PTC Earnings - A few of my (least) favorite things.
Earlier this week, PTC (NASDAQ:PTC) pre-released the results for its fiscal Q4 and by extension, the results of fiscal year 2016. The results were, perhaps, a bit confusing in that the headline numbers are likely to feature a significant miss while the most important number, bookings was a substantial beat. In the wake of the pre-release, PTC shares have continued their lengthy up-trend and are above $46/share for the first time since the era of the tech bubble at the start of this century.
The title for this article comes from the quintessential American Opera, Porgy and Bess composed by George Gershwin and a libretto written by the partnership of DuBose Heyward and Ira Gershwin. As the article will discuss, the earnings to be reported by PTC really aren't necessarily so, the name of one of the more famous songs from the opera sung by such notables and Aretha Franklin, Sting, and most recently Brian Wilson.
The lead-in comes from The Sound of Music and the song about some of the most favorite things. It is a bit tongue in cheek as the disclosure in the pre-release is sparse to say the least and leaves more than a bit to the imagination The Sound of Music was the last collaboration of Rogers and Hammerstein and opened in 1960. The song "My Favorite Things" was originally sung by Julie Andrews. It has been reprised by lots of famous singers since that time - but it would be very hard to either disassociate the song from Julie Andrews or find anyone who ever did it better.
PTC shares are up by 34% year to date, a significant over-performance when compared to an increase of less than 10% for the IGV tech-software index. They had a positive reaction to the preannouncement, appreciating 5%. Interestingly, the share price appreciation has had nothing whatsoever to do with reported headline numbers - it is really true that the reported earnings "ain't necessarily so."
As it happens, there have been a couple of articles regarding PTC and its vision published on this site in the past week. Visions are one thing and PTC CEO Jim Heppelmann is nothing, if not a visionary, and has been so for most of his career. He was one of the early developers of the entire concept of PLM and the technology behind Windchill, the company's PLM offering is a product of his development activities. The Internet of Things (IoT) is clearly an important initiative for this company as it is for many other companies in the enterprise software business. I have had the occasion to write about the IoT and its potential impact on various companies several times on this site myself. I am impressed by its prospects. My issue here is that I wonder the extent to which the technologies that have been collected by this company are really adequate to move the needle.
We do not have all that much data regarding the revenue contribution of the IoT business. We know that the Technology Platform group had 20% sequential growth between Q2 and Q3 in the current fiscal year. On the other hand, we know that TPG (IOT) bookings, absent the Kepware acquisition were flat in Q3 because of three larger transactions in the prior-year quarter, which had totaled $9.5 million. We know that IoT revenues were $11 million in Q4 of the prior fiscal year. It appears that organically, the IoT business declined by $6 million in the last quarter (fiscal Q3) and even excluding the large deal impacts, the growth might have been about 35%, decent, but hardly spectacular. But of course the point is that large deals that happened are real and one ought not to see any kind of decrease in organic growth from IoT at this point.
If investors are looking for IoT plays, then there are other companies whose future is more directly tied to the technology than PTC, including Silver Spring Networks (NYSE:SSNI) and LogMeIn (NASDAQ:LOGM) although most certainly the shares of those companies reflect a significant premium for their IoT exposure.
I think the real issue that I propose to address in this article is to try to take a more specific look at what are the growth prospects for PTC regardless of the source, and for that matter compare those results to similar outlooks for its peers in the PLM space and see which, if any of these names makes sense from an investment perspective.
I first recommended PTC in an article on this site on January 25th. At that time, the shares were $29 and now they are $46. That is more than 58% share price appreciation. Are things better today at PTC than they were in January? Most likely.
Are they 58% better, I don't think so. Over that same period, the IGV is up 20%. There is nothing I can do to present a reasonable set of assumptions, involving IoT or anything else sold by PTC that is going to make these shares worth anything higher than their current price and there are many who would say they are worthless.
The investment cases for peers Autodesk (NASDAQ:ADSK) and Dassault Systemes (OTCPK:DASTY) makes far better sense and at some point, the valuation gap between the three names is likely to close as I will discuss below. Both ADSK and DASTY have had decent years with share price appreciation of 20% and of less than 4%, respectively. It is really almost impossible to compare relevant statistics due to the various states of transitions between revenue models that mark the businesses of all of the companies.
