Earnings Call Transcript - PTC Q3 2023

Operator, Operator

Good afternoon ladies and gentlemen. Thank you for standing by and welcome to PTC's 2023 Third Quarter Conference Call. 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, Head of Investor Relations

Good afternoon. Thank you, Josh and welcome to PTC's 2023 third quarter conference call. On the call today are Jim Heppelmann, Chief Executive Officer; Kristian Talvitie, Chief Financial Officer; and Neil Barua, CEO Elect. 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, July 26, 2023 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 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, Jim Heppelmann.

Jim Heppelmann, CEO

Thanks Matt. Good afternoon everyone and thank you for joining us. You probably noticed that we have some additional news regarding CEO succession to cover today. So, I'll kick off with an overview of Q3, but skip the normal customer commentary to allow time for the succession discussion. I trust that many of you had a good chance to interact directly with customers at a recent LiveWorx event and I hope that will carry you for a while. Starting with Q3 results then, I'm pleased to report that in Q3, PTC again delivered solid results. As you know, we feel that ARR and free cash flow are the best metrics to assess the performance of our business. In Q3, we exceeded our guidance on both metrics, and today, we are again raising our full year ARR guidance midpoint as well as our full year guidance for free cash flow. As usual, I'll focus my discussion on constant currency results when discussing topline metrics, and Kristian will outline currency effects later in the call. Starting with the topline metric of ARR on slide four. In Q3, we came in at $1.868 billion, which was above the high end of our guidance range and up 25% year-over-year. Organic ARR growth accelerated slightly to 14%. ServiceMax contributed the extra 11 points of inorganic growth to bridge us to the overall 25% growth rate. We passed the one-year anniversary of acquiring Codebeamer, so we're now counting Codebeamer in our organic ARR results. Though the manufacturing PMIs continue to indicate a sluggish environment globally, our topline ARR continues to show good resilience. In Q3, we saw broad-based ARR strength across all product groups and geographies and our churn results remain good. Given strong year-to-date results, together with a solid pipeline and outlook for Q4, we're raising our full year ARR guidance midpoint. As I mentioned, Kristian will provide the details later. Moving to slide five and switching to our bottom-line view, we delivered $164 million of free cash flow in Q3, ahead of our guidance and up 46% year-over-year. Remember that ARR is the primary driver of cash flow, so this result was driven by a combination of strong ARR growth and higher operating efficiency. We raised our key free cash flow guidance for the year. Kristian will elaborate on that as well. Turning to slide six. Let's look at ARR growth by geography. ARR growth in the Americas was 29%. In Europe, ARR growth was 24%. And in APAC, ARR growth was 16%. On a global basis, FX was neutral to our year-on-year growth in Q3, but regionally, FX continued to be a growth tailwind in Asia, whereas it's a growth headwind in Europe. All three regions benefited from inorganic growth to varying degrees due to the acquisition of ServiceMax. Speaking of ServiceMax, we saw our first cross-sell activity happen in the quarter and while it's still quite early in the integration process, there is a nice cross-sell pipeline building, which bodes well for the future. Next, let's look at the ARR performance of our product groups on slide seven. In CAD, which is those products that enable authoring of product data, we delivered 11% ARR growth in Q3 in a market that's been growing an estimated 7%. Within these results, the growth was primarily driven by Creo, but supplemented by strong percentage growth in Onshape. PTC is clearly taking share in different parts of the CAD market with both products. In PLM, which includes those products that enable data and process management, our ARR growth rate in Q3 was 36% and or 16% organic with the incremental inorganic growth coming from ServiceMax. In PLM, we continue to significantly outperform the market, which has been growing an estimated 8% in core PLM. ARR growth for PLM in Q3 was primarily driven by Windchill, supplemented by strong organic percentage growth in ALM and SLM. Clearly, we're taking significant share in the PLM market as well. Turning to slide eight, I want to double-click on our ARR growth strategy because we've been fielding many investor questions regarding how we've been able to perform so well on the growth front as compared to peers and whether this differential growth is sustainable. Some investors think we've shifted from one growth strategy to another over the years, but we see it very differently. In our view, we have consistently layered new growth strategies on top of existing growth strategies to create additional tailwinds that fuel faster growth. Let me explain. Our growth strategy starts at the bottom of the chart where we participate in CAD and PLM markets that are growing in the upper single-digit range. So, that is our baseline. On top of this, our products are very strong competitively, which has allowed us to take some incremental market share and outgrow our peers. Then back in fiscal 2014, we launched our IoT business, which will be more than $200 million of ARR this year and continuing to grow at a rate that's accretive to company growth. Perhaps the single biggest driver of growth was unleashed in 2015 when we launched the full-on transition from a perpetual and maintenance model to a subscription business model. This was a short-term pain for long-term gain type of strategy, and I'm pleased to say the pain bottomed out in fiscal 2017 and faded in fiscal 2019, and we've been enjoying the long-term gain and growth rate ever since. Simply put, a recurring model with sticky software creates much more growth than does a perpetual model even at the same level of new seed sales. That's why companies like PTC cross the Valley of Death to get there. You can refer to our FY 2021 investor deck where we took investors through the math model that shows how much easier it is to grow a sticky recurring business model than a perpetual one. Following that, we put a strong focus on commercial improvements, such as improved churn, improved discounting, and price optimization. And then redoubled our efforts in these areas when we entered the COVID and inflationary periods. Collectively, these improvements have created incremental tailwinds to company growth rates, and we think there's more to be done here going forward. We could have been satisfied to stop there, but we didn't. We saw the CAD and PLM markets beginning to pivot towards SaaS, which led us to acquire the peer SaaS Onshape and Arena businesses. These businesses continue to be growth tailwinds as the growth is accretive to PTC's overall growth rate. Then in fiscal 2022, we decided to bring the SaaS phenomenon that was driving strong Onshape and Arena growth to our core CAD and PLM business, which we did using the Atlas platform that leveraged Onshape technology. This strategy allows us to land larger ARR run rates because we're selling both the software and the service to deliver it. And of course, now we can expand the existing on-premise customer base ARR run rates by shifting customers to SaaS and upselling to include the value of the delivery service the customer now gets from PTC. Frankly, this growth driver is in its early stages and its impact is minor right now compared to what it promises to contribute in the coming years. Because we already enjoy strong growth independent of this SaaS driver, you should consider that SaaS is not our growth strategy per se, it's just another tailwind that helps in our quest to drive our growth rates higher. Finally, during fiscal 2022 and 2023, we made smart acquisitions like Codebeamer for the ALM part of our PLM strategy and ServiceMax for the SLM part of our PLM strategy. On a standalone basis, these businesses are growing faster than PTC. And of course, these growth tailwinds will increase as we further develop the cross-sell synergies we're pursuing. Cross-sell is already becoming meaningful for Codebeamer now and looks very promising for ServiceMax where we're still quite early in the process. So, when an investor asks what is driving the 14% organic growth that PTC is reporting this quarter? The answer really is all of it, except of course, ServiceMax, which is not yet factored into the organic calculation but will be in a few quarters. For those who questioned whether this level of ARR growth is sustainable, I'd first like to point out that fiscal 2023 will be the seventh consecutive year of double-digit ARR growth