PTC: That Old Gray Mare Begins To Trot

| About: PTC Inc. (PTC)


PTC's apparent miss reported last week turns out to have actually been a beat-and-raise quarter.

Last quarter's results suggest that PTC is one year ahead of its plan to establish a subscription-based revenue model.

Revenue for the company's traditional family of products has muted growth potential.

The key to the company accelerating its top-line growth is in its IoT product initiatives.

The company has a real set of products in that space, and the market potential is vast.

PTC - Another Milepost On The Company's Transition To Cloud

PTC Corp.'s (NASDAQ:PTC) shares are up 28% in the last three months since I first wrote about the name. That is not an insubstantial move when compared to the software index IGV, which is up 10% over the same time frame. So the question has to be whether or not the shares still have positive alpha potential going forward. As I recently wrote on this site, I think that PTC is one of those companies in the midst of a multi-year transition to cloud that will significantly change the financial basis of the company. That transition took a significant step in the recently reported quarter when cloud bookings dramatically accelerated and went from 14% of total bookings to 54% of total bookings in just one year. Investors are far more likely to value companies that have completed their cloud transition far more highly than those still struggling with that process. If ever there were a proof point of that thesis, Adobe's (NASDAQ:ADBE) shares would be the poster child for such an assertion.

But is there anything about long-term growth that might support continued alpha upside for this name? PTC fundamentally sells to the manufacturing space, and whatever else is true about the macro economy, the manufacturing space remains in a significant recession both in this country and globally. PTC managed "real" bookings growth of 8% last quarter, which is a considerable achievement in a period in which many of its customers are showing negative growth, but it is still 8% growth. I think the answer to the question posed above is that there are two factors that might support continued positive alpha. One is the completion of the transition and the substantially higher operating margins that are likely when it is complete.

It is almost impossible to handicap PTC's margins during its transition or better put, its reported margins. PTC has constructed a formula that suggests that in the year it happens, every 1% change in the subscription mix will impact annual revenue by $3 million and impact annual non-GAAP EPS by $.02. The problem with the formula is that it really doesn't account for what happens in the second and the third and the fourth years and so forth, when the higher subscription mix will add to revenues from the software service turned on in prior years while reducing the earnings for the software turned on in the current year. I just don't think that watching either reported EPS or reported operating margins will mean much to investors during the transition.

The company has a sustained history of strong financial discipline. If PTC needs to take cost reduction action to ensure margins, I have no doubt that it will. It has done so more than a few times in the past and it is in the midst of yet another cost reduction at this time. The company's margin goal post transition is in the low-30% range. Operating margins as reported were 14% this quarter, although if one were to reconstruct financial results absent the transition, margins would have been 21%. But on a reported basis, the company plans to double margins, and I think that is a reasonable goal.

How can investors measure financial progress during the transition? There are going to be financial markets of significance including bookings growth, the growth in deferred revenues and the growth in the Annual Recurring Revenue (ARR) metric. The company is now forecasting that ARR will reach $79-84 million this year, which is 50% greater than PTC's prior forecast. That is the kind of metric that investors ought to focus on. There have been cases where investors simply chose to look through the transition and value companies based on ultimate cash flow goals. Just look at the performance of Aspen's (NASDAQ:AZPN) shares during its transition to a subscription model to see that in operation. But I'm not sure to what extent this company's shares will track the performance of Aspen's shares absent some other meaningful strategy that can change the growth trajectory of the company.

How To Produce Positive Alpha While Not Producing Impressive Headline Numbers

So what might be able to produce positive alpha for this company? Simply put, it may be the revenue generation from the commitment this company has made to the Internet of Things (IoT). PTC is led by a visionary engineer and not a finance guy or a sales guy. Jim Heppelmann essentially was one of the principal developers in what is today the PLM space before he sold his company, Windchill, to Parametric more than 15 years ago. It is not terribly surprising that he is betting much of PTC's future on a new technology.

At this point, PTC has made a significant commitment to the Internet of Things in terms of acquiring a bunch of companies in the space. The IoT at this point is not a make or break business imperative for PTC. It is, however, the business that will either lead the company to double-digit growth or not depending on its success.

