PTC Inc. (NASDAQ:PTC) Q2 2024 Earnings Call Transcript May 2, 2024
PTC Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Good afternoon, ladies and gentlemen. Thank you for standing by, and welcome to PTC’s 2024 Second Quarter Conference Call. During this — during today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. I would now like to turn the call over to Matt Shimao, PTC’s Head of Investor Relations. Please go ahead.
Matt Shimao: Good afternoon. Thank you, John, and welcome to PTC’s fiscal 2024 second quarter conference call. On the call today are Neil Barua, Chief Executive Officer; and Kristian Talvitie, Chief Financial Officer. Today’s conference call is being broadcast live through an audio webcast and a replay of the call will be available later today at www.ptc.com. During this call, PTC will make forward-looking statements, including guidance as to future operating results. Because such statements deal with future events, actual results may differ materially from those projected in the forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements can be found in PTC’s Annual Report on Form 10-K, Form 10-Q, and other filings with the US Securities and Exchange Commission, as well as in today’s press release.
The forward-looking statements, including guidance provided during this call, are valid only as of today’s date, May 1, 2024, and PTC assumes no obligation to update these forward-looking statements. During the call, PTC will discuss non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with the Generally Accepted Accounting Principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures can be found in today’s press release made available on our website. With that, I’d like to turn the call over to PTC’s Chief Executive Officer, Neil Barua.
Neil Barua: Thanks, Matt. I’m proud of what the PTC team accomplished during our second fiscal quarter. We again delivered solid results, which Kristian will take you through in detail. This quarter continues to demonstrate that PTC is on the right track and that our portfolio of products is resonating with customers. Before going into more detail about our strategy and discussing some proof points from the quarter, I’d like to address our mid-term targets, which we have updated today. To be clear, we are not changing our cash flow guidance. What we have updated is our mid-term ARR growth targets. We are now targeting constant currency ARR growth in the low double digits over the mid-term, which is consistent with the performance we have delivered over the past five years through varying macroeconomic conditions.
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In addition, we feel very good about our ability to hit our cash flow targets even while we appropriately reinvest into the business for product development. This is because we have a disciplined process to manage our internal spending based on the level of ARR growth we are seeing. This year, as an example, our internal spend framework assumed 10% to 12% ARR growth. In addition to adding incremental investment to drive multi-year growth, we are also proactively managing our existing spend. We were able to do this effectively by leveraging the skill sets of our global R&D teams, where we could shift the focus of these resources towards the product areas that create the greatest customer value. In addition, we have confidence in generating increasing operating leverage from our go-to-market and G&A teams.
The investments we make are aligned to the market environment and our five focus areas to ensure appropriate resource allocations towards the areas that create the greatest customer value. As an example, we are currently in the process of rebalancing resources, primarily in R&D, away from creating new standalone IoT and AR applications to instead support PLM, ALM, and SLM growth. While these are not huge movements of people and there will not be a restructuring charge associated with this, it is an example of how we plan to put a greater focus on driving our priorities more effectively. As a reminder, our five focus areas include: number one, PLM, which is driven primarily by our Windchill product; number two, ALM, which is driven by our Codebeamer product; number three, SLM, which is primarily driven by ServiceMax; number four, CAD, which is driven primarily by Creo; and lastly, number five, our continued focus on SaaS.
I’d like to turn now to discuss two of our focus areas to illustrate the significant value we bring to customers. This quarter, I’ll touch on what we have been seeing with customers of our Windchill PLM and ServiceMax SLM products. Starting with PLM. This is product lifecycle management and Windchill is our flagship PLM product. PLM systems tend to be highly configured, really sticky, and our mission-critical system of record for our customers. This is software that historically had the function of helping CAD engineers keep track of their CAD files. Part of the reason PTC’s growth has been so solid over the last few years is because PLM systems have grown in importance at product companies. Today’s products are more complex, typically with embedded electronics and software, and even the mechanical components are now more complex.
To drive revenue growth, product companies have become increasingly focused on producing more variants of their products, mixing certain hardware configurations with other software configurations, while at the same time compressing the time it takes to get new products to market. That’s a tall order. Simply put, product companies that offer multiple configurations of their products face a diversity at-scale challenge. And sooner or later, it becomes clear to these companies that having an advanced PLM system is a strategic necessity. In general, manufacturing companies have a long way to go in terms of their digital transformation journeys. When a product company gets really serious about optimizing in automating their workflows, we tend to see large PLM expansion projects.
This creates a step-function increase in ARR as customers expand their Windchill deployments in terms of both seats and functionality. This is what we saw at a leading medical equipment company with over $5 billion of annual revenue and 20,000 employees. Getting new products to market faster is a top business priority for them. As a first step, they standardized on Windchill within R&D across all their business divisions and harmonized their engineering practices related to product changes and configuration management. By doing this, they established a solid engineering foundation that ensures the traceability work performed and updates made for both productivity gains and also to remain compliant with regulations. Before standardizing on Windchill, this customer did not have an authoritative source of truth for their product data.
