Earnings Call Transcript - PTC Q4 2023

Operator, Operator

Good afternoon, ladies and gentlemen. Thank you for standing by, and welcome to PTC's 2023 Fourth Quarter Conference Call. 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, Danica, and welcome to PTC's 2023 fourth quarter conference call. On the call today are Jim Heppelmann, CEO; Neil Barua, CEO-elect; and Kristian Talvitie, CFO. 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 U.S. 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, November 1, 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 CEO, Jim Heppelmann.

Jim Heppelmann, CEO

Thanks, Matt. Good afternoon, everyone, and thank you for joining us. As usual, I will focus on constant currency results when discussing top-line metrics, and Kristian will cover currency effects later in the call. I'm pleased to report that in the fourth quarter, PTC again delivered solid financial results in terms of ARR and free cash flow, which are the most important metrics to assess the performance of our business. Reflecting on the full year, which will be my last year in the CEO seat, fiscal '23 has been one of PTC's best years ever. Despite a challenging economy, we delivered a seventh consecutive year of double-digit top-line growth, with ARR growing 23%, 13% organically, and revenue crossing the $2 billion threshold. And on the bottom line, we delivered 41% growth in free cash flow. This performance is a great stepping off point for me as I hand the reins of the company to Neil Barua going forward. Given the CEO transition that's actively underway, during this call, I'll focus my comments on Q4 and fiscal '23 and let Neil take the lead on forward-looking commentary. Coming back to the Q4 results and turning to Slide 4. Though the manufacturing PMIs have indicated a sluggish global environment for many quarters now, our top-line ARR continues to show good resilience. In Q4, we saw broad-based ARR strength across our product groups and geographies. Our churn remained low. And for the full year, we did better than the churn targets we had shared previously. Customer demand was solid in Q4, up overall and on an organic basis, in line with the exceptional results we delivered in Q4 last year. Within this context, the portion of business that we signed in Q4 but that did not start in Q4 or fiscal '23 was greater than we had modeled. Since ARR only kicks in when the subscription starts, Q4 ARR was $8 million lower than we had modeled, while deferred ARR is consequently $8 million higher. With this influx, our total deferred ARR is now $20 million higher than it was at the beginning of fiscal '23. Kristian will explain that because of this added strength in deferred ARR, we are now guiding ARR to grow 11% to 14% in fiscal '24, higher than the 10% to 14% growth range we discussed previously. Moving to Slide 5 and switching to our bottom line view. We delivered $44 million of free cash flow in Q4, ahead of our guidance and up 52% year-over-year. For the full year, our free cash flow was $587 million, ahead of our guidance and up 41% year-over-year. Remember that ARR is the primary driver of cash flow, so this robust result was driven by a combination of strong ARR growth and higher operating efficiency. In fiscal '23, we delivered 38% operating efficiency, which was 620 basis points higher than fiscal '22, well above our initial target that called for approximately 450 basis points of improvement in operating efficiency. We expect these operating efficiency improvements to be sustainable, and we think our subscription business model will continue to provide us with operating leverage. Turning to Slide 6. Let's look at ARR growth by geography. ARR growth in the Americas was 25%. In Europe, ARR growth was 24%, and in APAC, ARR growth was 18%. Regionally, compared to a quarter ago, the gap between as reported and constant currency ARR widened in Europe and narrowed in APAC. On a global basis in Q4, our constant currency ARR growth was 3% less than our reported ARR growth. Versus prior quarters, we saw improved demand in China and in our SMB reseller channel. All three regions benefited from inorganic growth to varying degrees due to the acquisition of ServiceMax. Next, let's look at ARR performance of our product groups on Slide 7. In CAD, we delivered 10% ARR growth in Q4. Within these results, the growth magnitude was primarily driven by Creo but supplemented by strong percentage growth in Onshape. PTC is taking share in different parts of the CAD market with both products, and we're excited about the potential of our new Creo+ SaaS offering as well as Onshape. We launched Creo+ at LiveWorx event this past May, and the initial customer demand for Creo+ has been encouraging. Regarding Onshape, with NPS scores that lead the industry by a considerable margin and solid retention rates, we see good opportunities to take share in the part of the CAD market that Onshape focuses on. Garmin's recent decision to replace their incumbent CAD system with Onshape speaks to the maturing functionality and competitive differentiation of our products. In PLM, our ARR growth rate in Q4 was 34% or 15% organic, with the incremental inorganic growth coming from ServiceMax. ARR growth in Q4 was primarily driven by Windchill, but supplemented by strong organic growth in ALM, thanks to Codebeamer. Codebeamer has proven to be a great addition to our portfolio, with strong demand coming from manufacturing companies that might already be professional at managing hardware development but are struggling to deal with a growing wave of software complexity. While demand is most notable in the automotive industry due to the rise of software-defined vehicles, we see customer demand for ALM tools expanding in other verticals as well, driven by the trend towards software-driven products of all types. Not only do manufactured products contain more software than ever, but there has been an explosion of software configurations that need to be developed and maintained across a company's different product lines, including across model years, sales options, and cloud deployments. That's why we supplemented our Codebeamer ALM solution with the acquisition of Pure Systems. You probably know that on the hardware side of the manufactured product, configuration management has always been the special sauce of Windchill. Now, with the addition of the pure::variants solution, Codebeamer will be able to offer equally robust configuration management for the software side of the product. The Pure Systems company is relatively small, but their breakthrough pure::variants offering has already landed early wins at many of the same auto and industrial companies that are adopting Codebeamer. Introducing this key competitive differentiator and value proposition into Codebeamer makes our position in the ALM market even more promising. We've been taking significant share in the PLM market and are well-positioned going forward, with our strength in core PLM with Windchill Arena, complemented by strong positions in the faster-growing ALM and SLM parts of the market. Wrapping up my comments then. First, I'd like to say a heartfelt thank you to all of you who have supported me and my team over the years. Your insights and support have helped us to transform PTC into the awesome company it is today, a $2 billion scale growth and profit leader with a unique product portfolio that helps our manufacturing customers digitally transform their businesses. I'm personally very proud of what the PTC team has accomplished during my 13 years as CEO and much longer tenure as the company's technology and strategy leader. I feel things are in good position to transition the leadership to Neil Barua. Neil will be supported by the same team who drove our transformation, including Kristian, Mike DiTullio, Aaron Von Staats, Kevin Wrenn, Steve Dertien, Catherine Kniker, and thousands of other PTC employees. I wish them all the best as they evolve the business in pursuit of new ways to create value for our customers and shareholders under Neil's leadership, just as they did during mine. I will remain in the background supporting Neil through February, but I plan to let him take the stage in investor discussions going forward. With that, I'll hand the call over to Neil to share his perspectives on the CEO transition and the future of the PTC business.