PTC has seen substantial changes to its estimates that are related to the change in the business model and which mean less than might meet the eye at first glance. The company has changed the way it reports its business segments and it's obviously hard to compare a model based on 70% subscription with a model that just a year earlier had a 17% subscription component. Jettisoning former standards of reporting growth makes it more than a bit more troublesome to try to take a look at how the company is doing. It is definitely not one of my favorite things.
It is not self-evident that the pace of growth at PTC has significantly accelerated although it did so in the just past quarter. On the other hand it is not quite evident if that is a trend or a phenomenon of a quarter or two. To what extent growth acceleration has to do with just the extension of the subscription/cloud offerings, to what extent it is a product of competitive displacements or to what extent it has to do with faster growth in the overall design software market space is almost impossible to quantify. And again, the company does not always specifically quantify which of the groups in terms of solution offerings have been responsible for the more rapid growth. Much as it would be a great story to suggest that the IoT was the main growth driver, the real reasons seem likely to be more mundane and far less likely to be sustainable.
So there is lots that isn't known and isn't likely to be known in the near term. But regardless of that, I really do not think there is much further positive alpha to be found in the shares at these levels.
The shares currently have a price target of $48.55 from the 10 analysts who post their target on 1st Call. On the other hand, the average rating of 1.8X is above the level that would be implied by the price target. Because of the model change, reported EPS is under extreme pressure and reported revenues are forecast to shrink as well. I think the combination of significant share price appreciation in the last several months, coupled with comparative financial statements that are likely to be difficult to decipher make these shares vulnerable to pullbacks. Again, while PTC might seem to be a logical candidate for consolidation, the requirements to keep up with a rapidly-changing market environment in just so many different market segments would challenge most potential financial acquisitors.
As mentioned earlier, the two other prominent companies in the space, Dassault Systemes and Autodesk would seem to offer better appreciation potential and potential for positive alpha from this point forward. Given that Autodesk is in the midst of its own transition while DASTY is also offering multi-year solution pricing options, trying to do a complete job in terms of comparisons is just not feasible. I will offer some assumptions and conclusions knowing full well that it would be better if there were some objective way of presenting contrasting assumptions.
Q 4's come every year
For folks like myself who have followed PTC for a long time, it is reasonably well known that its success in a particular quarter is primarily a function of how many large deals it closes in that quarter. And it is equally well known, that forecasting large deals of the kind often called "whales" is not something to be undertaken with any degree of certainty. So, to a certain extent, a few years ago, PTC started to strip larger potential transactions from its forecast and its guidance in order to avoid disappointing investors. A sensible practice, but one that can lead to a bit of analytic schizophrenia. Another one of my less favorite things.
A few years back, the company would forecast how many major deals it would close in a year or in a quarter and at that time, during what might be called an adolescent PLM growth spurt, the company handily exceeded those large deal estimates quite regularly and in the wake of the recovery from the Great Recession, it was hoping to see long-term PLM growth in the high teens range for an indefinite period. And then along came Creo, which was a major replacement for the company's older CAD/CAM technology and for a few quarters that was going to be a significant demand driver. There were actually a couple of quarters in the company's CAD revenue stream that showed 40%+ product revenue growth but given that CAD is a mature market with low single-digit growth, that couldn't and didn't last for more than a quarter or two.
The CAD space lends itself to both the creation of products and to the creation of fantastic graphics in terms of marketing materials. In that regard, Creo, as was illustrated in one of the articles on the SA site, has some gorgeous graphics. After attending the launch of the product and watching the graphics, I wanted the product to be a success and for a couple of quarters it looked as though that might happen. Hasn't really been the case, although PTC/Creo has retained its market position. But as mentioned earlier, the CAD market is not really growing rapidly with a CAGR of 6%, much of that coming from migration from older technologies. Because of the migration, the various vendors in the space have seen very variable quarterly results when one or two large customers decide to make the upgrade from 2D to 3D.
So here was PTC with an oft repeated forecast for product revenue growth in the low-teens or greater and earnings growing at 20% and as this decade progressed, it became obvious that there was no way the company might achieve those objectives. In the software business, however, if you can't grow organically, inorganic growth works as well much of the time and PTC entered several new markets with the expectation that if enough parts were put together it would count for a leg. Some of the new categories did seem to have some growth prospects when they were first introduced to analysts including myself but were never quite enough to make up for a real leg to PTC's growth stool. Application Lifecycle Management (ALM), Service Lifecycle Management (SLM), Supply Chain Management (SCM), Mathsoft (industry standard for engineering calculations) and modeling through CoCreate, have all been product families for PTC which have been built on various acquisitions. The sum of these acquisitions has been intended to create another leg to the PTC revenue school but the end result has not quite worked according to plan.