So, whenever they ran into conflicting product data in their systems, they lost a lot of time figuring out why that happened and what to do about it. While the first step for this customer was expanding Windchill within R&D, they also want to accelerate their new product introduction timelines. To do this, they needed to drive earlier collaboration around new products across other operational functions outside of R&D. To accomplish this goal, they decided to leverage their Windchill system as a backbone for enterprise-wide collaboration around product data and they expanded their Windchill deployment to teams including manufacturing, supply chain, quality, regulatory compliance, and marketing. For example, providing the supply chain team with relevant product data earlier in the process enables any issues around component availability or component pricing to be identified earlier resulting in less need for products to be redesigned or reworked later.
Turning to the second customer example for today, which is about cross-selling ServiceMax SLM into our base. First, a reminder that SLM is Service Lifecycle Management, and our main product here is ServiceMax, which we acquired a little over a year ago. ServiceMax is the industry leader in field service management for high-value long lifecycle products. Our customers are not only facing complexity challenges, competitive pressures have also increased. Globalization has forced companies to be more efficient if they want to remain competitive. They are looking for new steady sources of top-line growth and margin expansion. In order to drive scalable service revenue, expanding their focus with digital tools on their services operations is key.
The example I want to highlight here is one of the largest elevator companies in the world with billions in annual revenue. After struggling with disparate disconnected systems that got in the way of providing good service to their customers, they decided to embark on a complete service transformation to improve both the growth and profitability of their services business. In the future, when their service technicians go into the field to service an elevator, they will know using the ServiceMax application about the specific elevator so they bring the right parts to the worksite. They will know the service history and have service instructions for that specific elevator. And of course, they’ll be scheduled and routed efficiently to the job site.
Furthermore, the elevator business is highly regulated and the ServiceMax application will ease the regulatory compliance burden by having traceable records of the work performed during service calls. This is how ServiceMax helps our customers. We’ve been focused on cross-selling ServiceMax into a strong base of customers where we have established customer trust. As of the start of fiscal ’24, we aligned the PTC sales team with the ServiceMax sales specialists to go to market together and this collaboration played a big role in getting this deal across the finish line. We also remain encouraged by our other focus areas that I didn’t provide examples for this quarter, which are Codebeamer ALM, CAD, and SaaS. In each of our five focus areas, we made incremental progress during Q2 towards executing in a scalable fashion and focusing our investments on the product advancements that customers care the most about.
As many of you know, during my transition period before taking over as CEO, I spent time listening to employees, digging into our product strategy, speaking with customers and partners to understand their needs and how we address them. As a result of the time I spent on this, I feel good about our product portfolio and strategy, which guides our five focus areas. You should expect to see a continued emphasis on focusing our resources in the areas that create the greatest customer value and where we have a right to win. I’ve also started to focus on our operations. I began to examine where we excel and have room for improvement. As you know, PTC has been on a multi-year journey to improve efficiencies. But my early observations are that PTC will benefit from a fresh look at innovative ways to continue to drive operational improvements.
I’m turning over lots of stones and we’ll look at everything to usher in a new phase of focus and effectiveness across the entire company. With that, I’ll hand the call over to Kristian to take you through our Q2 financial results.
Kristian Talvitie: Thanks, Neil. Hello, everyone. Starting off with Slide 8, PTC again delivered solid financial results in terms of both ARR and free cash flow in a challenging selling environment. As you know, we believe ARR and free cash flow are the most important metrics to assess the performance of our business. To help investors understand our business performance excluding the impact of FX volatility, we provide ARR guidance and disclose our ARR results on a constant currency basis. At the end of Q2, our constant currency ARR was $2.075 billion, up 12% year-over-year and above our guidance range. Note that, we acquired ServiceMax in Q2 of fiscal ’23, so we’re no longer excluding ServiceMax from our organic ARR results.
In Q2 ’24, our cash flow results also came in ahead of our guidance with operating cash flow of $251 million and free cash flow of $247 million, both of which were up 19% year-over-year. Our cash flow performance is driven by our ARR and operating efficiency. And in Q2, we extended our track record of disciplined operational management, while continuing to invest in our key focus areas. Turning to Slide 9, let’s look at our ARR growth at a more detailed level. Starting with our product groups, in CAD, we delivered 11% constant currency ARR growth in Q2 with the growth primarily driven by Creo. In PLM, our constant currency ARR growth was 13%, primarily driven by Windchill. And despite the overall demand environment, which has been sluggish for many quarters now, our top-line has shown good resilience.
Our solid ARR growth is supported by our unique portfolio with a solid footprint in higher-growth segments of the market and the digital transformation journeys of our customers. These underlying strengths are further supported by our subscription model, our low churn rate, and the propensity for our customer base to prioritize their own R&D investments through challenging times. Moving to our ARR by region. Our constant currency organic ARR growth was solid across Americas, Europe, and APAC with growth in the low to mid double digits. Across all regions, our year-over-year organic constant currency growth rates in Q2 were similar to the growth rates we saw in Q1. Moving to Slide 10. First of all, given the consistency and predictability of our free cash flow, we aim to maintain a low cash balance.
