in maintenance and much better services margins in Q2. Also in Q2, we began to migrate our R&D spending towards our longer-term business model, though, in reconfiguring these resources, we incurred a $3 million onetime severance cost in the quarter that serves to mask the progress we've made, but that progress will now become more apparent in future quarters.

And then finally, on the predictability front, our goal is to evolve toward a business mix that has less quarterly volatility. That means a strong emphasis on our portfolio of annuity customers and the significant optimization of our Maintenance business that we've been working on. The 24 large deals in this quarter, this past quarter, as well as the 22 in Q1, demonstrated that, yes, we are building a solid base of dependable annuity accounts.

If you look at the average deal size this year, you can see that we haven't had the megadeals, those license transactions larger than $10 million that we saw last year. At least we haven't had them yet, We remain hopeful. We might see some of those, but nonetheless, we remain at or above our plan in revenue and EPS outlook for the year because this base of annuity customers is really forming up nicely.

So above all, I think this quarter shows how far we've come on the predictability front, that we can reach the high end of our guidance range without megadeals and even if a few license deals slip, such as we saw in the federal and defense arena in the midst of the federal budget chaos during Q2.

So to summarize the quarter, we saw a Creo demand at levels we haven't seen since the mid-90s, but that level of activities stole some thunder from our Windchill business. We've seen the combination of strong license growth in recent quarters, coupled with tighter business policies, translate into real strength in our Maintenance business that should persist for a long time going forward.

In terms of headwinds, we mentioned in the prepared remarks that we saw a few big Windchill deals in the federal and defense sectors slipped due to the federal budget crisis that nearly shut down the government. But with that crisis now resolved, we remain optimistic we'll land those deals in the back half of the year. We also absorbed the $3 million severance in the quarter.

So when you net all that out, we still ended at the high end of our guidance ranges, so I'd have to say it was a very solid quarter, yet, we all know we could have done better. So with Windchill, Creo, Arbortext, and soon MKS, all showing strong growth possibilities, we're going to commit ourselves to ensuring that we have the balance and the capacity to capitalize on the full opportunity going forward.

If we succeed in doing that, we should be looking at a situation of increasing organic growth going in the next year. And then with MKS layered on top of that, we could very well be looking at an upper teens growth opportunity in 2012. That would put another year of 20% earnings growth within reach based on revenue growth alone. And then we wouldn't have to stretch too far to meet or surpass that goal again for the third year of this 5-year plan.

On a different note, you'll notice that yesterday we announced the management change in our sales organization, that I think is going to be a big positive going forward. Paul Cunningham was a 22-year PTC sales veteran with a long list of accomplishments. But with a new CEO and a new CFO wanting to reshape the company and move the business forward, I think we're better served by having some fresh energy and new ideas coming out of the sales leadership position.

Bob Ranaldi, who we've reappointed that position, has done very well running our North American commercial business over the past several years, it's been very strong. And then years prior to that, he played a number of roles, but in particular, played a strong role in recruiting and developing our current channel sales leader, our current European sales leader and our current Asia-Pac sales leader.

So I think Bob Ranaldi is just what we need and not the experience with the PTC system to take over without missing a beat, yet, someone who's is going to bring new energy, a fresh perspective, incredible work ethic that's going to help us evolve our distribution channel for the next level. So Paul's departure was very amicable, and we wish him the best in his new pursuits. I'm sure he'll do well.

Finally in closing, I'd like to remind you that you are invited to our Investor Day, on June 14, at our Planet PTC event in Las Vegas. This is our worldwide customer group. It's a great opportunity to meet the team, see the newly-released Windchill 10 and Creo 1 products, learn about the MKS transaction and what that acquisition is going to mean to our models going forward and so forth.

So please follow up with Kristian if you have an opportunity or an interest in participating.

So with that, I'll turn it over to Jeff Glidden, to see if he has any comments to add to that.

Jeffrey Glidden

Great. Thank you very much, Jim. I'll just make a few brief comments on Q2 and then some comments on our guidance for Q3 and the balance of the year. Just adding a few comments on the revenue mix, as Jim cited, our license revenue was up 15%, and we were impacted by lower than our estimates and lower than prior periods business from a U.S. federal operations. Just a reminder, traditionally, approximately 10% of our business over the past number of years has come from U.S. federal, so that was down in the quarter.

