Report Entitled "The Accounting of Things"
Spruce Point Capital Management is pleased to announce it has released the contents of a unique short idea involving PTC Inc. (Nasdaq: PTC or "the company"), a legacy application software company (formerly Parametric Technology, Nasdaq: PMTC) struggling to transform through a subscription conversion story while hyping its Internet-of-Things ("IoT") roll-up. We have conducted an extensive fundamental and forensic accounting review, and believe the nearly 100% appreciation in PTC's share price since early 2016 is unwarranted. As a result, we have a "Strong Sell" opinion and a price target of approximately $27-32 per share, or approximately 50% to 60% downside. Our short thesis, which details PTC's struggles to transform its legacy CAD software business, has striking similarities to our earlier and successful short campaigns against Sabre Corp (NASDAQ:SABR) (2016) and NCR Corp(NYSE:NCR) (2015). The full contents of our short thesis are detailed extensively on our website. Due to size limitations, some of the key highlights are noted below. Please review our disclaimer at the bottom of this email.
Our report cautions PTC investors about the following:
- PTC's conversion story from selling perpetual licenses to a subscription model is late to the game, an excuse for management to explain away poor results and deteriorating economics, and looks nothing like a traditional conversion relative to peers. Its conversion uses gimmicks and a questionable value proposition to compel users to subscribe. PTC customers must stick with a subscription at least 4yrs+ and not churn in order for PTC to breakeven, a considerable challenge given the average customer contract is just 2yrs. As can be seen below, even management has had difficulty keeping its story straight.
- PTC's conversion story has investors excited because Adobe (NASDAQ:ADBE) has made a successful transition. However, most investors and sell-side analysts ignore the fact that: 1) there are plenty of companies that have struggled to transform to the Cloud or to a SaaS model that aren't highlighted (eg: ORCL, IBM, SAP, PRO, SABR), and 2) PTC's conversion metrics looks nothing like Adobe's or even Autodesk's, especially the decline in its deferred revenue accounts, which should be rising if PTC were a true SaaS company.
PTC claims that shortfall is a result of a two-day calendar shift impacting the timing of fiscal quarter ends and billing schedules. (1) Color us skeptical, but this just sounds like a convenient way to explain away a $64m shortfall.
- Investors are ignoring PTC's terrible GAAP financial results in favor of dubious Non-GAAP reporting, and metrics such as "Bookings," "Annualized Contract Value" and "Unbilled Deferred Revenue" - read the fine print, they have no correlation to future results. Pay attention to working capital and free cash flow going negative while PTC has to borrow on its revolver (subsequent event 10-Q, p. 22)
For highly acquisitive companies effecting a roll-up strategy, Spruce Point has consistently advocated to evaluate financial performance by looking at cash flow after recurring acquisitions (see our reports on AMETEK and ECHO which foretold 20%+ price declines). At the moment, it's clear that PTC is on a non-economic path with declining operating cash flow, and no evidence it can earn back the $1bn+ it has paid for 11 acquisitions. It's also worrisome that PTC's liquidity is at an all-time low while its debt is at a high. PTC recently disclosed that just $40m of capital was available to borrow on its revolver due to covenant restrictions in the 10-K but omitted its borrow availability in the recent 10-Q. (1)
From FY-2012 to current, the divergence between PTC's GAAP and Non-GAAP EBIT and EPS is cumulatively almost $1 billion and $7.10 per share, respectively. We will expose the questionable restructuring programs and tax rates driving this unusually large divergence.
PTC guided down all year in FY16, and its GAAP earnings were wiped out from a small decline in sales. Investors chose to focus on Subscription ACV, % Bookings and other loosely defined Non-GAAP terms.
We've attempted to recast PTC's financials as if no conversion took place. Not surprisingly, we believe there's no underlying growth at PTC. This shouldn't be surprising given the intensely competitive and mature markets PTC sells its Computer Aided Design [CAD] / Product Life Cycle [PLM] / Service Life Cycle [SLM] products suites into (industrial, federal gov't, aerospace and defense end markets comprise almost 50% of PTC's revenues).
PTC's Bookings, ACV and other loosely defined metrics should be taken with a grain of salt. Our research process included speaking with PTC's former EVP of Global Sales. When we asked him to explain and clarify the definitions and meanings of these terms he simply could not.