Overall, the company's revenues in the fiscal year that will be formally reported the end of this month are about where revenues were five years ago and non-GAAP EPS is going to be lower. Yes, the business model has changed quite a bit from perpetual license to a ratable model, so perhaps the comparison is not as much apples-to-apples as would be desirable, but there it is. Five years and no growth in most of the valuation metrics that most analysts delight in using. A case could be made that the emperor's clothes are far too sparse to support current valuations.
Again, with all of the acquisitions now driving some revenues, it would seem that a reasonable conclusion that both the PLM and the CAD/CAM businesses are showing some level of organic revenue decline, even adjusted for the change to a ratable mix, although is a bit more difficult to ascertain.
As I mentioned, Jim Heppelmann is an industry visionary and has been committed to the PTC growth story for many years now. When the Internet of Things set of solutions evolved, Mr. Heppelmann embraced and has done his utmost to make it a key part of the PTC's strategic offerings. Like all of the other categories listed above, the IoT strategy that PTC is pursuing, does have some connections to product design. As I have written about the company's IoT strategy recently in other articles, I will simply mention some of the company's acquired solutions in the category.
The ThingWorx platform is a set of product development tools; its Kepware acquisition has a set of what are called industrial connectivity solutions; ColdLight is a company that provides analytics in the IoT space; and Vuforia is a platform developers use in designing apps that help users "see" what they are developing.
All of these are part of an IoT strategy and if one had the facility to add all of the revenue contributions from these acquisitions together, they would really not be adequate to move the needle. Maybe the collection of products will someday develop a critical mass that will generate a noticeable amount of revenue for PTC. Maybe someday there will be an integrated suite of IoT offerings that will appeal to "C" suite managers and maybe one day there will be a sales channel that doesn't rely on a high level of engineering know-how to sell the product. Maybe, someday but for now, I think that in constructing some kind of reasonable expectations for PTC's growth, IoT has to be expected to be an adjunct to overall revenue objectives and not as a main driver.
The company has had a strong sales quarter and significantly exceeded its bookings target for the period. But honestly, Q4s happen once a year and salesmen do their utmost to hit commission accelerators. Does this pre-announcement mean much other than as a random event? Let's take a look at the specifics the best we can.
The sweetest sounds I never heard
The specifics of the PTC pre-announcement are easy to record and much harder to use as the basis for forward-looking assumptions. In the nature of things pre-announcements are often less than totally informative but this one, under the specific circumstances is more than a bit uninformative. The company announced that bookings for the quarter would be around $140 million, which is more than 20% greater than the guidance given at the time of the prior earnings release. The company announced that there were two mega deals in the quarter, including a large PLM displacement and a cloud implementation of what the company calls its service parts management business, better known as SLM.
The company further announced that the company's bookings mix would include 70% ratable compared to the prior estimate of 46% ratable. That is going to drive total revenue and EPS forecasts below the low-end of prior guidance. In the prior quarter, bookings had been $105 million and the ratable rate was 58%. The Q4 guidance had assumed that the ratable rate would decline to levels more consistent with those earlier in the fiscal year.
Prior guidance had called for total revenues of a minimum of $305 million with non-GAAP EPS of at least $.36. The company's model says that for every 1% change in the ratable rate, there will be an annual impact of $3 million in revenues and a $.02 diminution of EPS. So, taking those numbers at their face, the annual run-rate of revenues ought to be decreased by about $70 million and EPS should be diminished by $.48. That is an impact of approximately 6% on revenues and would take full-year EPS that had been expected to be about $1.40 to below $1.00 on an annual run rate basis. It does not appear that consensus estimates have been adjusted to the likely results of the quarter, which probably reflects PTC's sparse press release which doesn't explicitly call out EPS estimates.
It is more than a bit more difficult to forecast quarterly results with the information given. Just based on normal pricing, which PTC says is for the sale of a perpetual license to be worth 2X the annual rate of a subscription sale (although that can vary materially across products and depending on specific terms in large deals) might suggest that license revenues, could have been $20 million or more below expectations while the upside in terms of ratable bookings would have had a marginal influence on product revenues in the quarter.