across good macro setups and bad. And indeed, ARR growth has generally been accelerating over that time as more of these growth drivers came into play. I'd also point out that several of these drivers should be more impactful going forward, whereas none of them show signs of fading away. The sluggish macro, no doubt has cost us a small amount of growth here in fiscal 2023, but past history suggests we'll get it back when macro conditions improve. Bottom-line is we feel very confident that PTC is positioned to deliver sustained double-digit ARR growth at or near the top of our peer group. Most importantly, please keep in mind that it is ARR, not revenue that drives free cash flow at PTC. On the subject of free cash flow, then, let's turn to slide nine where I'd like to double-click on the dramatic increase in margins that we've been driving, which raises similar investor questions of how and for how long. Our strong margin expansion, best measured using our operating efficiency metric, starts with the bottom four strategies we've been driving for many years. The first and biggest expansion driver has been the mix shift from professional services to software. Before this transformation, our revenue had a roughly 25% mix of low-margin professional services, whereas currently, we're at about 7% professional services mix on our way to a 5% mix thanks to the recent arrangement to sell a portion of our professional services business to ITCI in the form of DxP Services. In turn, the large system integrator partner ecosystem we built has become a critical part of our growth strategy as SIs help create software demand in order to drive demand for their own services. We've been backfilling the low-margin services mix with high-margin software all along. And by the time we get to our 5% services mix target, the cumulative effect of this mix shift will be about 10 points of margin expansion. We feel the negative impact to revenue growth from declining services revenue over the years has been more than justified by the positive impact of the higher profit software mix to our margins and free cash flow. Said differently, the quality of PTC's revenue has increased dramatically. At the next level, a second big driver of margin expansion has been our go-to-market improvements, which had dramatically increased the productivity of our salesforce over the years. In particular, our development of a strong cross-sell muscle has been very helpful to sales productivity and naturally, we leverage this key strategy whenever we bring acquired products into the mix like Codebeamer and ServiceMax. The third big driver in this group is our R&D offshoring program, which allows us to maintain relatively rich resourcing against more moderate spending levels. We tend to have a higher degree of offshoring than peers, and we have consistently proliferated this strategy across our portfolio and into acquisitions that we make. On a non-GAAP basis, year-to-date R&D spending is around 16% of revenue, but R&D accounts for 37% of our employee base. Our largest offshore site is the PTC R&D center in India that will celebrate its 30th anniversary next year. So, you can see we have an incredibly deep pool of talent and expertise there. The fourth item to point out is the portfolio rebalancing we do as part of our planning every year to ensure that our resources are best positioned to drive growth while maximizing profitability. This strategy essentially boiled down to driving low-growth businesses at very high margins while driving moderate growth businesses at good margins, thus reserving sufficient dry powder to invest more aggressively to develop new high-growth businesses like Onshape, all while retaining an attractive and expanding company margin profile. The next layer, the margin strategy is to leverage the benefits of scale that a recurring subscription business offers. Because growth in ARR requires relatively little growth in terms of variable costs, we've been doing a good job following our rule of thumb that on average, our costs will rise at half the rate of ARR growth, helping to drive expanding margins year after year. The improving commercial discipline around churn, discounting, and price optimization that I previously mentioned as a growth driver is obviously a margin driver too, since our input costs are essentially the same independent of churn, discount, and price levels. The incremental growth we get here comes at nearly 100% margin. Finally, the changes we made in fiscal 2021 to align our field organization to SaaS organizational principles, together with the operational rebalancing we did in fiscal 2022 to better align spending with our growth outlook in IoT and ARR have been big margin drivers because they've allowed us to meet incremental resourcing needs without incremental hiring. Our IoT business, for example, now has mid-teens operating efficiency margins while being accretive to company growth. Similar then to what I said about ARR growth, the significant margin expansion we're delivering here in fiscal 2023 is really due to all of the above factors. In my view, these gains are fully sustainable with more to come in the future. As Kristian and I have said previously, we expect our operating efficiency margin to expand to 40% by fiscal 2025 and expect we can get to mid-40s longer term. So, we continue to have a lot of runway here. Moving on to slide 10 then. I'd like to discuss our plans for CEO succession. I feel the company is in great shape in terms of topline and bottom-line growth with multiple layers of initiatives that can sustain this performance well into the future. I trust you see we're continuing to demonstrate the resilience of our business as our growth powers on while PMI trends in the wrong direction. So, for me, with more than 25 years under my belt now at PTC, half that time as CEO, I think it's a perfect time to think about putting a new generation of leadership in place that can sustain this high level of success well into the future. I love this company, and I'm very proud of all that's been accomplished during my time here, but life is calling me to a new chapter and following the succession I plan to retire from traditional management roles. PTC's Board has given careful consideration to who should be PTC's next leader and how we could best transition this person into the role to preserve our strategy and momentum. Our Board engaged Korn Ferry's CEO succession practice to determine what characteristics were most important in our next CEO and to vet our internal candidates and to consider external candidates. That careful process led us to an ideal successor in Neil Barua, the former CEO of ServiceMax. Neil is smart and articulate and he knows our industry. He's been a CEO twice already, yet still has a lot of career runway. He has a finance background, but really leans in with customers and product strategies. He's developed great followership within PTC already. And by the time Neil becomes CEO, he will have spent more than a year coming up to speed as a PTC insider. We are set up to have a seamless transition that offers complete continuity in the company's strategy and performance. So, effective now we've made a series of changes that initiate the transition process. I have been named Chairman and CEO and with plans for the CEO role to transfer to Neil on February 14th, 2024, which is the date of our next Annual Shareholders Meeting. Neil has been appointed to the Board and has been given the title of CEO Elect. Neil and I will work together over the coming six months to ensure Neil has ample opportunity to get to know our important customer, employee, and shareholder constituencies and to transition my knowledge, relationships, and responsibilities to him. Given that I'm a non-independent Chairman by definition, the Board has appointed experienced Director, Janice Chaffin, to be Lead Independent Director. Neil will inherit and be surrounded by an excellent team that fully supports him. Mike DiTullio will continue to head our operations as President and COO. Kristian Talvitie will continue to head our financial strategy as CFO. Likewise, other PTC executives, such as our Chief Product Officer, Chief Technology Officer, Chief Strategy Officer, Chief Legal Counsel, and Chief Human Resources Officer will remain in place throughout the transition and beyond. This transition should be very smooth. The bottom line is that the Board chose a great successor whom I fully endorse and who has the support of the entire team. I'm very happy for Neil and for myself, I might add, that we could find such an elegant way to transition PTC leadership into what promises to be an exciting and successful next phase for the company. With that, I'd like to turn to slide 11 and ask Neil to spend a few minutes introducing himself before we move back to Kristian for additional commentary regarding results and guidance.