There are many things that are creatures of the devil in the analysis trade. One of those things is forecasting long-term growth rates, which has to be done in order to value companies. But how do you handicap the potential success for PTC in a space that is still in its infancy with products that are just now starting to be sold? One of our former presidents talked disparagingly about "the vision thing." And I imagine many readers are pretty dubious about management's vision as a mechanism in constructing a valuation matrix for a company such as this. But sadly, creature or the devil or not, if PTC is to have some longer-term positive alpha, it is necessary to investigate its presence in the IoT and try to evaluate how that is going to turn out over the years. In short, does it have the right vision to become a leader in the space?

The enterprise IT space is full of hyped trends, but just because they are hyped doesn't mean the trends aren't real. Latest industry analysis suggests that there will be somewhere between 20 billion and 30 billion "things" connected by 2020. Most of the use cases, while clearly futuristic, are more evolutionary than anything else. The fact is that there are already a few wired cities and as this writer can testify there are such things as wearable heart monitors which are connected to nurse stations. Perhaps the biggest deployment to date is that of the city of Songdo, South Korea, which is apparently completely wired with sensors that monitor all vital services and traffic and do so on an autonomous basis.

Analyst projections as to the size of the market are truly amazing, I think. The former CEO of Cisco (NASDAQ:CSCO) has said that he believes the market to be worth $19 trillion. I confess that my mind can't really wrap itself around that $19 trillion estimate. GDP in this country has yet to reach $18 trillion although it is close. Most other estimates from industry consultants forecast the market to be half that size. But my point here is simply that relative to the current size of PTC, which is forecast to have revenues just above $1.1 billion, the opportunity is vast.

PTC plans to focus on just one component of the IoT market where it already has a significant footprint and that is in maintenance for manufacturing companies. The fact is that it would be highly useful for factories and their equipment to be connected in order to schedule preventive maintenance and to reduce unexpected downtime and to measure and improve productivity.

I plan to expand the specifics of the PTC IoT strategy below, but first I want to review the operating performance for the quarter and comment about the company's forward guidance.

Going From 0 To 60 In About One Year

The recent quarter that PTC reported was not really a particular blowout although the company did exceed its prior bookings guidance by about 6%. The 8% growth in bookings is a nice achievement, particularly with the fierce macro headwinds the company faces in trying to sell to its large base of companies that actually make things, i.e. manufacturers. But as there is little sign that the recession in manufacturing is even abating, the macro for PTC is unlikely to improve any time soon. Full-year operating margins are forecast to be between 18% and 19% due to the higher subscription mix. One thing that helped drive performance in PTC's Q2 was what management calls a support conversion program. Simply put, support conversion for PTC means moving users from traditional maintenance agreements to becoming subscription-based cloud customers. The interesting thing about the program, at least to me, is that the large customers moving to subscription increased their Annual Contract Value (ACV) by 25-50%. I'm sure that kind of uplift will not persist. Maintenance is currently PTC's largest source of revenues generating well more than 50% of the total, and the company is not going to grow 25%-plus just by converting that base to subscription contracts. But even a modest uplift from the process would be meaningful for this company.

When the company started its transition it forecast that by the end of the third year, it would see a mix of 70% subscription and 30% perpetual. Current guidance is for 44% subscription this year, which is one year ahead of plan. Management is now speculating that it may be able to drive that 70% number to higher levels. In North America, last quarter, the mix was already 70% subscription. Management implied that if it were able to do so, it would want to reach a 100% subscription mix. For users, the crossover point, in terms of nominal cost, is probably around four years. In other words, if you plan to use a solution for four years or more, perpetual will be cheaper. But as I tried to point out in a prior article, that number is very suspect because of increasing maintenance pricing for software, the costs of extra personnel and the costs of operating data centers. I have no way of quantifying all of that, but if the notional crossover point is four years, then the real crossover point is probably 6-7 years. And there are very few users who actually are going to want to stick with a six or seven-year-old system, even in CAD. Things simply change too fast for that to happen. If I were doing my own long-term model for this company, I would imagine that within the next five years, subscription revenues will make up more than 90% of the total although the process of converting 25,000 maintenance paying customers to subscription is not going to be simple.