One issue that is difficult to reconcile is the extent to which what the company calls bookings are really simply the conversion of the company's maintenance revenue stream to a subscription model. The support conversion program is not a bad thing, to be sure, but it is not the same as selling a new product booking and really has no business being mixed up in the bookings bucket. That really has nothing at all to do with the company's success in selling new products but it is part of the number the company uses in its bookings metric and to calculate its ratable mix. It is another of my not very favorite things, which is more or less hidden behind layers of opacity.
The company's estimate for its non-GAAP tax rate had been greater than 50% based on the guidance it provided at the time of its Q3 earnings release. That is also likely to have changed substantially but in any event, but using that assumption suggests that the EPS diminution might have been in the range of $.08-.09, depending of course on the incremental margins of the estimated foregone revenue. Based on the very sparse information that has been supplied, in the wake of the pre-announcement, I expect that the company is likely to report revenues of $280-285 million and EPS of $.28-.30.
So, the question remains, what do Q4 results for the just ended fiscal year say about the company's current growth rate. We know that the comparison was against a very disappointing Q4 fiscal 2015. In that year, actual software revenues declined by 4% in constant currency. Unfortunately, in the company's fiscal '15 periods, PTC had not started to report bookings and hence we do not really know how fast growth may have been in that metric in the current year. There is no really reliable place to go to get market share statistics. Did PTC have some market share gains in Q4 that are replicable? Probably not? Is the large transaction that the company booked in the SLM space something that is part of a trend? There is no evidence that such is the case. Did the IoT space suddenly come alive for the company and start to move the revenue needle? I imagine if that had really happened it would have been part of the pre-announcement discussion since the company did discuss the source of the two large deals that contributed to the bookings upside.
Further, the company announced a greater level of restructuring than had previously been planned. Not a bad thing really, although this company has restructured almost as many times as I have had hot dinners. But usually, restructuring and accelerating growth are not linked. Bookings in Q4 were 35% greater than they were in Q3. In prior FY 2013 and 2014 before the transition to ratable bookings started, what would be a reasonable proxy for bookings, i.e. license revenues rose by 30% and 20% sequentially, respectively. So, Q4 2016 bookings were good, but not that fantastically good on a sequential basis. Absent any significant indication to the contrary, I am going to suggest that there was nothing totally evident in what we know of Q4 from the pre-announcement that really suggests that there has been a significant change in PTC's growth trajectory. Q4 last year was not a really satisfactory quarter for PTC and so far, as can be told there was almost no organic growth. My guess, for what it might be worth, is that on an apples-to-apples basis, bookings growth may have been 15%+ this year on a product basis, compared to a weak number the prior year. That is a number unlikely to be seen, reported or commented on and it is unfortunate that such is the case. Booking a maintenance renewal as a subscription is simply not what most investors think about when they try to compare bookings metrics.
What is the "real" growth rate for PTC. I just do not see that it can be much greater than 10% in terms of the value of new product that it sells per year. That doesn't mean there won't be quarters in which results won't be better or worse than that level. It simply means that looking at the entire portfolio, and including an allowance for better results from the IoT or the Technology Platform Group, 10% seems to be a fair, if not optimistic estimate. Given the gradually declining streams of maintenance and consulting revenues that are likely as the transition to cloud continues, I would expect the combined total revenue growth for the company to average in the mid to high-single digits for some period of time after the coming fiscal year.
What's it worth?
I really find this part of the exercise something akin to trying to cleanse the Augean stables. Obviously, no one would pay 45X non-GAAP EPS (the current multiple) for something whose growth rate is almost impossible to calculate with any precision and which is most likely to be less than 10%. The company's EV/S is well over 5X and at this point, expected reported sales are not likely to grow in the just started fiscal year. At that kind of valuation with a real growth rate hovering close to the double-digit mark, prophesying a deal in which the company is consolidated becomes difficult to do with a straight face. Doubtless investors believe that the metrics that are used to calculate these ratios are depressed by the company's revenue transition and that is doubtless the case. But precisely by how much and when the transition might be finished and what the metrics might be at that time is not really possible to determine with the information at hand.
PTC is not really a cash flow story. The growth in deferred revenues has been moderate and the overall balance of deferred revenues is not abnormal for a company of this scale. On the other hand, the company does not get significant benefits from stock-based comp. Overall stock-based comp represented a bit more than 20% of CFFO but it was down in absolute terms year on year in Q3.
Based on the company's free cash flow forecast, which was probably not greatly impacted by the bookings beat, the free cash flow yield is around 4%. That isn't bad and the number isn't contrived but it isn't an outlier that might inspire a strong positive outlook for alpha from the current share price. I certainly don't see that there is much incentive in continuing to own the shares that have seemingly discounted more than all of the good news that is likely available. Unless of course, one is looking to receive those great motorcycle design pictures in the mail.