Neil Barua, CEO Elect

Thanks Jim. Hello to everyone listening. It's great to be on the call today. PTC is a terrific company, and it's an honor to be named PTC's next CEO. I want to thank the Board for running a thoughtful succession planning process and for the vote of confidence they placed in me. I've learned a lot about PTC since the ServiceMax acquisition seven months ago, and I'm excited to continue learning from Jim, Mike, Kristian, and the rest of the leadership team during the transition period. I want to personally thank Jim for all he has done for PTC for setting things up so well for me and the team and for the friendship that we've built. For those on the call who don't know me, I've been in the tech industry for nearly 25 years. I was CEO of ServiceMax for about four years before the acquisition by PTC. Prior to that, I was CEO of IPC Systems for four years. Prior to IPC, I worked in the technology PE space as an operating executive at both Silver Lake and Francisco Partners. PTC is in a terrific position, and my top priority is continued execution. Over these last six months, I've seen firsthand how excited our customers are about our model-based closed-loop digital thread strategy and how critical our software is for their digital transformation journeys. I've also observed the talent and passion of our employees and the commitment they bring to our customers and partners. There is no other company like PTC, and I can't wait to roll up my sleeves and help take it to the next level. Over the next several weeks and months, I will be meeting and spending more time with our customers, employees, partners, and investors. I'll be joining many upcoming investor and analyst meetings with Jim and Kristian and I look forward to meeting you. Jim, thanks again to you and the Board. Over to you, Kristian.