And as you know, our long-term goal, assuming our debt-to-EBITDA ratio is below 3 times remains to return approximately 50% of our free cash flow to shareholders via share repurchases, while also taking into consideration the interest rate environment and strategic opportunities. So, given the strategic acquisitions, namely ServiceMax and Codebeamer that we’ve done over the past two years, we paused our share repurchase program. And as we’ve said before, we intend to use substantially all of our free cash flow to pay down our debt in fiscal ’24. Heading into fiscal ’25, we’ll revisit the prioritization of debt paydown and share repurchases. We were 2.3 times levered at the end of Q2. During the quarter, we paid down our debt by $256 million and we ended Q2 with cash and cash equivalents of $249 million and gross debt of $2.011 billion.
We expect to end the year with gross debt of approximately $1.7 billion. Lastly, we now expect our diluted share count to increase by approximately 1.5 million shares in fiscal ’24 versus our previous expectation of approximately 1 million shares. Under the accounting rules, specifically ASC 260, a higher share price results in incrementally higher diluted share count. With that, I’ll take you through our guidance on Slide 11. We’re reiterating our fiscal ’24 free cash flow guidance and narrowing our fiscal ’24 constant currency ARR guidance range. We’re taking the low end of the ARR guidance up by $10 million, reflecting our solid first half performance. We’re taking the high end of the range down by $10 million, reflecting a change to the deferred ARR we expect to recognize in the back half of the year.
You will recall that we said we had approximately $20 million more deferred ARR in the back half of fiscal ’24 compared to fiscal ’23. We’ve reduced this by $10 million as we’ve renegotiated a handful of customer contracts. While not commonplace with existing contracts, renegotiations do sometimes happen. Some of you may recall that we had a handful of these during COVID as well. The field teams do a good job here, working with customers in what I like to call a customer-friendly but commercially-responsible manner, meaning we’re doing the right thing for the customer now, while also ensuring that these deals will result in a higher exit run rate and better contractual terms for PTC. We remain squarely focused on long-term value creation for our customers and our shareholders.
It’s worth noting that we’re updating our fiscal ’24 revenue guidance accordingly, taking the low end up by $10 million, reducing the high end by $10 million. Additionally, we’re lowering the entire range by $10 million due to the impact of FX. As you’ll recall, we do not guide to constant currency revenue. Our EPS guidance reflects our first half performance and the impacts of the narrowing of the revenue range and the FX impact as well. And lastly, our free cash flow is also impacted by FX, but we’re reiterating the $725 million guidance given the first half results. For Q3, we’re guiding for free cash flow of approximately $220 million and constant currency ARR of $2.115 billion to $2.13 billion, which corresponds to year-over-year growth of 11% to 12%.
We believe we’ve set our Q3 and full year guidance appropriately. I’ll get into more ARR guidance details on the next two slides. But before we do, I’d also like to reiterate my favorite reminder. To help you with your models, we’re providing revenue and EPS guidance. But ASC 606 makes revenue and EPS difficult to predict for PTC since we sell primarily on-premise subscriptions. And the way revenue is recognized from these contracts can vary significantly based on variables that aren’t necessarily relevant to the performance of the business. I did a teach-in on this subject on our Q4 ’22 call that you may want to refer to if you’re new to PTC. The summary is we believe ARR and free cash flow, rather than revenue and operating income, are the best metrics to assess the performance of our business.
Importantly, we’ve maintained consistent billing practices over time. We primarily bill our customers annually upfront one year at a time regardless of contract term lengths. So, our free cash flow results over time are comparable. Let’s turn to Slide 12, and here’s an illustration of what’s needed to get to the midpoints of our constant currency ARR guidance for fiscal ’24. As you can see from the slide, to hit the midpoint of our fiscal ’24 guidance range, we need $145 million of sequential ARR growth in the second half of fiscal ’24. This is approximately $20 million more than we added in the second half of the previous two fiscal years. And in the second half of fiscal ’24, we expect to benefit from Codebeamer, cross-selling ServiceMax with an aligned and enabled sales force and $10 million more deferred ARR than we had in the second half of fiscal ’23.
Moving on to Slide 13, here’s an illustrative constant currency ARR model for Q3 ’24. You can see our results here over the past 10 quarters and the column on the far right illustrates what’s needed to get to the midpoint of our constant currency ARR guidance. This illustrative model indicates that to hit the midpoint of our Q3 guidance range, we need $48 million of sequential net ARR growth. Because our ARR trends tend to see some seasonality, the most relevant comparison is the sequential growth in Q3 of fiscal ’23 and Q3 of fiscal ’22. We think our guidance range for Q3 of ’24 and the full year balances both risk and opportunity. Finally, on free cash flow, I want to reiterate the point that Neil made earlier. We continue to have a high degree of confidence in our cash flow guidance and targets due to the predictability of our cash collections and the disciplined resource allocation structure we have in place.
In conclusion, PTC has a strong portfolio and strategy and a great team of people with deep expertise and strong customer relationships. We’re focused on disciplined and consistent execution to ensure we deliver on the value-creation opportunities we have ahead of us. With that, I’d like to turn the call over to the operator and begin the Q&A session.
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