At the same time, our commercial business, excluding the U.S. federal, was very strong. And license revenue in those areas was up approximately 25% year-over-year. We've cited the services revenues were up 19%, it's really reflecting the strong PLM license business of last year translating into the deployments this year at major customers and those are progressing well. Maintenance revenue was really a highlight, up 7% to $132 million, again, focused on policies and disciplines and really the value of the maintenance programs that we provide to our customers.

A second comment I'd like to make is on business leverage. Q2 operating margins expanded 210 basis points from 13.6% last year to 15.7%. It's really reflecting the leverage in the overall model. And on a 12% revenue growth, we're able to deliver 30% EPS growth.

A key highlight in the quarter was cash and cash flow. Cash increased $77 million, and we ended the quarter with $260 million in cash, so we're very pleased with that. A couple of comments on MKS acquisition, we'll give you a little bit more update in June, as Jim cited. Just to reiterate, we'll be funding that acquisition through a combination of borrowings of approximately $250 million off our credit agreement and existing cash of about $54 million.

We also plan -- we'll continue and plan to repurchase some $55 million worth of stock during FY '11. So we'll continue to have very strong cash position and be in the place to fund those continued repurchases.

Now I going to close with a few brief comments on guidance. As cited in the prepared remarks and in the press release, we expect revenue for Q3 to be $275 million to $285 million. This reflects year-over-year growth of approximately 13% to 17%, so accelerating growth in the quarter. And non-GAAP EPS of $0.28 to $0.32 per share. This is up approximately 30% to 50% year-over-year, again reflecting good leverage in the model.

For FY '11, we expect revenue growth of 11% to 12% or $1,120,000,000 to $1,130,000,000 revenue. We're continuing to make investments to support our long-term growth, and at the same time, we're focused on operational effectiveness to drive margin expansion.

For FY '11, we expect non-GAAP operating margins to be between 17% and 18%, up from 15.6% in FY '10. And clearly, we expect our FY '11 non-GAAP EPS to be between $1.20 to $1.25.

Thank you for joining us, and we'll now open it up for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Mr. Jay Vleeschhouwer from Griffin Securities.

Jay Vleeschhouwer - Merrill Lynch

Jim, I'd like to ask you about sales execution, which you highlighted in your comments and in the prepared remarks. You used a phrase about the dilutive effect of strong desktop on PLM sales that you've not used before, which is to say, you've not really said in the past that there's somewhat either/or quality to desktop sales and PLM sales. When Windchill has had very strong quarters you've not suggested that, that's somehow taken away from desktop execution or sales. So could you talk about how you can improve the execution or productivity with what you have today in sales? And otherwise, what are your plans for expanding capacity? I think that was one of your priorities for fiscal '11, and then I have a follow-up.

James Heppelmann

Yes, so it's a good question, and I'm glad you brought it up, so we could talk a little bit more about it. You should imagine that we have a certain capacity. And if you look at the commercial numbers worldwide, setting aside the aerospace and defense numbers, we had some pretty good results and that capacity was fully utilized. But a typical sales guy, there's only so many hours in a day. And when you have strong demand coming for Creo, and sometimes for the same customer, you go work on that project. And so what happened is we had a lot more hours spent selling CAD last quarter than we did spend selling PLM. Now the reason we never talked about in the past is it was implicit. Jeff -- Jay, sorry, I'm looking at Jeff here. In the past, the CAD story wasn't so exciting. So all the resources spent their time selling Windchill, and that was a huge boost to the Windchill business. But what's happened is with the CAD business, with this Creo launch, and quite frankly with the strong economy and demand for more seats, we've sort of -- the CAD business has stolen back some of the resources that maybe rightfully always were due to the CAD business, but in the meantime had spent their time and energy working out Windchill deals because there was so much more demand. So I think when we say dilution, what probably we mean is there was a rebalancing of energies away from PLM toward CAD. And that just tells us that we have a limit on capacity, that is the governing problem here, and that we probably need to think more about capacity. But I think our capacity outside this aerospace and defense sector -- or really the federal and defense sector was quite productive, and we really became limited by capacity more than anything.