Kristian Talvitie, CFO

Thank you, Neil. I want to start by highlighting Jim's strong support. It's been a pleasure getting to know you and I'm eager to collaborate with you in enhancing value for our customers and shareholders. Moving to slide 13, I want to point out that my discussion will focus on non-GAAP results and guidance, and that ARR references will be in both constant currency and reported terms. In the third quarter of 2023, our constant currency ARR reached $1.89 billion, reflecting a 25% year-over-year increase and surpassing the upper limit of our guidance. On an organic constant currency basis, excluding ServiceMax, we reported an ARR of $1.7 billion, a 14% increase year-over-year. Our as-reported ARR for Q3 was $61 million higher than our constant currency ARR on a year-over-year basis, with currency fluctuations being neutral to our growth in Q3. As Jim explained, our strong topline performance in Q3 was widespread across all regions and product categories. Many of you may have been tracking the manufacturing PMIs due to their historical connection to our topline when we previously operated under a perpetual business model. The global manufacturing PMI peaked in December 2021 and has remained under 50 for nearly a year. The Eurozone PMI has been especially weak. However, despite these trends, our topline, including in Europe, has continued to rise. Our subscription business model and low churn rates provide resilience to our ARR, and we see ongoing demand for digital transformation among our customers. In Q3, our ARR saw a benefit from timing, which we have considered in our Q4 guidance. We also adjusted our expectations for bookings, churn, start dates, and deferred ARR while raising the midpoint of our fiscal 2023 ARR guidance range. Now turning to cash flow, our results were robust with Q3 cash from operations of $169 million and free cash flow of $164 million, exceeding our guidance. This success stemmed from disciplined execution based on solid collections and cost management. Additionally, we experienced a net timing benefit of around $5 million in Q3, which is important to keep in mind as we discuss our Q4 cash flow guidance shortly. When evaluating and forecasting our cash flow, it's essential to remember that most of our collections occur in the first half of our fiscal year. Q4 typically generates the least cash flow, and annual free cash flow is primarily driven by ARR rather than revenue. In Q3, revenue totaled $542 million, an increase of $80 million or 17% year-over-year, and rose 21% on a constant currency basis. Recurring revenue grew by $83 million in Q3, though this was partially balanced by a $3 million drop in professional services revenue. This decline aligns with Jim's remarks about our shift to DxP Services for servicing our Windchill + lift and shift projects. As previously discussed, revenue is affected by ASC 606, leading us to view revenue as not the best indicator of our operational performance. Instead, we believe ARR is a more effective measure for analyzing our topline performance and cash generation capabilities. Moving on to slide 14, at the end of Q3, we had cash and cash equivalents totaling $282 million. Our gross debt stood at $2.365 billion with an average interest rate of 5.6%. During Q3, we paid down $180 million of debt, ending Q3 with $1 billion in high-yield notes, a $500 million term loan, and approximately $245 million drawn from our revolving credit facility. We have a second payment of $650 million for the ServiceMax transaction due in October 2023, with $620 million already recorded as debt on our balance sheet and $30 million in imputed interest expected to show in our Q1 2024 cash flow. This payment will be funded through our available cash and revolving credit facility. As previously noted, the deferred payment is included in our debt and is integrated into our debt-to-EBITDA ratio, which was three times at the close of Q3. We anticipate being at or below three times leverage by the end of Q4 and continuing this trend throughout fiscal 2024. Given the current interest rate landscape, we are focusing on reducing our debt during fiscal 2023 and 2024. We have paused our share repurchase program, expecting an increase of about 1 million shares in our diluted share count for fiscal 2023. By the end of fiscal 2024, we plan to have significantly reduced our debt and will reassess the balance between debt reduction and share repurchase opportunities. Despite this pause, our long-term objective remains to return roughly 50% of our free cash flow to shareholders through buybacks, mindful of the interest rate environment and strategic opportunities. Moving to slide 15, we can see our ARR by product group. In the constant currency section at the top, we use FX rates from September 30, 2022, to calculate ARR for all periods. The slide shows how FX dynamics have created discrepancies between our constant currency ARR and as-reported ARR over the past seven quarters. Based on exchange rates at the end of Q3 2023, our as-reported ARR for the end of fiscal 2023 is projected to be approximately $64 million higher than our constant currency guidance midpoint. We present both actual and constant currency results, with FX fluctuations potentially significantly affecting actual outcomes. It's important to remember that we provide ARR guidance on a constant currency basis. Should exchange rates vary considerably between Q3 and Q4, the effect on our as-reported ARR would also change. We believe constant currency is the most effective way to assess our business's topline performance as it eliminates the influence of FX fluctuations. With that, let’s go over our guidance on slide 16. For all ARR guidance figures, we're utilizing our constant currency FX rates as of September 30, 2022. For fiscal 2023, we anticipate constant currency ARR between $1.935 and $1.95 billion, corresponding to growth of 23% to 24%. We raised the lower end of our guidance by $10 million, resulting in a $5 million increase in the midpoint of our ARR guidance. Regarding cash flows, we are once again raising our fiscal 2023 cash flow guidance, now targeting cash from operations of about $605 million and free cash flow of approximately $585 million. As I mentioned last quarter, it's important to highlight that we're raising our cash flow guidance while also increasing investments in selected growth opportunities in the latter half of the year. The key takeaway is that our resilient business model allows us to maintain essential long-term investments even amidst a challenging macro environment. Furthermore, we are adjusting our shorter-term investments according to our business performance and outlook. This strategy has led to solid and consistent cash flow growth. We have streamlined our billing practices and optimized our billing and payment processes over the past couple of years. Consequently, the seasonal pattern of our free cash flow results has stabilized, and we are on track to preserve similar quarterly continuity in fiscal 2023 as well. For Q4, we are projecting free cash flow around $42 million, anticipating about $2 million in CapEx for the quarter, which leads to a cash from operations forecast of approximately $44 million. It is worth noting that we incurred acquisition and restructuring-related payments of $11 million during the first three quarters, with $3 million in Q3. We plan for another $11 million in payments for Q4, which is included in our free cash flow guidance. Looking ahead, we also intend to provide full-year and quarterly estimates for both revenue and EPS. We maintain the stance that revenue and EPS are not the best indicators of our business’s performance. Internally, we focus on ARR as our primary topline measure and free cash flow for our bottom-line assessment. Nonetheless, we recognize that external evaluations often center on revenue and EPS. Although we have consistently met or exceeded expectations regarding ARR and free cash flow in recent years, we have occasionally fallen short on revenue or EPS metrics that we did not explicitly guide to on a quarterly basis. Therefore, we will begin providing guidance on revenue and EPS quarterly. The EPS ranges we are offering correspond with our revenue guidance ranges, allowing for a wide spectrum of potential outcomes due to ASC 606-related factors. For fiscal 2023, we have narrowed our revenue guidance range and, mainly due to FX fluctuations, decreased the revenue midpoint by $5 million. Our fiscal 2023 revenue guidance is set between $2.09 billion and $2.12 billion, with Q4 guidance of $540 million to $570 million. Just a reminder, ASC 606 complicates revenue prediction in the short term, particularly for on-premise subscription companies. More importantly, revenue does not impact ARR or cash generation, as we generally bill customers annually upfront, regardless of the contract term. Now, regarding EPS, for fiscal 2023, we foresee GAAP EPS between $2.14 and $2.45 and non-GAAP EPS ranging from $4.07 to $4.38. Our Q4 guidance range for GAAP is $0.47 to $0.77 and for non-GAAP, it’s $0.95 to $1.25. Since revenue is subject to ASC 606 effects, it’s critical to remember that earnings per share is also influenced. Having laid out our guidance, let's quickly recap how it has evolved this year on slide 17. To start, looking at ARR, when we commenced fiscal 2023, we had a constant currency ARR growth estimate of 10% to 14%, attributed to the uncertain macro environment. While it’s evident we are navigating a challenging macro landscape, we’ve managed to achieve solid results, raising our low-end guidance each quarter this year. Our midpoint for fiscal 2023 ARR guidance now reflects a growth estimate of 13% in constant currency. As we look ahead to next year, while we aren't offering fiscal 2024 guidance yet, it’s reasonable to anticipate a similar setup for ARR guidance as we weigh our market opportunities, pipeline, momentum, and the macro environment at the time. Assuming the current conditions persist, I would expect our ARR guidance next year to mirror this year’s, and just as this year, we anticipate delivering a free cash flow result within our previously communicated guidance range for fiscal 2024, irrespective of ARR outcomes. In a macro environment, we will approach our spending with more caution, while in a more favorable topline environment, we would be inclined to increase our investments. Thanks to the stability of our business model, we have considerable flexibility to align ongoing topline revenues with corresponding operational investments, mainly in headcount and COGS linked to SaaS delivery. We have proven our capability to actively align our investments with the macro and business momentum we experience. Looking at the growth of our free cash flow guidance, we have successfully raised our guidance every quarter this year, starting the year with a forecast for 35% growth and now projecting 41% growth. Turning to slide 18, you can see an illustrative constant currency ARR model demonstrating our results over the past seven quarters, with the column on the right showing what is required to reach the midpoint of our Q4 fiscal 2023 ARR guidance. Given the seasonal nature of our ARR, the most relevant comparison is the sequential growth from Q4 of 2022. The model indicates that to achieve our Q4 2023 guidance midpoint of $1.943 billion, we need to add $75 million of ARR sequentially, which is $1 million less than the $76 million added in Q4 of fiscal 2022. With all that in mind, we believe our constant currency ARR guidance range is set thoughtfully. To summarize on slide 19, we have a strong portfolio and strategy. This year, we expanded our leadership in PLM, which has established a technological backbone for digital transformation in industrial companies. The addition of ServiceMax further enhances our already unique portfolio of interconnected digital capabilities throughout the full product lifecycle. Second, we are executing well with organic growth at double-digit levels. We are in the initial stages, but successfully navigating a significant shift from on-premise to SaaS, creating a growth tailwind that should last for years. Additionally, as Jim mentioned, it’s too simplistic to focus solely on SaaS as the growth engine for PTC. We continue to benefit from multiple PTC-specific growth factors, such as customer expansion through cross-selling our exceptional portfolio. Third, we have a proven track record of margin expansion built over more than a decade. We are careful with our investments, balancing long-term prospects with short-term macro uncertainties. Operationally, we are streamlined and foster a culture of continuous improvement at PTC. Fourth, with organic ARR growth in the low teens against PMIs typically in the mid-40s, it’s clear that our business model demonstrates considerable resilience. Our topline growth and profitability margins are nearing leadership levels in our peer group. Finally, we are led by a team with deep expertise and a strong capability for enhancing growth and margins. The surrounding environment will continue to shift, and we will adapt while striving to advance the value we create for our customers. We’re making progress towards our midterm goals. In a tough macro environment, we've managed to deliver solid ARR growth in fiscal 2023. We are optimistic about continuing double-digit ARR growth and achieving our free cash flow target for fiscal 2024 amid persisting macro uncertainty. We are confident in our midterm growth and cash flow goals. With several positive trends in our favor, we genuinely believe PTC has a significant opportunity to enhance shareholder value. With that, I will hand the call back to the operator to start the Q&A session.

