PTC Inc. - The Old Gray Mare Is More Than What It Used To Be

| About: PTC Inc. (PTC)

Summary

PTC's recently reported quarter better than suggested by headline presentation.

PTC guidance already reflects headwinds from the worldwide manufacturing slowdown, exchange rate fluctuations and the shift to a subscription based revenue model.

PTC has a leadership role in the Internet of Things (IoT) that is now linked with its basic solution set.

PTC is a prime potential acquisition target.

PTC has a visionary CEO coupled with very strong financial management.

Introduction:

Sometimes when I think of the companies that I follow I see them in colors. For example, I see Salesforce.Com (NYSE:CRM) in hot pink, I see SAP (NYSE:SAP) in forest green and I see Oracle (NASDAQ:ORCL) - well I see Oracle as a brown study. I have always thought of PTC as a company colored in shades of gray. Somehow it is hard to get particularly excited about a company whose software basically enables computer aided product designs (CAD). A few years ago the company expanded its foot print from CAD to Product Lifecycle Management (PLM), which for me is another shade of gray. And more recently it expanded yet again to cover Application Lifecycle Management (ALM) and Service Lifecycle Management (SLM). Given that it is a vendor who specializes in things, it decided early on to make a significant commitment to the development of solutions for the Internet of Things (IoT). But for some years this has been a grey company, at least to me.

The other day the company released its results for Q1 fiscal 2015 and while it seemed to be a typical PTC quarter in which revenues missed but EPS was an upside, I was able to discern certain signs of a pink dawn in the grey overcast. Like almost all enterprise software vendors, PTC has been moving to a recurring revenue basis. It would be somewhat difficult, I think, to implement a true cloud for some of the very complex and very customized solutions that this company offers. I just don't think it would make sense for a large aircraft or automotive vendor to try to design their products through a remote, centralized cloud when they are managing literally millions of part numbers. That being said, however, PTC has kept pace with market needs and 28% of product bookings were subscription based significantly ahead of prior guidance. Overall product bookings of $69 million were at the top end of the company's range.

Needless to say the high mix of subscription had a negative impact on license revenues which on a constant currency basis fell by 2%. And consistent with typical PTC's history, operating expenses excluding a significant restructuring charge declined by a few percent. Overall, PTC was able to report EPS of $.50 for Q1 of 2016. The impact of a dramatically higher subscription mix and the significant impact of FX on this company which has a very high percentage of its installed base overseas cost the company a total of about $.11 in reported EPS. Given the severe earnings headwinds during the quarter, PTC's ability to print a significant upside EPS surprise was a significant accomplishment, in my opinion.

The company provided guidance that seemed to fall short of some expectations with regards to potential performance in the March quarter although most of that in reality had to do with a combination of seasonality which tends to be under rated by analysts coupled with the continuing swing to subscription bookings. The company forecast full year EPS expectations consistent with current forecasts but in essence raised its full year subscription revenue expectations and its overall product bookings forecasts. There are still plenty of grey clouds hanging around but it looks as though the sun is beginning to poke through. Investors ought to note of some of the encouraging developments at the old gray mare.

Investment Thesis:

Like almost all enterprise software companies, PTC shares have pulled back in the last few months. The shares are down about 15% since the beginning of November. The shares trade at a valuation that can best be describes as moderate. The shares are now selling for 3.3 EV/S with a PE based on forward non-GAAP earnings of a bit less than 17X. The company has coverage by 9 analysts who rate the shares at 2.1 on a scale where 1 is a strong buy and 5 a strong sell. Fairly recently, there was an enlightening article by Seeking Alpha Contributor, Terrier Investments, regarding the company's strategy. The company's guidance is for essentially a small decline in total revenues and a somewhat greater decline in non-GAAP EPS. And analyst estimates suggest more of the same for fiscal year 2017 (ends 9/30) with a small decline in revenues and a somewhat steeper decline in EPS. (I should point out that this year's estimates are significantly depressed by both currency fluctuations and by an accelerating swing to subscription licenses. Absent those two factors and further adjusting for the recent small acquisition the company made toward the end of the calendar year, it would appear that "real" growth is perhaps 5% or thereabouts. One should also be aware that PTC has a long record of under-promising and over-delivering when it comes to earnings guidance. Indeed, the past 4 quarters all showed earnings beats ranging from 4% to 16% that were in spite of declining sales.)