Another frustrating undertaking. Once upon a time, comparisons were easy. Just look at metrics like EV/S, free cash flow or even proxy bookings and the growth in deferred revenues. That just will not work in trying to find the right name to recommend in this sector because of all of the multiple transitions now underway by the other two independent vendors.
The cleanest name to consider for investors is Dassault Systemes. It seems likely based on the statistics that are available that Dassault Systemes is experiencing the most rapid growth in the design software space. The largest issue for most American investors is that only 37% of its revenues come from the US although growth in organic, constant currency terms has been and remains in double digits in our country. This is a French company headquartered in France and run by French nationals. While it is listed on NASDAQ and its financial material is in English, it reports in euros and uses the IFRS as its guide in preparing its statements. In that regard, it is at least as transparent as SAP and is one of the larger European tech enterprises and its shares are likely to command a premium multiple simple for that distinction. While there are arguments to be made on both sides, the preponderance of opinion would appear to be that this company has the most comprehensive portfolio of design software products.
Overall, DASTY is forecasting 6-7% growth in constant currency revenue to about $3.4 billion. It is forecasting the equivalent of non-IFRS EPS of $2.75. It is generating free cash flow at about an $800-million-year annual rate. The company currently has an enterprise value of about $19 billion. So, the EV/S at the current time is 5.7X and it is 5X on estimates for the forthcoming fiscal year. It has a P/E of 30X current year projected EPS and 26X for the earnings estimated in the following fiscal year. Its free cash flow yield is estimated to be about 4.1% this year. Overall, DASTY has the fastest growth of the three large PLM vendors both in headline terms and in terms of the equivalent of new product revenue growth.
I will reprise the Autodesk statistics but it is important to note that as is the case for PTC, Autodesk is moving rapidly to a recurring revenue model and has stopped selling most of its products on a perpetual basis. And it is worth noting that ADSK has a very strong revenue component that comes from its AutoCAD architectural products, which have outlooks that may and do often differ from the outlooks from its product design portfolio. In any event, ADSK has a current enterprise value of $15.4 billion. The company has seen a significant increase in its share value since the start of the year and a stronger increase over the prior 12 months. The share price increase, in whole or in part, reflects the company's transition to a subscription model.
Because of the transition, the traditional valuation metrics are not particularly representative and have led to a relatively modest analyst rating with a price target that averages below the current share price.
The company is currently forecasting reported revenue to be in the range of $2 billion with a non-GAAP loss. The company's CFFO and its free cash flow metrics are also not currently representative of a steady state model. Even the sub-headline metrics have been impacted by the accounting treatment of enterprise business arrangements. I think, and this might be subject to disputation, that overall, the company is seeing about a 14% apples-to-apples growth in its product design portfolio while its architectural and media portfolios are showing lower percentage growth. It's strong growth in deferred revenues of 23% is representative of the impact of the company's new business model.
The PLM space is a significant component of the enterprise software pie with total revenues of about $47 billion this current year and a CAGR of 8%+. Compared to most other software product categories, relatively less PLM software is consumed in North America with a 33% share compared to over 40% in the EMEA region. Cloud transitions are essentially on the same track as they are in other components of the enterprise software space.
There are three major independent PLM competitors including PTC, Dassault Systemes and Autodesk. Another major competitor is part of Siemens. PTC's share price has appreciated to a point where there is little remaining upside in my opinion and the specifics of the bookings upside recently announced may not be adequate to sustain the new highs of the company's share price.
DASTY appears to have the broadest portfolio of product design technology on the market. It's new license revenues are showing the strongest growth in the space and the company is achieving 30%+ operating margins, non-IFRS. It is my choice as the best investment vehicle in the space and I think it has significant positive alpha potential.
Autodesk is the third company in the space although it is perhaps better known for its AutoCAD architectural software. The company is in the midst of a significant transition to an all-subscription model which makes reported headline metrics and even some sub-headline metrics not useable to value the name. It appears that it is also achieving growth greater than the PLM market average in the space. Because of the transition and the inability to value the name easily and its recent share price appreciation, the shares are a bit controversial although the rapid growth seen in adjusted subscriptions and in deferred revenues suggests that the current price remains reasonable. For investors deterred by DASTY's foreign status, ADSK is a decent alternative.
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.
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