Operator, Operator

Thank you. Your first question comes from Jason Celino with KeyBanc Capital Markets. Your line is open.

Jason Celino, Analyst

Hey guys. Lots of unpack here. Jim, it looks like we have a couple of more quarters with you. So, I guess this isn't a goodbye yet. And Neil, looking forward to working with you as well. But I guess my question will go to Kristian. But to clarify, I think you said similar guidance framework for entering 2024 on how you kind of entered 2023. So maybe can you just elaborate on this a little bit more because I know you entered this year with 12% guidance midpoint. Thanks.

Kristian Talvitie, CFO

Yes. Thank you for the question, Jason. We're not providing guidance for fiscal 2024 just yet. Let's focus on finishing 2023 and see how the macro environment and pipeline develop. We initially set a guidance range of 10% to 14% for fiscal 2023 to account for significant macro uncertainty, which we have observed. I wouldn't be surprised if we see a similar situation as we enter the next year.

Jim Heppelmann, CEO

Yes, I think as we reflect on it, how we guided and how the year has transpired, we're pleased with the guidance. We're pleased with how resilient the business was. We're pleased with the fact that we've been able to ratchet the guidance up, but it feels like that was a good approach.

Operator, Operator

Your next question comes from the line of Matt Hedberg with RBC Capital Markets. Your line is open.

Matt Hedberg, Analyst

Great. Thanks for taking my questions. Congrats, Jim, 26 years, quite a run. Neil, I look forward to working with you more closely. And yes, I guess, Jim, we do get you for a few more quarters. So, that's good as well. I had a question on Creo Plus. Obviously, it just launched. Curious on some of the initial customer feedback. And really then, once you start to get more data, do you suspect that we'll see similar upsell to what you're seeing with Windchill +, which I believe is somewhere in the neighborhood of 2x uplift?

Jim Heppelmann, CEO

Yes, Kristian, why don't I take the first half of the question and the customer reaction and you take the uplift part. So, yes, we have, I'd say, good momentum out of the blocks. I mean, in the first quarter, introducing it in the middle of the quarter, we didn't expect to necessarily do a lot of business. But actually, our first order came from a customer was at LiveWorx and said, wow, that's kind of what we're looking for. And that's a customer incidentally who was planning to add multiple CAD systems right now and was planning to standardize on one kind of had a preference for Creo and then came to LiveWorx and said, what we really want is Creo Plus. So, that example of a relatively short sales cycle from a company who was pretty impressed with the technology and some of the advantages it brings. So I think the reaction is good. I mean, it's very, very early. And so we shouldn't get ahead of ourselves. But it's always good to get out of the blocks fast and I feel like we did with Creo Plus in the quarter.

Kristian Talvitie, CFO

Yes. And hey Matt, just back to your question on the uplift. We would expect, obviously, an uplift for Creo Plus as well, although I don't think it's going to be quite the 2x; it will be a little bit less than that. out of the gates, somewhere probably closer to, I don't know, 1.7-ish, maybe 1.7, 1.8, somewhere in that ballpark.

Operator, Operator

Your next question comes from the line of Steve Tusa with JPMorgan. Your line is open.

Steve Tusa, Analyst

Hey guys. Good evening.

Jim Heppelmann, CEO

Hi.

Steve Tusa, Analyst

Congrats to both of you, Jim and Neil. Jim, didn't work with you for very long, but quite a run for sure.

Jim Heppelmann, CEO

Well, thank you.