Jay Vleeschhouwer - Merrill Lynch

Your single largest source of revenue is still, if I'm not mistaken, Pro/E or Creo maintenance, larger than license revenues or Windchill license and maintenance. The question there is over the last year you've had, according to the data sheet, a 7,000 unit increase in your active installed base for Creo. By my calculation, over that same last 12 months here, you've probably sold, referring to the license revenues, something around 20,000 new seats of Creo, give or take. And this has been the case now for the last couple of years where there's been a significant difference between that improvement in your maintenance base versus adds to new units. I don't know if there's always a lag in maintenance, but this is a seemingly considerable one, and I'm wondering if you could talk about when there might be more upside in the active base numbers?

James Heppelmann

Let me start, and then Jeff can jump in. I mean, first, let's just talk about our Maintenance business. I mean, we're not forecasting for the full year numbers far in excess of our plan and far in excess of our original guidance for maintenance. And we think that strength will continue. So if you say, why is that? Well, number one factor, we had very strong license growth a year prior. So there's a one year lag factor for sure here. And then the second thing is, we changed some policies. As I was becoming CEO and Jeff was coming on as CFO, we took a look at some of our policies and said, why do we do it that way? Let's change it. And the combination of these 2 factors has added 3, 4 points in growth to our maintenance revenue stream, that's 45% of our revenue. And so it's pretty exciting. So I think that you're going to see next year, a strong Creo Maintenance business. And I think that, that strength will persist across the board into next year and beyond.

Jay Vleeschhouwer - Merrill Lynch

All right. And lastly, same question I asked Dassault yesterday on their call, and that is, could you comment on the profitability of your Windchill business, obviously less than the CAD business, but are you seeing improvements in the profitability of that part of the business?

Jeffrey Glidden

Yes, I'd happy to take that. So, I think, as we've said, the mix of business there is very important. The margins on license in both our CAD business and PLM are very, very strong. As you know in the license side, it's 95% margins along with the maintenance in the mid to upper 80s services with the maintenance and the mid- to upper 80s services with lower margins. So as that mix continues to shift to melt maintenance and license, and we believe that's the case certainly for the year if not for this quarter, we'll continue to see margin expansion in that side. And we said, reiterating Jim's perspective from prior quarters, our goal is first and foremost to improve the profitability on that business as well as get Creo growing. So right now, I think we've got both of those and will continue to expect improving and building profitability in the PLM business.

James Heppelmann

Yes, I think, just looking at this 4-box here, and this is only one quarter's worth of data, but it all comes down to mix. If license and service begins to outweigh and then dramatically outweigh -- I'm sorry, if license and maintenance begins to outweigh and then dramatically outweigh service, that business is going to become very profitable. And I think, just looking at the numbers here, we've now -- we're at the position where license plus maintenance is greater than service. And I don't have the trend here, but I anticipate that, that trend has been continuing to improve over time. And I think we'll continue to see that going forward. The growth in the Windchill business, maintenance business should not be missed here. That's very important. And the fact that, that business is clipping a line in that upper right box and a 15% growth rate is pretty interesting.

Operator

Sterling Auty from JPMorgan Chase.

Sterling Auty - JP Morgan Chase & Co

Yes, I want to drill into the PLM business, So you talked about the federal and the aerospace and defense. And I think you talked about a couple of large deals that slipped, but the fact that you're bringing down the license growth estimate for the year would seem to indicate that it's more than just a couple of slipped deals. So can you talk to us in a little bit more detail about the demand environment, not only in those weaker but in the other areas relative to what you've seen in the last couple of quarters.