- PTC appears to make liberal interpretation of them as well. For example, in October 2016 during Q4'16 results, PTC announced a $20m "mega deal" with the US Air Force it claimed was a closed deal in Jan 2017. However, we struggle to even find the contract according to government sources (USASpending.gov and Defense.gov), and three months later PTC is adding fine print disclaimers to its press release announcing the contract, and couldn't even reinforce the $20m headline contract. Look carefully at the disclaimer language that says:
The announcement of a customer's selection of PTC software is not necessarily indicative of the timing of the related booking, recognition of related revenue, or the amount of revenue for any particular period, or that any related applicable implementation and deployment activities are complete."
- Compare the disclaimer to previous disclaimers used (eg: ZF Selects PTC) a month earlier in Dec 2016, and you will see our caution about the reliability of PTC's booking promotions.
Management makes all sorts of disclaimers about its ACV and Bookings. We think investors should pay close attention. Many of the assumptions behind management's metrics (e.g. renewal rates) are not disclosed and require investors to make a leap of faith in their meaning:
PTC's ACV Calculation As Explained, With Little Support or Justification and Unknown Values For Variables:
In order to normalize between perpetual and subscription licenses, we define subscription bookings as the subscription annualized contract value (subscription ACV) of new subscription bookings multiplied by a conversion factor of 2. We arrived at the conversion factor of 2 by considering a number of variables including pricing, support, length of term, and renewal rates. We define subscription ACV as the total value of a new subscription booking divided by the term of the contract (in days) multiplied by 365. If the term of the subscription contract is less than a year, the ACV is equal to the total contract value. License and subscription bookings equal subscription bookings (as described above) plus perpetual license bookings plus any monthly software rental bookings during the period. Total ACV equals subscription ACV (as described above) plus the annualized value of incremental monthly software rental bookings during the period." (Source: 10K, p. 26)
It's also questionable and an aggressive move that management annualizes monthly "rentals" when considering short duration usage of its software: we note the recent disclosure change starting in Q1'16:
In order to normalize between perpetual and subscription transactions, we define bookings as either the annualized contract value [ACV] of a new subscription multiplied by a conversion factor of 2, the annualized value of incremental monthly software rental bookings, or the contract value of a new perpetual license. We arrived at the conversion factor of 2 by considering a number of variables including pricing, support, length of term, and renewal rates. We define ACV as the total value of a new subscription solutions booking divided by the term of the contract (in days) multiplied by 365, unless the term is less than one year, in which case the contract value equals the ACV. For monthly rentals, bookings equals revenue in the period, and ACV equals the annualized value of the rentals." Source: 10-Q, p.23
PTC's backlog definition is a moving target, and now it is touting "unbilled deferred revenue" which it should disclaim is a Non-GAAP number and potentially misleading to represent it next to deferred revenue, a balance sheet item:
Backlog (2014) - Early Part of Transition: "We generally ship our products within 30 days after receipt of a customer order. A high percentage of our license revenue historically has been generated in the third month of each fiscal quarter, and this revenue tends to be concentrated in the latter part of that month. Accordingly, orders may exist at the end of a quarter that have not been shipped and not been recognized as revenue. We do not believe that our backlog at any particular point in time is material or indicative of future sales levels." (Source: 10-K, p.4)
Backlog (2015): "We define backlog as contractually committed orders for license, subscription and support with a customer for which the associated revenue has not been recognized and the customer has not been invoiced. Deferred revenue primarily relates to software support agreements invoiced to customers for which the revenue has not yet been recognized. Customer commitments for amounts that are not in deferred revenue and have not yet been invoiced to customers related to multi-year support and subscription contracts totaled approximately $210 million at September 30, 2015 (compared to approximately $185 million at September 30, 2014), of which we expect to invoice customers approximately $140 million within the next twelve months." (Source: 10-K, p.5)
Deferred Revenue and Backlog (Unbilled Deferred Revenue): "We define unbilled deferred revenue as contractually committed orders for license, subscription and support with a customer for which the associated revenue has not been recognized and the customer has not been invoiced. We do not record unbilled deferred revenue on our Consolidated Balance Sheet until we invoice the customer. Deferred revenue primarily relates to software agreements invoiced to customers for which the revenue has not yet been recognized. Of the unbilled deferred revenue balance at September 30, 2016, we expect to invoice customers approximately $210 million within the next twelve months. The increase in unbilled deferred revenue is primarily due to the increase in our subscription bookings, which are generally billed annually at the start of each annual subscription period." (Source: 10-K, p. 17)
- PTC appears to be purposefully obscuring, and now omitting, key metrics used to evaluate its business - we believe in an attempt to hide the deflationary forces affecting its business.