Kristian Talvitie, CFO

We're concentrating on ARR and free cash flow, particularly sequential ARR, as our framework. The complexity of bookings involves many dynamics that require careful consideration, but ultimately, it all reflects in the ARR number and guidance. As we refine our guidance process, I hope you recall our previous discussions about expectations for the full year. We've adjusted the low end for the year and mentioned some timing issues. We exceeded our sequential ARR guidance for Q3, which contributes to our positive outlook on the business and the pipeline.

Steve Tusa, Analyst

And I guess the 11 to 14 you mentioned as like a good framework. Is that an organic constant currency metric that you're talking about?

Kristian Talvitie, CFO

Yes, it was actually 10 to 14. And yes, that would be organic constant currency.

Operator, Operator

Okay. And then one last one, just on the new guidance for EPS and revenue. Was that a decision made by you, or was it more of a strategic discussion related to investor relations?

Kristian Talvitie, CFO

Yes, that's exactly right. I mean, again, really, the way that we look at the business is ARR and free cash flow. Revenue is very volatile, not necessarily for performance reasons, but for accounting reasons. And it really doesn't tell you anything about the performance of the business in any given quarter or even trended just because varying term lengths caused so much volatility that you actually can't really use revenue and therefore, really the full P&L as barometer of business performance. But that said, we also recognize that the investment community when doing comparative analysis and so on, does actually still refer to revenue and EPS. And as I said, there's a scorecard out there, and we look at the ARR and free cash flow scorecard and say, hey, great, we're actually doing good. We're meeting or beating expectations. And then on revenue and EPS, where we don't provide quarterly guidance, then everybody's left up to their own devices to define what that might be on a quarterly or a quarterly basis for revenue and EPS. Sometimes we miss on the scorecard. We score a miss. And so we're really just trying to be more proactive about that and provide some color.

Jim Heppelmann, CEO

I want to reiterate some points. We don't see these as significant metrics, but we prefer to be aware of them. Therefore, we will provide some guidance to help you set your targets correctly.

Kristian Talvitie, CFO

Jim always makes much more sense.

Operator, Operator

Your next question comes from the line of Matthew Broome with Mizuho Securities. Your line is open.

Matthew Broome, Analyst

Thanks very much and congratulations to Neil on your appointment and of course, to Jim, on your retirement. You'll certainly be missed. In terms of the timing benefits to ARR, just how big was that benefit? And what was the reason for that?

Kristian Talvitie, CFO

Hey Matt, it's Kristian. So, the timing benefit was a few million dollars, and it just has to do with when contracts are actually getting signed, is basically what it boils down to. I mean, deals are being worked for, in many cases, many months. And it just has to do with that really.

Jim Heppelmann, CEO

Yes, I mean it's the start date phenomenon that Kristian always talks about sometimes. It's pretty typical that we signed a contract in this quarter. Sometimes it starts in this quarter, sometimes it starts next quarter. Sometimes it then ramps or not. So, just what we call in-quarter starts if it started in Q3 rather than Q4, well, it helped Q3, but then it came out of Q4. So, that's really what we're talking about.

Matthew Broome, Analyst

Got it. And then sorry, if I could just maybe quickly ask just in terms of this year's constant currency organic ARR growth guidance of 13%. How sustainable is that level of growth sort of going forward into FY 2024?

Kristian Talvitie, CFO

We are not providing guidance for fiscal 2024 at this moment, but we are aiming for mid-teens growth in the midterm. Jim did an excellent job detailing the various growth drivers that contribute to that potential growth, and we need to consider the macroeconomic factors that could affect it at any given time. I would not be surprised if our guidance is similar to last year's. We believe that a low to mid-teens growth rate is sustainable.

Operator, Operator

Your next question comes from the line of Adam Borg with Stifel. Your line is open.

Adam Borg, Analyst

Awesome. Thanks so much for taking the question. Maybe just on the macro, Jim. I know you don't want to talk or Kristian, do you want to talk explicitly around bookings trajectory in the quarter. But maybe you can talk a little bit more about the macro overall, how sales cycles changed in the quarter? And any changes by geography or vertical.

Jim Heppelmann, CEO

Yes, I think we can talk about it. I mean, I think at a high level, in the past several quarters, three quarters probably, we've talked about SMB being a challenge, China being a challenge. I think that continues particularly pockets of SMB, our arena business is not at the growth level it was previously. But that's not new news. That's kind of been here for multiple quarters already. And I think in Europe, we're actually surprised at how well we're doing, given some of the macro data points, the PMIs, stuff like that. So, it's sort of the same story as before, inside an uncertain environment, there's a few pockets of weakness. Most of the geographies and products are kind of doing just fine, and then there's some real pockets of strength too. Like we've said before, Aerospace and Defense, for example, happens to be a pocket of strength, medical devices happen to be a pocket of strength. So, it's kind of a mixed bag. I think it nets out for the year to less favorable than I want to be. And I said we did slow down a bit. I mean, we exited last year with 15% growth. And this year, at the midpoint, we're calling 13%, but the year is not over. So, it could be we lose a point, point and a half of growth this year, two points maybe, I don't know. But I'll tell you what, that's pretty darn good in this environment. And it's certainly better than any of our peers have been able to do in this environment. So, we feel proud about it and feel confident going forward that this is a very growth-oriented sustainable, resilient business and it's not likely to change dramatically from that. And one other thing I'd say, we've also experienced in the past that when there's a slowdown, for example, in some of these pockets like, let's say, arena, when the environment improves, we get a surge as all of that business come trickling in now because people have authorization to go forward with this project, they've had sitting on the shelf for a while. So, we saw this in 2009, we saw in 2020. In 2020 Q2 and Q3 were pretty weak, and we had a blockbuster Q4 and kind of made up for all of it. So, I also think our view is probably when the environment improves, and I'm not sure when that will be, probably, we'll get a surge of strength as some of these projects that have been held back by the customers get funded again.

Operator, Operator

Your next question comes from the line of Jay Vleeschhouwer with Griffin Securities. Your line is open.