Management has yet to provide anything more than qualitative detail regarding its success with the company's IoT initiative although it is now described as "popping up all over." We do know that its platform revenues are running about 8% of the total and were up 15% last quarter on an organic basis, but not all of platform revenues are derived from IoT. About all of the quantification that the company provided was that 4,000 developers have downloaded ThingWorx software. Obviously, that number includes multiple developers within different organizations. Management didn't discuss the number of new name logos represented in the 4,000 developer cohort.

Management, at its last investor day, suggested that it wants to return to posting consistent low to mid-teens percentage top-line growth. That would be a greater achievement than it might seem. Revenues this year, mostly due to the impact of the transition, are going to be 8% lower than revenues were in fiscal 2013. There was a brief period at the end of the Great Recession during which the company was growing its PLM revenues by more than 30% a year and then when it replaced its CAD suite with new technology it kept that growth spurt going for a little while longer.

Now, however, growth has been non-existent over the last three-four years, so reaching the low to mid-teens in terms of sustainable growth is going to be a marked achievement if PTC can pull it off. And to evaluate that potential we have to turn to evaluating how the company is likely to do with regard to its solution set within the IoT.

Can PTC Actually Become A Leader Within The Part Of The IoT Space That It Chooses to Address?

Before turning to that question of Parametric's potential role in the IoT with a modest bit of detail, it is probably well to expand on why it is so important for PTC. PTC these days derives its revenues from a vast array of different solution offerings. It sells CAD, which is called Creo; it sells PLM which is called Windchill; and it has essentially invented a product category called service lifecycle management (SLM) an acquired another category called application life cycle management (ALM). It lumps those products into what it calls its solutions group.

No one thinks that CAD is much of a growth market for anyone these days. The growth in the number of product designers is minimal. Whether or not CREO has a better solution than major competitors Autodesk (NASDAQ:ADSK) or SolidWorks is something I will leave to others. Market shares in CAD change glacially if it change at all.

It is really difficult for most observers to forecast the growth rate for PLM solutions. The major issue is that PLM's customers have been mired in their own recession for years. The other reason is that there seem to be an absence of mega-projects out there. A few years ago, PTC was deeply engaged with Airbus (OTCPK:EADSF) and with Korean car makers that had major projects. There seems to be an absence of that these days. So, it is very hard to determine if the market is growing in PLM or if this company is taking share from either Dassault (OTCPK:DASTY) or Siemens (OTCPK:SIEGY), the two major competitors in the space.

SLM probably has a better outlook than the other two major buckets in PTC's solution bucket, but it is the smallest revenue contributor of the three. Last quarter, adjusting for currency and adjusting for the business model transition, revenues in the Solutions Group were flat.

The Solutions Group currently makes up 92% of PTC's software revenues. It is going to be quite difficult for PTC to achieve double-digit growth without some contribution from the Solutions Group to growth.

At the moment, analyst consensus rating on the shares is 1.9 on a 5-point scale with 1.0 being the highest possible rating. The mean price target overall is $44 compared to the company's current share price of $37. And no analysts are forecasting any growth for this company for more than the next two years because of the transition.

So, the only way that PTC can really show significant sales excellence is going to be through the IoT set of solutions. While the revenue segment in which IoT products are located, the Technology Platform grew by 99% last quarter, much of that growth was inorganic. Growth on an organic basis was 15%. The company is seeing a fair number of new name accounts buying its IoT offerings. In the first six months of the year, the company has added 131 new logos, as defined, a 26% increase compared to last year.

Making pronouncements about a space that is in its infancy and trying to forecast the success or failure of individual vendors in that space is really one of the more fraught exercises I can imagine. Every software vendor - or most every software vendor - is going to want a piece of the IoT market. Whether or not the market really is $10 trillion-plus I will leave to wiser heads. But it will be a very large market in which to sell or lease enterprise software.