- Using the Wayback machine, we find that PTC's resellers are in structural decline. Given its claim that 20-25% of sales come from this channel, it's a little concerning. Our belief that PTC isn't really growing (and potentially declining) is supported by the facts that resellers are in decline and revenues per sales quota rep are also declining
PTC Reseller Analysis
- PTC's resellers (aka: indirect revenues) are no longer disclosed in its SEC filings; instead, PTC includes % breakdowns in its supplemental data tab and excel file found on its website.
- Curiously, we find historical revenue discrepancies suggesting potential misstatement of $35-50m. Look carefully and you'll see the percentages don't match.
Source: PTC FY'12 10-K Annual Report, p. 16
- PTC's reseller economics don't look good. According to a recent illustration found on the PTC user community, the company asks for upfront payment, and leaves resellers on the hook for collection. In effect, PTC asks its partners to finance it. We don't imagine its reseller partners particularly like this requirement.
- Not surprisingly, PTC's receivables and financials look nothing like its peers. It reserves little for allowance for doubtful accounts. We ask which duck looks different from the rest and why?
- Its peer ANSYS describes a nearly identical revenue recognition model, has nearly identical % of channel sales, and yet has 10x the allowance for doubtful accounts. Something doesn't look right....
- Further evidence to suggest obfuscation of receivables is evident upon closer inspection. Upon reviewing PTC's deferred revenue disclosures, we noticed something unusual. The company cites "Billed but uncollected support and subscription-related amounts in other current assets." To us, this certainly sounds like a receivable. Upon further inspection, we notice that PTC discloses its DSO in its financial spreadsheet. The trend makes it look as if DSOs have been rapidly improving. We decided to see what would happen if we included the billed and uncollected receivables into the DSO calculation. Not surprisingly we've found almost no improvement from FY 2013 - 2016.
- In addition, PTC is making frequent revenue and segment reclassifications in an attempt to flatter its results. For example, it is now allocating more revenues such as Navigate to IoT and stuffing "unallocated operating expenses" to bolster IoT segment revenues and profit.
- Our skepticism with PTC's financials are heightened by its 5-year recurring restructuring odyssey, which appears to be an elaborate accounting scheme designed to sell investors on meaningless Non-GAAP figures.
- We've done a deep dive analysis and have significant difficulties reconciling PTC's employee headcounts and office locations.
- Furthermore, we believe its restructuring violates SEC guidelines given its inability to make reliable restructuring estimates due to frequent revisions and now PTC's complete omission of restructuring charges allocated by segment (see ASC 420, 280 and SAB 100)
PTC's Increasing Restructuring Charges:
Frequent revisions to the FY 16 restructuring program may run afoul of SEC guidelines
Evidence of Diminishing Returns on Restructuring Activities
PTC says in its 10-K, p.13: "On October 23, 2015, we initiated a plan to restructure our workforce and consolidate select facilities to reduce our cost structure to enable us to invest in our identified growth opportunities."
However, according to its 10-K discussion of its properties, PTC's office locations and total square footage of leased space increased in between FY 2015 and 2016. Its operating lease obligations also increased from $144m to $156m.
Worrisome Systematic Overstatement of Office Locations Suggest Business Misrepresentation
- Here's more evidence that employee counts don't reconcile and calls into question the accuracy of the 810 employees PTC claims to have terminated. We estimate FY16 ending employees of 5,367 = FY15 employees + FY16 employees added from acquisitions - FY16 terminated employees. PTC reported 5,800 employees, which suggests that PTC hired 433 employees in FY16 (more than half it claims to have terminated).
- PTC describes its restructuring activity to be "materially complete;" however, according to its restructuring accrual accounts, it still has a $25.6m accrual amount. When comparing this amount with the total $83m of charges taken, it would appear that the accrual outstanding is material and not completed!
We continue to proactively manage our cost structure and invest in what we believe are high return opportunities in our business. Our goal is to drive continued margin expansion over the long term. To that end, we restructured our workforce in 2016, and we completed facility-related restructuring actions in the first quarter of 2017. As of December 31, 2016, we were materially complete with those actions and had incurred total restructuring charges of approximately $83 million. Of that amount, $6 million was recorded in the first quarter of 2017." (Source: 10-Q, p. 25)
- Our last piece of evidence to suggest dubious restructuring is found by critically analyzing PTC's segment reporting. If you look carefully, you will see a movement towards less and less disclosure, and reporting practices of significant departure from ASC 280 Segment Reporting.