Jay Vleeschhouwer, Analyst

Thank you. God evening. Jim, Neil, one of the interesting things about your closed-loop life cycle management strategy is the multiple forms of associativity across the product line. And with that in mind and at the risk of asking which of your children do you favor the most question. What do you think is the next big thing in closed-loop life cycle management? Is it PLM and ALM, PLM and SLM, is it perhaps CAD in simulation and SPDM or all of the above. But how do you think about where the next big thing in terms of incremental growth or share might be? And then if I could just add to that, related to the share, it's been demonstrable that you've gained share in your two biggest businesses, CAD and PLM, but SLM and ALM are smaller, arguably more fragmented businesses. So, how do you think about gaining share in both of those?

Jim Heppelmann, CEO

Yes, I think I'll take that one, Jay. It's probably not fair yet to pin on Neil, but maybe on the next call. But for this call, I'll take it. So, I think, first of all, I don't want to pick one thing, and that's kind of a message here is it's not like just one good thing happening at PTC. There's a whole stack of good things. But nonetheless, I think you would agree, we have a very strong PLM position and we've been taking share for years with PLM. In fact, you suggested it went from third place to second place and then I think we've gone to first place. So, PLM is a strength and I don't see that dying anytime soon. Now, that said, we acquired a real strength in ALM with Codebeamer, and that is a hot market. particularly in some places like automotive, which is a massive industry. I think most of you know, there's three to four software engineers per mechanical engineer in automotive development right now across all companies. So, that's a hot place to be, and we have a hot product in Codebeamer. And then I'd say in SLM, we have an offering that's pretty much unmatched. And particularly so when you take ServiceMax, the strategy we outlined at LiveWorx ServiceMax with Arbortext, with Servigistics, with ThingWorx, IoT with Vuforia ARR. There's just nothing to go against that, frankly, and certainly not anything model-based close-loop life cycle. I mean, the nearest thing we could point to in a competitor there would be like IFS, which is kind of a Swedish mainframe company. Not really over Siemens or anybody like that. So, I think we have some real strengths. But again, I don't think there's one. I think we have a portfolio of advantages we've been developing and will play out in our favor.

Operator, Operator

Your next question comes from the line of Joshua Tilton with Wolfe Research. Your line is open.

Joshua Tilton, Analyst

Hey guys. Thanks for sneaking me in here and congratulations to both of you. Jim, you mentioned you have a hot product with Codebeamer. We keep hearing nothing but positive things. Any chance you could just give a little bit more color on how it performed in the quarter. And I understand that it's officially organic, for Kristian, maybe just any sense for how it contributed to ARR this quarter and what you guys are baking in for its contribution in 4Q? Thanks.

Jim Heppelmann, CEO

At a high level, we previously had an offering called Integrity, which had aged over the years. Codebeamer is a much newer and cutting-edge product with excellent functionality and usability, supporting all the Agile principles that embedded software developers are looking to adopt. At the same time, it provides the regulatory framework necessary for development. It's an exceptional product, best in class, and it's thriving in a hot market. We have been doing very well with major automotive companies that are well known. I believe we will secure a few more in the upcoming quarters. It has certainly added to our growth. Last quarter, we reported 13% growth, but if we examine Codebeamer differently, it was 14%, and this quarter it remains at 14%. This indicates that while Codebeamer is not yet a large business, it is performing strongly enough to enhance the organic business by up to 100 basis points.

Operator, Operator

Your next question comes from the line of Ken Wong with Oppenheimer. Your line is open.

Ken Wong, Analyst

Great. Thanks for sneaking me in as well. So this question, I'm not sure if kind of appropriate at this stage, Neil. But mean Jim has established a pretty well-deserved reputation for delivering on cash flow and EPS in a past life. I guess as you kind of think about your background, how do you look at the business, would you characterize yourself as having more of a growth or margin tilt?

Neil Barua, CEO Elect

Thank you for the question, Ken. I appreciate it. To provide some context, I've been at PTC for the last seven months, getting myself embedded here. I've been spending meaningful time in Boston and will be moving my family here soon. This has given me a solid understanding of the business. As we transition from the great work Jim and the executive team have done, I am looking forward to deepening my knowledge of the company. I've been involved in collaborating with the executive team to build both our near-term and long-term plans, and I'm confident in what we have laid out based on the momentum I've observed. I fully support how Kristian has structured our free cash flow framework, focusing on our resilient business and the growth opportunities Jim has outlined. Even though I am new, I have invested time in understanding the business and I feel good about our layer cake growth strategy, as well as our disciplined approach to ensuring we remain focused on free cash flow.

Jim Heppelmann, CEO

I want to acknowledge that he is ahead of plan on the free cash flow for ServiceMax. He understands that cash flow is driven by growth and careful spending, and he has a solid plan in place.

Kristian Talvitie, CFO

And demonstrated you not to answer the previous question about which of Jim's children do you like.

Operator, Operator

Your next question comes from the line of Daniel Jester with BMO Capital Markets. Your line is open.

Daniel Jester, Analyst

Great. Thanks for taking my question. So, congratulations on the first cross-sell of ServiceMax, which I suspect on a different call might have been highlighted more in your opening remarks. Maybe you could just spend a minute sort of providing a little more context kind of how that deal came together. And as you think about accelerating the cross-sell opportunity, any sort of learnings or strategic adjustments you've made as you've got this first deal across the door? Thank you.

Kristian Talvitie, CFO

Thank you for the question. Over time, the integration of our services will enhance the entire digital process. Regarding ServiceMax and SLM, we are seeing strong cross-selling potential and positive momentum from a significant deal we finalized last quarter. This deal involved an established customer of PTC that we have been working with for several years. For the past three years, we aimed to secure this account as a standalone business under ServiceMax. However, when we merged the companies and presented our closed-loop digital thread strategy at LiveWorx, which combines PLM and SLM, it became clear that we offered valuable solutions for the customer. There were no other competitors for the industrial manufacturer from Europe. As for your second question, we are integrating our SLM portfolio with our PLM offerings across our customer base. We have only just begun this process, and as Jim mentioned, we've landed a significant deal. We feel assured that we are developing a robust pipeline and generating enthusiasm among customers who recognize the unique benefits of our closed-loop strategy.