James Heppelmann

Yes, Jim here, again. So let me first say, we didn't plan for a strong year in federal, aerospace and defense. We're aware of the macro situation, and we planned accordingly. But what did catch us by surprise was a couple of deals that we thought we were going to get, suddenly in the midst of this "we're shutting down the government" crisis, nobody wanted to spend any money on anything because they weren't sure what was happening. So these deals slipped, we think we'll get them. But I think we as a management team, clearly our Maintenance business is well ahead of plan, and clearly our license business is not well ahead of plan. Although keep in mind, we had a very aggressive plan. So I think we said, we either need to take our guidance up or we need to switch the mix around and de-risk it all a little bit. And we just thought it was a prudent move to fix the mix, add a little bit more maintenance and take some of the pressure off license, and so give you different guidance mix that gets us to the same result. I'm not sure we would give up on the idea of the license plan we had, but I think we would admit that we're going need a big back half to hit that original plan of 20% to 25%. It's more likely we're going to sort of end up in that 15% to 20% range which, quite frankly, we're still proud of.

Jeffrey Glidden

And Sterling, this is Jeff. I'd just add that we've been very focused on building these annuity accounts, really focused on that recurring maintenance stream. And when we look at the overall year, we basically -- I would suggest taking the license number down by approximately $10 million to $15 million and reflected that in increased maintenance. And that trade is always a good trade, where we're more disciplined on the maintenance side because that represents an annuity that, that $10 million will come year in, year out. And so we feel very good about it. It improves the predictability and is fundamentally a wash on margins and profitability, but it gives us much better predictable and annuity streams that we really like.

Barry Cohen

I think the main point as you were asking to is we're not seeing a lesser demand in Windchill at all. $24 million plus deals reflects quite a strong robust quarter. Our pipeline is very strong for that. Last quarter, $22 million of those deals. So we're seeing that. I think, Jim alluded to, is if you look at last year versus this year and you look at the number of megadeals about $10 million, we haven't seen those deals this year, and we haven't seen these deals yet, and certainly, if we got one of those megadeals in, it would change our outlook. And those megadeals are not predictable, kinds of deals that sort of come together and more or less based on the business planning of our customers. So I think, we feel very strong that the demand is there, that Windchill is very healthy and that will -- we see and will continue to see a growing pipeline in relation to Windchill.

Sterling Auty - JP Morgan Chase & Co

But when you say aerospace and defense, the only thing that pops to mind is some domino accounts like in Airbus. Can you just give us some confidence that the annuity-like stream out of some of those domino accounts in those industries that you pointed out as weak continue to be good?

James Heppelmann

Yes, can I just make a clarification? Normally, we have a segment we call Federal, Aerospace and Defense. For purposes of today's conversation, we've been trying to take aerospace out of it because the aerospace industry, quite frankly, is just fine. It's the federal and defense sector that's under the government spending pressure. That does not generally apply to the aerospace sector. So that should alleviate your fears now.

Sterling Auty - JP Morgan Chase & Co

All right. Great. And last question would be when you talk about maybe some capacity constraints and having to deal with that, in my mind, I have to try to -- the margin expansion opportunity versus the increased investment necessary that you might need to drive the top line, if you invest more heavily in sales and marketing capacity, what's the other lever that you can pull on to drive more margin expansion?

James Heppelmann

R&D spending is one we've talked about many times. And look at our R&D numbers, subtract $3 million of severance cost and see what they look like. I think they're pretty interesting and indicative of our movement to take R&D spending back to sort of normal levels of historical span. So that would be a key opportunity. But let me reiterate something I say each time, we're working backwards from 20% earnings growth. We are not going to come to you with a plan that says, we have a lot more growth opportunity here but, sorry, we're going to blow the margins. We're going to stay committed with 20% earnings growth. It's baked into our strategy. It's baked into our compensation. You can pretty much take it to the bank that we're going to do everything we can to deliver our net 20% earnings growth. It's just a question of what combinations of revenue growth and margin expansion get us there? The more revenue growth, the better from my perspective because the expansion opportunity -- the margin expansion opportunity doesn't go away. That just becomes more years of sustainability of this goal because we can always continue to do that when you're 6, 7, and 8, if we've been able to get there on more revenue growth than we anticipated.

Operator

Next question, Ross MacMillan from Jefferies.

Ross MacMillan - Jefferies & Company, Inc.

Jim, I was curious, just because of the original license guidance and where you guys turned out. How big is that federal and defense business for you? What sort of magnitude is it for Parametric?