Given that background, why do I think PTC shares are a decent buy at current levels. My thesis has three basic pillars: 1) This company shows a significant correlation with the worldwide manufacturing economy. Its results and its forecast already reflect the significant slowdown in the manufacturing economy seen in most worldwide economies and more recently in the US. The downside is already factored into the current valuation, I believe and should central banks succeed in preventing a further decrease in the growth of the macro economy this would be a significant positive for PTC whose results are highly correlated with macro conditions and the manufacturing sector in particular.

Specifically, the company announced a significant RIF in conjunction with its earnings release which will probably reduce operating expenses by as much as $50 million on an annual basis. If revenue declines are less than forecast, the combination of falling expenses and greater revenues will likely have a significant impact on non-GAAP operating margins that is certainly neither anticipated or is part of the company's current share valuation.

2) The company as I detail below has an outstanding product portfolio and most importantly all of the products work together in what is meant to be a seamless fashion. I think that many of the company's customers have chosen to work with PTC not because of the value of individual solutions per se, but because there is integration between products on the desktop, enterprise products, service products and now products that help users to build out their own Internet of Things offerings.

3) The company's CEO, Jim Heppelmann has built an effective and flexible management team since he ascended to his current role in 2010. Heppelmann is an exceptionally impressive leader who has been able to combine deep technology skills with enough common sense to lead an organization that has to be sales focused. The former CEO, Dick Harrison, was an effective and well respected sales leader but visionary strategies and long term thinking just wasn't part of his makeup. While Heppelmann had been a senior executive of the PTC since his Windchill company was acquired by PTC back in 1998, some of the steps he has taken, particularly are just now starting to bear fruit and he has been quick to take advantage of the opportunities that PTC has in the emerging IoT space.

A quick aside here. Some readers are going to cavil that IoT is just another software buzzword and that the concept is over-hyped and will never achieve remarkable acceptance. In the last quarter, IoT, or what PTC now described as its Technology Platform Group, accounted for a bit more than $13 million of revenues, or about 5% of the company's product revenues. Growth for the quarter was 33% which understates the actual trend; the prior year's period had seen several large license deals. The company closed 65 new logos this past quarter up from 42 in the prior year's period.

The growth of IoT is being driven by manufacturers looking to either differentiate their products or to respond to competitors who have already started to embed IoT capabilities. Whether or not readers think much of connected stoves or refrigerators or plumbing valves, enough consumers apparently want the technology and are willing to pay for devices that embed the capability. Personally, I can't imagine using a connected washing machine but that doesn't mean I don't appreciate that some cohort of consumers thinks the capability very important and will pay a premium for products that have it available.

I once spent a very long hour being briefed by a PTC marketing person regarding the enhanced functionality that its then new CAD product, Creo, had over its predecessor. I doubt that I could repeat as much as a single sentence of her presentation. That didn't mean that because I had no idea what the benefits of Creo were in the mechanical design industry that I didn't realize its importance to the future of PTC. Just because I have no use for connected washing machines doesn't mean that they won't be sold in the tens of millions.

To sum it up, PTC has a moderate valuation based on results that are already significantly depressed by the worldwide manufacturing recession. The company has already taken aggressive steps to manage costs during a period in which revenue growth is harder to come by. Analysts and investors are anticipating the worst in the manufacturing space and they have based their forecasts for PTC's operations on a very negative outlook.