This company has adopted a variety of arcane product names for its entries in the IoT market. I can't really avoid using some of them as annoying as that may be. The company recently introduced a Freemium model for the company's ThingWorx technology. The company sells what it refers to as a "Smart Manufacturing" solution in which it uses its software to monitor the performance of machines and factory buildings. It bought a company called Kepware because Kepware's KEPServerEX provides instant connectivity to all kinds of industrial information. A couple of months ago, PTC put together something called the ThingEvent, perhaps not the most fortunate name for discussing maintenance solutions. My own recollection is that the Thing was a down market horror movie that was reprised a few years ago with an even more down market horror movie. Sometimes writing about the IoT or what is called Augmented Reality might seem like a horror movie - but it is really the key to understand where PTC wants to go.

AR is a solution that allows its users to dramatically improve the productivity of service personnel. One user said that "The ThingWorx platform and the other PTC solutions that ThingX enable will allow Schneider to connect the dots." Another user, a motorcycle manufacturer, said that "AR will really speed up more complex tasks by allowing the technician to find information and understand it much faster than today." Trying to simplify what PTC wants to accomplish is that PTC is taking data collected by sensors within machines and other parts of the manufacturing process. It then uses advanced algorithms to analyze the data and advise plant operators of any maintenance that will need to be done before a machine breaks down. If a machine does break down before it is repaired, the software helps technicians figure out what is wrong with the process and to fix it more quickly.

I would not necessarily put too much stock in the reaction of industry analysts to the burgeoning PTC IoT ecosystem. Analysts have a self interest in writing favorable reports because they may get consulting assignments by praising products. But for what it is worth, one leading analyst wrote that, "A string of software and platform acquisitions (including Vuforia) over the past two years has positioned PTC as a leader in the emerging IoT ecosystem and has created a set of assets to increasingly provide enterprises with the puzzle pieces with which to construct industrial IoT solutions." There are plenty of other analyst accolades and maybe some of them are valid in part. At the least, PTC marketing is doing its job.

I have to imagine that solutions that tell operators when their machines are going to break before they break and identify hard-to-find maintenance problems and recommend remedial activities are going to find a ready market. Just how large that market is, how fast adoption will be, and what competitors might emerge is really hard to predict and I won't try it.

My overall conclusion is that the company's IoT strategy is well thought out and merges well with many of the company's other solutions, particularly its set of SLM solutions. It is well to remember that this company's bookings are running at something like $365 million/year. I don't think it is wild to anticipate that PTC will be able to build a $50 million/year business in IoT over the next three to four years. Doing so would go a long way to change current investor perceptions and the valuation of this name.

Some Closing Thoughts

PTC's shares have appreciated smartly since my initial article regarding the company in late January. The shares are up more than 2X the appreciation of the software index over the past three months. The question thus becomes, do the shares offer continued positive alpha?

There are two distinct elements needed to answer that question. The one thing about the quarter that was recently reported was the striking change in the proportion of new bookings that have gone to a cloud subscription model. The increase was far above prior PTC projections and puts the company one year ahead of its current business transition plan. Inevitably, moving to a subscription model will help PTC significantly improve its profitability by the end of the transition. And it may well, in and of itself, lead to more growth as customers can acquire PTC solutions on a ratable basis rather than having to put them into capital budgets which remain under severe scrutiny.

But, perhaps the more important issue for investors, is how PTC is going to fare with its major growth initiative, software that allows users to monitor the performance of factory capital assets, alerts operators to potential maintenance issues before production is halted, helps technicians diagnose what has or what will go wrong and in general helps to smooth out many of the rough edges in today's factory operations.

It is really difficult to forecast things that haven't happened. There are no real trends. PTC's revenue from its IoT segment is quite small and it is hard to evaluate the competitive landscape which is likely to get more crowded in time.

That being said, I think that PTC's IoT strategy is well considered, that it is aimed at the company's current core customers and that it integrates well with the company's SLM business segment. Given the magnitude of PTC, moving the needle in terms of growth is probably a modest goal. If the IoT can generate $50 million in annual bookings within a few years, it will have a material impact on PTC's likely growth rate.

Overall, my contention is that PTC still has plenty of positive alpha to come.

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.