Jeffrey Glidden

Yes. Our traditional, and really looking back over the last 4 years, U.S. Federal has been approximately 10% of our business. So again, that's a piece of the business that we feel very good about. There was some deferrals that occurred this quarter. I think it's clearly we've got some long-term macro trends there related to federal spending and defense. That's going to continue to be a healthy business, but probably at a smaller percentage of the business. That said, as we have cited earlier, our commercial business was up better than 25%, that's really the key driver in my mind for the growth going forward.

James Heppelmann

Just to add a little more color. Typically, we've reported our federal, aerospace and defense business is about 20% to 25% of our business in a typical year. You could basically say aerospace is half of that and federal and defense is the other half would be a good way to look at it. So that said, the federal spending is divided across many different parts of the federal government, some of which are doing just fine. Nobody's trying to cut Homeland Security spending. So it's Army, Navy, Air Force. It's NASA, it's Department of Energy and the nuclear weapons complex. It's a lot of different programs that have independent customer relationships with us. When you add them altogether, it becomes this 10%, 11% of our revenue.

Ross MacMillan - Jefferies & Company, Inc.

Great. And then on Japan, you actually look fine there. Any thoughts about, do you have any views as whether there could be a delayed impact in Japan? I was just curious because your actual license growth seems to be pretty good there.

Jeffrey Glidden

First, I should cite and just say that we have about 250 people in Japan, and the good news is they were all safe. And some of their families were impacted but we are very pleased with the leadership in Japan and really how people work through it. I think Jim's been there a couple of times, both just before and just after the event, So the business was good, and there was no real impact in the quarter. Typically, this is a strong quarter for us in Japan. We usually see Q2 being strong and that was consistent. I think we're still cautious. There's uncertainty as to what will happen in the next couple of quarters with Japan. But I think long term, it's a very resilient economy and culture. And we'd expect continued growth. We've got great leadership there, and I think the long-term view will continue to be very, very strong in Japan. But there's some uncertainty about the next couple of quarters.

James Heppelmann

Yes, I mean, let me also say, in Japan, we had a very good quarter. And that's it. I don't think all of our problems are managed with good fix. I think on the path to better and better and stronger and stronger business, this was extremely strong quarter. And we think things are getting better, but I don't think they're that much better instantly. Our leader over there is extremely good. You should know that a fair amount of that license revenue, the majority of it was closed after the earthquake. So I think that companies didn't just stop spending money. Jeff mentioned, I traveled over there. I was actually supposed to go there the Saturday immediately after the earthquake, but I postponed it a bit. I traveled from Narita to Tokyo to Nagoya and back. Incidentally, I brought a radiation detector with me. I didn't see a single speck of evidence that an earthquake had ever happened anywhere along that route. And my radiation detector didn't pick up any radiation. So I think the Japanese people who are immediately involved around the area of the earthquake and the nuclear, it's a big deal. But I think by the time you already get to Tokyo -- it's just my sense, my personal sense is that it seems far away from the people in Tokyo. And they were in the office working, and you look over at Tokyo and there's a million high-rise buildings it seems, and there isn't a single one of them damaged or anything else. It's not like -- somehow it's not as bad as the U.S. seems to report it. But I don't really want to say it's not bad because I think if you're in that immediate area, it is pretty bad. But I think that a good amount of our customers aren't there.

Ross MacMillan - Jefferies & Company, Inc.

That's helpful. Just a few quick other ones. Just as you thought about your revision to your full year license, Jeff, I think you described it is about a $15 million reduction. How did you kind of gauge that, I'm curious as to how you kind of got to that level of license growth?

Jeffrey Glidden

So we look at the business holistically. So we look at both license, maintenance and service in aggregate. And as we said, we've got major deployments underway in the services site. We have seen a mixshift, but I think it's actually healthy between -- in some cases, more maintenance and higher annuity streams from the maintenance side versus license. So I think the mix is actually a positive signal for us, and it's really based on pipeline and outlook and customer plans and programs. So I think the lift that we're seeing in maintenance, I think, it's terrific, and it's very sustainable, and at the same time, in a number of cases, because we're not forecasting large deals with perhaps a little bit more conservative on what we thought the license numbers could be this year. I think as Barry cited, there's some big deals out there to be worked, those are yet to be closed.