PTC has an exceptionally diversified product portfolio within its core competence. This portfolio is likely to cushion the worst of the downturn in its legacy products in CAD and in Product Lifecycle Management. The long term opportunities in its newer solution sets such as Service Lifecycle Management and Application Lifecycle Management are probably somewhat greater than the opportunities in PLM and much greater than the minimal growth opportunities that remain in the CAD space. The company has a toehold in the IoT space that is likely to serve as a major revenue driver as the technology matures and is more broadly accepted. The company has a strong leader who has surrounded himself with a strong team. I think it is worth the macro risks that prevail to initiate positions in PTC shares at these levels.

Background-PTC's Fascinating Solution Set

PTC over the years has built a portfolio that is one of the more interesting in the enterprise software space that might best be called "product development" software. At one point where the company essentially had two major product families, CAD and PLM, it reported its revenue split between those two product sectors. Now with at least five major product sectors as described below, it only reports product revenues split between all of its design solutions and products that address the nascent IoT market which is just 5% of product revenues at this point.

The company is probably best known to investors as one of the leading players in the Computer Aided Design (CAD) space where it competes against companies such as Adobe (NASDAQ:ADBE) and Autodesk (NASDAQ:ADSK). It is also one of the major players in what is known as the Product Lifecycle Management arena where its principle competitors are Siemens (OTCPK:SIEGY), Dassault (OTCPK:DASTY), Oracle's Agile product family and SAP . In addition, both Adobe and Autodesk offer PLM solutions but are not primarily known as competitors for major enterprise class deployments in PLM. The Siemens product family is the result of an acquisition a few years ago and includes a CAD product. Dassault, which was founded with just a CAD offering acquired an American company called MatrixOne in 2005 that is the current basis of its technology Obviously SAP and Oracle offer solutions that are integrated with their ERP offerings and for some users that is telling. On the other hand, in industries where product design means virtually everything such as aerospace, automotive or really anything that has lots of parts and components and numerous shapes and sizes and options, best of breed suppliers including PTC appear to have significant advantages and while it is difficult to determine, in recent years it would appear that PTC's Windchill PLM offering has been gaining market share.

PTC has also entered the market for what is called Application Lifecycle Management. ALM is a tool that essentially automates the design of chips with embedded functionality, dramatically improving the productivity of designers within that discipline. The use of ALM technology also insures the compatibility of product families from one generation to the next. from one generation to the next.

PTC has also entered the market for what is known as Services Lifecycle Management Again, PTC entered the SLM market through acquisition buying a company called Servigistics in 2012. Servigistics products essentially help manufacturers to optimize parts stocking strategies and improve the performance and the profitability of their service operations which have become an increasingly significant revenue component for many manufacturers in recent years.

Not too surprisingly given the overall thrust of the total PTC solution set, the company entered the market for what is called the Internet of Things at the end of 2013 with the purchase of a company called ThingWorx. ThingWorx is a toolkit that allows users to build applications to facilitate machine to machine communications. At this point, it is the core of PTC's overall IoT solution set. Subsequent to the ThingWorx acquisition PTC has purchased Aveda, a company which essentially builds solutions that allow manufacturers to securely connect their products and sensors to the cloud. Last year the company bought ColdLight (Vuforia) from Qualcomm. ColdLight is a solution set can be built so that it will analyze the performance of devices and components and it uses predictive analytics to …well to predict when failures are likely before they happen.

PTC has been a very acquisitive company since it was born 30 years ago. It has acquired well more than 25 companies since its founding as well as several products families and the acquisitions are really the backbone of what the company sells these days. A couple of key acquisitions along the way have included Arbortext which is a publisher of service manuals and documentation and MathCad which essentially automates engineering calculations facilitating reuse and graphical presentation. Almost all of PTC's acquisitions have been strategic in that they filled product gaps in the company's offerings. Unlike many acquisitions made by other software vendors, most prominently Oracle, PTC for the most part has moved rapidly to integrate their acquisitions as part of a coherent solutions set and to attempt to use leverage their existing customer base as a target for their new acquisitions and vice versa.