- ASC 280 requires certain components of segment profit or loss that are reported to the CODM to be separately reported for each reportable segment, including revenue, depreciation, interest revenue, depreciation, income taxes, and significant noncash items.
- Below we've pasted the segment footnotes. By Q4'16 you will see the restructuring allocation was completely omitted, and by Q1'17 there are zero explanations of segment results.
We recorded restructuring charges of $4.6 million and $41.7 million in the second quarter and first six months of 2016. Software Products included $3.7 million and $16.8 million, respectively; Services included $0.2 million and $5.0 million, respectively; sales and marketing expenses included $0.7 million and $16.6 million, respectively; and general and administrative expenses included $0.0 million and $3.3 million, respectively, of these restructuring charges" Source: 10-Q, p.16
We recorded restructuring charges of $2.8 million and $44.5 million, respectively, in the third quarter and first nine months of 2016. Solutions Group included $1.4 million and $16.3 million, respectively; Technology Platform Group included $0.6 million and $1.3 million, respectively; Professional Services included $0.3 million and $4.8 million, respectively; and unallocated departments included $0.5 million and $22.1 million, respectively, of these restructuring charges. We recorded restructuring charges of $4.4 million and $42.6 million, respectively, in the third quarter and first nine months of 2015. Solutions Group included $1.0 million and $8.5 million, respectively; Technology Platform Group included $0.1 million and $0.3 million, respectively; Professional Services included $0.3 million and $10.9 million, and unallocated departments included $3.0 million and $22.9 million, respectively, of these restructuring charges." (10-Q, p.19)
FY 2016 Annual Report (Notice No Restructuring Charges By Segment Discussed)
The Solutions Group segment includes depreciation of $5.4 million, $5.6 million and $5.7 million in 2016, 2015 and 2014, respectively. The IoT Group segment includes depreciation of $1.6 million, $1.0 million and $0.1 million in 2016, 2015 and 2014, respectively. The Professional Services segment includes depreciation of $2.0 million, $2.2 million and $2.3 million in 2016, 2015 and 2014, respectively. Unallocated departments includes depreciation of $19.7 million, $20.1 million and $19.0 million in 2016, 2015 and 2014, respectively." (PTC 2016 10-K, p. F-42)
Q1'17 (Now You Will See No Footnote To The Reporting Segments or No Footnote to Unallocated Operating Expenses)
Source: Q1'17 10-Q, p.19
- Meanwhile, investors are also overlooking management's past association with questionable companies. PTC's CFO was Chief Accounting Officer and Controller at Autodesk (2003-2009) during a period of time when they announced an SEC investigation and that the financials could no longer be relied upon. (Source: 10K) When viewed in the context of PTC's recent financial snafus, these facts become worrisome. To illustrate:
- PTC recently settled with the SEC and DOJ for violations of the Foreign Corrupt Practices Act in China.
- PTC failed to issue accurate earnings guidance by omitting interest expense, and
- PTC's tax situation has also been under audit review, and it recently paid $12m to settle with Korean authorities. (Source: 10-Q) PTC's tax situation appears divorced from reality:
While investors give PTC a "pass" on producing GAAP results and positive cash flow, they are being baited by the heavy promotion of its Internet-of-Things [IOT] business
- In our opinion, PTC is also hyping its IoT business as means to distract investors from its legacy business issues, and to dangle a carrot of upside. The CEO uses bloated language such as PTC being the "big dog" and "thought leader" in the space. In our view, PTC has squandered $585 million on its IoT acquisition spree. The following quote from the CEO of ThingWorx Rick Bullotta is instructive:
"Our CFO put out a real stretch number, and we all said, 'Wow, that's ambitious, Not so for PTC" (Source)
PTC's Expensive IoT Roll-Up Acquisitions
- We view PTC's IoT business as nothing more than a highly promoted, low growth, money losing business that is failing to scale. Management is making absurdly promotional statements and using misleading organic growth and market share figures.