Jim Heppelmann, CEO

Yes and I think that one was fortunate because LiveWorx made the lightbulb come on, and then we had a very short sales cycle. So I certainly hope we can have other such short sales cycles, that's atypical. But I think the light bulb went on for a lot of companies at LiveWorx, there was a lot written about it, if you've seen that. So, it was great support for the concept of the physical and digital, the closed loop model-based closed-loop product life cycle management concept. So, I'm very optimistic, and there are numerous deals in the pipeline. They just didn't happen to close quick enough to get done in the quarter.

Operator, Operator

Your next question comes from the line of Saket Kalia with Barclays. Your line is open.

Saket Kalia, Analyst

Awesome. Hey guys. Thanks for taking my question here and congrats Jim and Neil, on your respective next phases. Listen, most of my questions have been answered. But maybe one for Kristian. Anything to note on pricing here, Kristian. I know the last couple of years have been responsive to the macro backdrop, right? Like not necessarily using that as much during tough times, also responding with inflation during more inflationary times. Anything to note more recently on pricing? Or how are you thinking about pricing going forward?

Kristian Talvitie, CFO

Yes. Thank you for the question. I believe that as the Consumer Price Index continues to decrease and we see more stability in the overall economic environment, this will also influence our pricing strategy. Therefore, I expect we will witness some normal price increases again, unless there is an unusually extreme macro situation. That is what I anticipate regarding pricing actions returning to a more normalized state, similar to what we experienced prior to COVID.

Operator, Operator

Your next question comes from the line of Andrew Obin with Bank of America. Your line is open.

Andrew Obin, Analyst

Yes, hi. How are you guys?

Jim Heppelmann, CEO

Good. Hey Andrew.

Andrew Obin, Analyst

Jim, Neil, congratulations on the transition. I have a question. I know you have several AI offerings, including co-generative AI design and expert capture that utilizes semi AI. You've had AI within ThingWorx for a while now. Are you seeing an increase in customer inquiries due to the current AI news cycle? And is this enough to start making a significant impact?

Jim Heppelmann, CEO

Yes, I don't think it's ready to be a layer in the layer cake yet, Andrew, but it could head that way because certainly, there's a lot more industry buzz, a lot more people saying, what should we be doing? A lot of engineers saying, what does AI mean to engineering? And there's a lot of work going on at PTC, as you would expect, say, what else could we do? And of course, there's two dimensions of that. What can we do in our products that would create more value for our customers? And then secondarily, what can we do in our operations that would make us more productive? So, there's a lot of things happening here. And then we do have these three capabilities in the market already. So, I don't think that deserves yet to be a layer in that layer cake of growth drivers, but hey, let's try to develop it into one. I know that's on Neil's list.

Andrew Obin, Analyst

Excellent. And just a follow-up question. What areas have you been adding incremental spending year-to-date?

Kristian Talvitie, CFO

Andrew, it's Kristian. So, if you're referring to the comments that we were talking about kind of increased investment in the back half and growth drivers that's been primarily in continued investment in Windchill + in Codebeamer, in particular, to name a couple.

Operator, Operator

Your next question comes from the line of Nay Soe Naing with Berenberg. Your line is open.

Nay Soe Naing, Analyst

Hi, thanks for taking my question. Congrats to Jim on your upcoming roles. I wanted to ask about the weakening macro numbers in the global manufacturing PMIs. When do you expect to start feeling the impact from these declines, and which areas would you address first? Would it be new business or when renewing contracts, especially if customers are committing to lower contract values than anticipated? Additionally, how much of a risk to growth percentage points do you foresee if these macro pressures affect performance?

Jim Heppelmann, CEO

I think I can start this discussion with some help from Kristian. The factors that contribute to annual recurring revenue are primarily bookings and churn, so let’s exclude deferred revenue for now. We haven’t seen any signs of increased churn during tough economic times. We didn’t observe it in 2009, 2020, or this year. Our software typically remains fully utilized in production, with churn rates staying consistent. So, I believe we can rule that out. There’s no data across three economic downturns to suggest that our model is vulnerable. Regarding bookings, we have seen some pressure in certain areas. When Kristian mentioned previously that we expected our organic bookings to be flat this year, we had hoped for better outcomes. That's where we’re feeling the pressure. Last year, we provided scenarios with a forecast of 10 to 14% and indicated that we could handle considerable pressure on bookings while still achieving strong ARR results and impressive free cash flow. Our business model demonstrates considerable resilience due to its recurring nature combined with low churn rates. You can revisit that guidance. While we’re not trying to forecast the next year, I’d note that the low end of our scenario anticipated a 30% decline in bookings, similar to what we experienced in 2009, though the metrics were different then. Ultimately, we believe that even in challenging environments, we can achieve growth rates that outpace our peers, as well as leading free cash flow growth, thanks to the nature of our business.

Kristian Talvitie, CFO

And I mean we're in a difficult environment right now.

Operator, Operator

Thank you very much. Particularly helpful. That is all. I'd like to turn the call back to Jim for closing remarks.

Jim Heppelmann, CEO

Thank you all for your kind comments regarding Neil and me. We appreciate it. There's a lot happening, and we will be quite active in Investor Relations this quarter. We will start with callbacks, both Neil and I will participate. We plan to be in New York on Tuesday of next week, and details will be shared via email from Matt and Shama. Additionally, various PTC representatives will attend the KeyBanc Virtual Road Show on July 31. We will be at the KeyBanc Annual Technology Leadership Forum in Vail on August 7, and at the Stifel Tech Executive Summit in Deer Valley on August 28. Furthermore, we will attend the Citi 2023 Global Tech Conference in New York City on September 6. There will be plenty of opportunities to connect with us. There's a lot of positive developments in the business, and we see this CEO succession as a healthy and careful process, which everyone is pleased with. Thank you for your time, your support is appreciated, and I look forward to seeing you on the road or during the next earnings call. Thank you.

Operator, Operator

This concludes today's conference call. You may now disconnect.