Ross MacMillan - Jefferies & Company, Inc.

Okay. And the very last one, just on the severance in the R&D area. Could you maybe just add some color, you mentioned automotive. I wasn't quite clear just kind of what actually you're doing there.

James Heppelmann

Okay, well you remember last quarter when we announced this HKMC contract and the accounting hit we took for it and so forth, many people said, does that mean you're hiring new people? And we said, no, we're going to repurpose. We're going to take R&D spending down. And the net effect is a transfer of resources from R&D to services from an accounting perspective. The only thing is, in taking down those R&D resources, we had to pay out some severance. So I think, it really was associated both with our general automotive strategy and then, specifically, with HKMC contract and rejiggering our resources to align with what we told you last quarter.

Ross MacMillan - Jefferies & Company, Inc.

Is it actually a transfer of employees from you to the customer?

James Heppelmann

No, no. Think of it is a transfer of employees from largely North America to Korea. But a lot of North Americans don't want to move to Korea, so it became a termination of some employees in North America and hiring of some employees in Korea. Some of the employees in Korea are not working necessarily directly on the HKMC project. We announced we were opening an R&D center in Korea to really build some automotive expertise as a company strategy around that, but a fair amount of them are people doing work in that contract for which we described the accounting last quarter.

Ross MacMillan - Jefferies & Company, Inc.

Got it. That's helpful.

Operator

Richard Davis from Canaccord.

Richard Davis - Canaccord Genuity

So first, a tactical one. Is the Q4 guide -- does that include the MKS revenues or not?

Jeffrey Glidden

It does not. We'll give you an update on that in June.

Richard Davis - Canaccord Genuity

Got it. I didn't think so, but I just want to make sure. And then the second one is, in your opinion, is Windchill 10 a margin driving vehicle for you? And also, should we kind of, adjacent to that question, assume that if I were a salesman I would kind of be pre-selling this to my customer base saying, hey, look, we got Windchill 10 coming out, it's a really whizbang improvement, maybe you should buy this. And the point is, does that give you at least notionally some cushion in your PLM business as the second half of this year rolls out?

James Heppelmann

Yes. So in the first part of the question, is Windchill 10 a margin driver? I would say yes. Because really, 2 reasons. Number one, it reduces the degree of customization. A fair amount of customization has been user interface tweaks and then a fair amount has been functionality gap-filling historically. And with 10, of course, there's a lot more functionality, but more importantly, I think the era of customizing user interface has come to an end. So there should be less customization, therefore, less services, therefore a better license to service mix. The second thing that's very important is we should also have faster adoption thereby leading to the next license order, which again, improves the license to service mix over the course of a year or so. So I think it should help a lot with the margins. And then, regarding the pre-selling, I think there was a concern that this launch of Creo was going to hurt our CAD revenue. And in fact, the launch of Creo has, in part, I want to give the economy some credit here, but the launch of Creo has caused our CAD revenue to explode, and the explosion of CAD demand has hurt our Windchill revenue. So I think, Windchill 10 is neutral on Windchill revenue, if anything mildly positive. But I think it's really this transfer of selling cycles over to the CAD side of the house because of such strong demand for Creo. I mean, I don't think anybody on this call probably were going to post a 57% license increase in our CAD business in those large accounts in Kristian's upper left box. I mean, I think we're all extremely pleasantly surprised. And if we could get all of these cylinders hitting at the same time, this is a different company than the one we're talking about here today even. So I think it's pretty interesting, but we need to execute better on multiple dimensions.

.

Operator

Yun Kim from Gleacher.

Yun Kim - Gleacher & Company, Inc.

So I just wanted to ask you regarding the business dynamics in the Creo in the quarter. So the Creo doesn't get released until the summer. So I mean, you explained that the economy contributed to the success of the CAD business in front of a major release. It's just -- is there any other dynamics that showed the strength in the quarter? Could it possibly be that people now wanting to buy Creo, and that's why they're buying the older version before it gets released?