- For example, PTC has suggested organic growth and market share of >50% and 18-28%, respectively. (see: research reports it cites e.g. IoT Analytics and CEO's statements at the GS Tech Conference) However, we estimate organic growth at an anemic 8-9% rate and market share of just 10%. PTC claims it will break even at a $200m revenue run rate (Q1'17 Conf Call); are investors willing to wait 10yrs for this (LTM revenues are $90m with 8.5% p.a. organic growth)
Spruce Point's Organic Growth Calculation for IoT
Shrinking TAM in IoT Indicated From Recent PTC Slide Revisions
Bearish Evidence of Lower Spend Per Customer and Less Recurring Revenue
Warning: PTC uses vague charts with no scale to promote IoT
IoT visionary founders of companies sold to PTC are departing:
- In our opinion, PTC's IoT growth cannot bail it out and the company is acting as if it's distressed. The company is dangerously levered at 3.5x Debt/EBITDA and just did a stealth credit amendment in Q1 after it burned cash flow in Q1 for the first time in recent history. It appears that PTC has largely tapped out its revolver (just $40m of availability at year end - 10K, p. 36), has too much cash trapped internationally (77% of total), and has to fund its negative working capital position.
- PTC's Total Leverage Ratio covenant may not exceed 4.0x, giving it very little wiggle room. Note: PTC's recent amendment to add back changes in deferred revenue is aggressive and some companies (such as Barracuda Networks) recently stopped this practice "to comply with recent SEC interpretations on the use of Non-GAAP metrics)
- While every analyst says "Buy" six insiders have 10b5-1 stock sale programs and are doing nothing but selling at every chance they get. Insiders own just a meager 1% of the company, and they still want out. Analysts' see upside to $60/share or (+12%)
- By all valuation benchmarks, PTC's share price is overvalued at 5.6x, 23x, 40x 2017E Sales, Adjusted EBITDA and Non-GAAP EPS, respectively.
- Average takeover multiples (which include a control premium) over the past decade in the technical and electronic data automation software sector suggest 3.5x and 14x NTM sales and EBITDA, respectively. These multiples further our case of extreme overvaluation in PTC's share price.
- PTC's share price is being valued at an all-time high multiple. Successful investing rarely involves paying peak entry prices.
- Given the serious concerns we have about PTC's financial reporting of Adjusted EBITDA and EPS, we believe the best way to value its shares is on a multiple of revenues and operating cash flow. For the sake of argument, we assume management's 2017E guidance estimates are achieved, but apply more realistic multiples to discount our concerns. At 2.5x-3.5x revenues and 18x - 21x operating cash flow, we see approximately 50-60% downside risk.
Thanks again for your interest in our investment ideas. We truly appreciate all your support over the years.
About Spruce Point Capital Management
Spruce Point Capital Management, LLC, is a New York based investment manager founded in 2009. The firm focuses on short-selling and special situations opportunities. The firm conducts in-depth forensic fundamental research and takes an activist approach to investing. Our research challenges conventional thinking with deep fundamental analysis, analytical rigor, and conclusions rooted with our unique viewpoints. For more information visit our website.
This research expresses our investment opinions, which we have based upon interpretation of certain facts and observations, all of which are based upon publicly available information, and all of which are set out in our complete research presentation report on our website. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained herein may include forward looking statements, expectations, pro forma analyses, estimates, and projections. You should assume these types of statements, expectations, pro forma analyses, estimates, and projections may turn out to be incorrect for reasons beyond Spruce Point Capital Management LLC's control. This is not investment or accounting advice nor should it be construed as such. Use of Spruce Point Capital Management LLC's research is at your own risk. Any historical performance achieved from any idea or opinion from Spruce Point Capital Management should not be considered an indicator of future performance. You should do your own research and due diligence before making any investment decision with respect to any of the securities covered herein. Spruce Point Capital Management, subscribers and/or consultants shall have no obligation to inform any investor or viewer of this report about their historical, current, and future trading activities
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To the best of our ability and belief, as of the date hereof, all information contained herein is accurate and reliable and does not omit to state material facts necessary to make the statements herein not misleading, and all information has been obtained from public sources we believe to be accurate and reliable, and who are not insiders or connected persons of the stock covered herein or who may otherwise owe any fiduciary duty or duty of confidentiality to the issuer, or to any other person or entity that was breached by the transmission of information to Spruce Point Capital Management LLC. However, Spruce Point Capital Management LLC recognizes that there may be non-public information in the possession of PTC or other insiders of PTC that has not been publicly disclosed by PTC. Therefore, such information contained herein is presented "as is," without warranty of any kind - whether express or implied. Spruce Point Capital Management LLC makes no other representations, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. All rights reserved. This document may not be reproduced or disseminated in whole or in part without the prior written consent of Spruce Point Capital Management LLC.
Disclosure: I am/we are short PTC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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