Most recently, with the release of WindChill 11 in November of 2015, PTC took the initial steps to "close the loop." That is the company now has tools that allow the feedback of data to product developers from the IoT platform that users can purchase from PTC. It is, potentially a powerful marketing tool although there is plenty of skepticism within the engineering community that the functionality that PTC has announced can actually be delivered. Some industry consultants have written in surprisingly frank language that there are concerns that PTC has been spending too much time and investment in IoT at the expense of advancing product design capabilities.

It would be terribly presumptuous on the part of this writer to attempt to suggest that there is today a knowable answer to the question as to whether PTC has bitten off more than it can chew and has not taken proper care of its most important product. I wish I had some way of knowing the future with regards to that and many other things. That being said, I would suggest the following. PTC's share price in no way discounts the kind of growth that a successful implementation of this strategy could produce. If it works, PTC will achieve growth far beyond consensus numbers regardless of the transition to a subscription based revenue model. If it doesn't work…well in essence, that is what analysts are suggesting with their forecast of a further small decline in fiscal '17 revenues. Not the worst bet that investors can find in the enterprise software space.

It is very difficult for outside observers to determine what the real normalized organic growth rate for PTC is likely to be. At one time before the company dramatically increased the complexity of its product offerings it spoke to an organic growth rate in the low teens which was the product of minimal growth in the company's desktop or CAD products and 20% growth in the company's PLM offerings. Obviously that kind of revenue growth hasn't happened for several years and for many reasons. And now, in the midst of a significant transition in the revenue model from perpetual to subscription based it is hard to know when the company will be able to start to grow "headline" top line numbers at a meaningful rate. Management has presented its calculation that each 1% change in subscription mix will raise or lower annual revenues by approximately $3 mil and will either add or subtract from non-GAAP EPS by $.02 per year. But management hasn't provided outsiders with a "waterfall" calculation that will try to estimate how the impact of rising subscriptions might be offset by the multi-year impact of subscriptions. At some point, but one not known, the impact is going to be positive and when that happens growth and operating margins are going to show dramatic improvements.

PTC as an Acquisition Candidate

PTC has been a prospective acquisition for many years now and at some level I have been surprised that it hasn't been consolidated. It would fill gaping product holes for either SAP or Oracle whose solutions in the space are far less functional than what PTC offers and whose pervasive distribution networks could almost certainly achieve significant revenue synergies. Were IBM to attempt to reimagine its software offerings in a bold, outside the box fashion, this would be an interesting acquisition. While the company's valuation is not dirt cheap, neither is prohibitive. The company's CEO is certainly an industry visionary who enjoys the challenges of his role; on the other hand, Mr. Heppelmann has been in harness at PTC a long time and he is more of an industry intellectual who might wish to devote further time to research and writing than managing. It is really impossible to forecast acquisitions in advance. No one can know anything substantive and if one did the fact couldn't be disclosed. All I can say is that if I were a corporate strategist, it would seem to me that acquiring PTC would be a real coup that could have unimagined positive consequences for the potential acquirer.

Conclusion:

I think that a commitment in PTC shares a reasonable bet at current prices. The company reported what was essentially a better than anticipated December quarter despite stiff macro headwinds in the manufacturing space. Analyst expectations for the company's performance are quite modest given the costs of transition to a subscription based revenue model, continued impact of exchange rate fluctuations and fierce headwinds in the manufacturing sector to which the company's performance is strongly correlated. It would seem that for the most part, the current share valuation which has slipped 15% since the start of November is already discounting many negatives and takes no recognition of potential positives.

The company has an early leadership role within the IoT space which seems destined to be an important revenue contributor for this company. It's closed loop solution that is beginning to emerge has been described as "a brilliant idea, elegantly coherent and with data-driven predictability."

The company has strong financial management and a visionary CEO. I am sure there is plenty of controversy regarding the company's competitive positioning. It has major roles these days in 5 spaces and it would be surprising to me if it were not deficient in some aspects of some major product lines. But it does seem to have done an outstanding job amongst its competitors of "putting it all together" and management has done an excellent job in attracting new logos. I think the risk/rewards favor investors at this point.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.