James Heppelmann

No, so let me take you through the story again here. Nothing's changed here, but I want to remind you kind about the facts because it's probably hard to remember all the stuff. We used to have 3 discrete products: Pro/ENGINEER, CoCreate, ProductView. And in Creo, we came out with the new concept that blends these 3 together in a pretty interesting way. So Creo is actually the successor of the 3 product families. Now Pro/ENGINEER and CoCreate were never cross-sold in the past. So with our branding, we went back and renamed -- because all 3 of these products are now upward compatible to Creo, we went back and renamed Pro/E to be Creo Elements/Pro. We renamed CoCreate to be Creo Elements/Direct. And ProductView, Creo Elements/View. So those are the 3 products we're selling today, and what's happened is suddenly, we're seeing a tremendous amount of cross-sell. We are seeing the Parametric customers who formerly had Pro/ENGINEER begin to buy the Direct product, formerly known as CoCreate, and vice versa in particular. So we're seeing a cross-sell having been unleashed in anticipation of a unifying product that actually blends the 2 together in a more perfect way. So that's pretty exciting, but again, I think that's exciting and we have evidence that this Creo launch has made a difference. But I don't really want to take it away from that fact people are hiring more mechanical engineers, and they simply need more seats as well. So it's really probably, first and foremost, better economy, secondarily, maybe a third of the factor, is the cross-sell that we've unleashed in anticipation of the unification.

Yun Kim - Gleacher & Company, Inc.

Okay, great. That's very helpful. And then I just want to make sure, given the constraint in your sales capacity that you mentioned, do you plan to accelerate sales hiring in second half of the year?

James Heppelmann

Yes, I think we're going through a planning process on that dimension right now. I would anticipate our June Investor Day might be an opportunity to give you an update on that. We've not yet authorized that. Normally, going into the next fiscal year, starting October 1, we would authorize a new wave of capacity. The question for us is, can we accelerate that and begin some of that hiring in anticipation of next year earlier than October 1? And that's an open question that we can give you an update on in June.

Yun Kim - Gleacher & Company, Inc.

And I just wanted to sneak one last one in. Jim, what has been the initial reception regarding the Windchill 10 release, so far?

James Heppelmann

It's extremely positive. We had one small VAR account that told us it took a day to install it and go into production the next day. So very small customer, like 8 seats or something like that. We've had many, many big customers participate actually in the development of the software and then comment on it afterwards. So I think Windchill 10 is going to be a blockbuster release. I think it's a little unfortunate for the Windchill fans out there that Creo blockbuster release stole some of its thunder, but trust me, that Windchill 10 product is going to prove very material to our results going forward.

Operator

Thank you. Steve Koenig from Longbow Research.

Steven Koenig - Longbow Research LLC

I guess I'll start with my easy question first, and then I got a little bit more involved one. The short question is, can you all explain how you will differentiate MKS from the embedded systems functionality that Dassault has? Are you all approaching the market differently or do the products compete pretty head-on?

James Heppelmann

Well, Dassault formerly had no capability in this area. They, about -- I don't know, maybe a year ago acquired a little company called Geensoft, which is I think it's $1 million revenue company based somewhere in Europe. So Dassault bought a small little player who has stitched together some open source products. We bought the industry leader, or in the process of acquiring the industry leader whose doing $75 million in revenue. So I suppose, you could say the 2 compete, I think, that we have the industry-leading platform, the best technology, the most customers, the broadest footprint, the number one position by a factor of 10. So that's how I would characterize it, Dassault will be a competitor, but we think they're not necessarily a strong competitor.

Steven Koenig - Longbow Research LLC

Got it. Okay, that's very helpful. And then the more involved question is about just wanting to get your updated view on the market growth rates in the CAD and the PLM segments. And then, how you guys will compare to that. And the backdrop for this would be just looking at organic growth rates from you guys versus Dassault. We don't have the UG [ph] numbers. You guys were ahead of them last year in growth, and PLM really drove that. The last couple of quarters, they pulled even pretty much on those organic constant currency growth rates.

James Heppelmann

Hang on, though, Steve. Dassault hasn't posted any organic growth rates in 4 quarters now. Because they're rolling IBM into their numbers.

Steven Koenig - Longbow Research LLC

We're doing that backing, We're looking at the combined IBM, Dassault, 12 months ago versus what they're doing now, so that's somewhat of an organic calculation. But leaving that aside, I guess my real question here is, you referred to the PLM market, the upper right boxes, kind of a 15% fitness. So I'm wondering what you think the growth rate is there about the market and for you guys, and kind of same question for CAD.

James Heppelmann

Yes, I think, I'm reading the same data Kristian gave me as they gave you here. But looking backwards, it's sort of been the upper single-digit 9%, 10%, 8% to 10%, let's say, percent growth for the industry -- the PLM industry, and CAD's probably been 3% to 5%. We have been a strong over-performer in the PLM segment because we've had a 17% growth CAGR in that upper right box, or actually that red column, during a period with the -- for many years while the industry was growing 8% or 9%. So we've doubled industry growth historically in PLM. And we probably lagged industry growth in CAD by 1% or 2%, maybe the industry was growing 4%, and we were growing 2% or 3%, during much of that period. 2009 aside, when nothing was growing for anybody. I think going forward, we think we're going to continue taking market share in PLM. We didn't necessarily take any this quarter, but this quarter we probably took a lot of market share in CAD, certainly from a revenue standpoint. I would expect that this phenomenon of explosive growth in CAD will probably temper itself a bit over time. And that the growth in our Windchill PLM business will accelerate again. And I think we'll probably get back to a situation where we're a low teens organic grower based on a Windchill rate greater than low teens. And a CAD rate probably in mid -- currently, I believe, mid upper digits for some time now -- mid to upper single digits.

Operator

Ben Rose from Battle Road Research.

[Technical Difficulty]

Ben Rose - Battle Road Research Ltd.

On HKMC, can you give us an update on any milestones that have been reached thus far? And your perspective on how things are looking going into this next portion of the year? And then a follow-up would be, and I will limit myself to one follow-up would be, any evidence that HKMC is turning the heads of others in the automotive industry?

James Heppelmann

Yes. I think just to be honest, Ben, it's a little too early on both of those fronts. Most of our early milestones at HKMC have really been around mobilizing the resources to do the project, and we're doing fine there. But it's too early to declare ourselves ahead or behind schedule in any meaningful way. And then I think on the sales front, I certainly couldn't point any revenue, but I think we've engaged in a series of conversations where people want to hear what's going on at HKMC. Incidentally, the same automotive companies want to hear about what are you going to do with MKS because MKS has quite a bit of traction in the automotive industry as well.

Operator

Your last question comes from Mike Olson from Piper Jaffray.

Michael Olson - Piper Jaffray Companies

Just a quick one here. Back to this question about resources going into Windchill versus the CAD side and the focus shifting somewhat back to CAD. You guys have clearly been taking share in PLM over the last few years. Is it possible that with Creo and all the resources you're putting in on the CAD side that we'll actually see an increasing ability to gain share on the CAD side, or is it more the case that competitor implemented CAD systems are just generally too sticky to push out and replace?

James Heppelmann

I think we are going to take some share. I mentioned we had our first Creo domino. The first account where we could say this really was a situation where they like that Creo story better than these competitors and decided to turn off competitor seats to standardize on Creo. I anticipate we'll have more of those going forward. One of the interesting things about Creo, remember we talked about AnyMode Modeling, AnyBOM Assembly, AnyData Adoption, et cetera. This AnyData Adoption concept really allows Creo to bring data in from other CAD systems in a much more meaningful way that has been historically possible and use that data productively going forward. So I do think we're going to be able to take share, and I think really, it's going to be this combination of the story of Creo, Windchill, Arbortext, MKS, Relex, et cetera, that just becomes so compelling that one becomes increasingly tempted to bite the bullet and switch out to CAD tools as well. Some of our competitors have probably not done themselves any favor by being a little heavy-handed with their customers. So there's also a base of frustrated customers out there, from one competitor in particular, that are somewhat vulnerable. And so, I think we'll be able to take some share.

Kristian Talvitie

.

Great. Thanks very much, everybody, for the questions. And we look forward to seeing you all, or anybody or any of you that can make it to Las Vegas, in June for another update. Thanks again.

Operator

Thank you for participating in today's conference call. This concludes today's call. Please disconnect at this time. Thank you.

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