Neil Barua, CEO-elect

Thanks, Jim. Hello, everyone. Let's turn to Slide 9. The CEO transition is progressing well and according to plan. I'm excited to soon step into the CEO role, and I appreciate everything Jim is doing to ensure a seamless transition. I spent much of the past quarter traveling with Jim to visit customers, employees, and partners. These meetings have been good opportunities for me to listen and to build relationships with key stakeholders. These meetings have also reinforced how relevant our software is to our customers' digital transformation initiatives. PTC has established a strong position with customers, and it is clear to me that there continues to be a lot of opportunity ahead. I'm also starting to meet with investors and analysts, and I'm looking forward to continuing and deepening the two-way dialogue. To that end, I'm looking forward to callbacks with many of you as well as some investor roadshows upcoming and conferences. We are working on nailing down a date for an Investor Day, likely in the spring after the CEO transition. More broadly, I've been immersing myself in all aspects of PTC's business. As one example, I worked closely with our team on the win at Volkswagen Group that we announced yesterday. This significant expansion of PTC's footprint underscores the value PTC brings to customers, and our customers rely on us to support their product development needs at scale. Our teams understand the digital transformation needs of our customers, and we have the right strategy and product portfolio to help them achieve their goals. There's no other company that can help manufacturers drive closed-loop product life cycle management across engineering, manufacturing, quality, and service. PTC is in a very healthy position, and I am energized by the business that has been built and the job ahead. Next, let's turn to Slide 10. On the Q3 call, we shared this framework, which shows the layers of cumulative drivers that support our top-line growth. Fiscal '24 is expected to be our eighth consecutive year of double-digit constant currency ARR growth. PTC's ability to put up consistent double-digit growth is well established. This is a good framework to understand the sustainability of our top-line performance. I won't go through each of the drivers now, but the takeaway is that all the layers contribute to our growth. PTC is clearly moving in the right direction, and my focus as the new CEO will be on ensuring disciplined and metrics-driven execution of the strategy. Moving to Slide 11. We also shared this framework on our Q3 call, which shows the layers of cumulative drivers that support our bottom-line growth. It's important to recognize that our strong free cash flow growth in recent years is attributable not only to our solid top-line growth, but also to our subscription license business model and strong operational discipline. Focusing on operational execution is essential to consistently deliver for our customers and our shareholders. As with the previous slide, all the layers in this framework are important, and I see good opportunities to further expand our operating efficiency. I want to reiterate that with our subscription model and operational discipline, we expect our free cash flow to grow faster than our ARR over the midterm. As we reinvest in our business to drive growth, we expect to do so prudently such that non-GAAP operating expenses are expected to grow at roughly half the rate of our ARR over time. Let's turn to Slide 12. Today, we are providing targets that reflect solid top-line and bottom-line growth over the medium term, which Kristian will take you through in more detail. As you will hear from Kristian, for fiscal '26, we are targeting ARR growth in the mid-teens and free cash flow of approximately $1 billion. If there is one takeaway from my comments today, it should be that I am singularly focused on leading PTC to execute to its full potential. As the company's next CEO, I strongly believe that we have the right strategy, organization, and product portfolio to drive consistent customer and shareholder value in the years ahead. Over to you, Kristian.

Kristian Talvitie, CFO

Thanks, Neil, and hello, everyone. Starting off with Slide 14. In Q4 '23, our constant currency ARR was $1.941 billion, up 23% year-over-year and in line with our guidance range. On an organic constant currency basis, excluding ServiceMax, our ARR was $1.77 billion, up 13% year-over-year. In Q4, our as reported ARR was $38 million higher than our constant currency ARR. Also in Q4, ARR was impacted by $8 million due to start date timing. The key point is we contracted the overall amount of business that we guided to at the beginning of the quarter. At end year starts landed as expected, we would have been around the high end of our guidance range. Now, with approximately $20 million more deferred ARR starting in fiscal '24 compared to what started in fiscal '23, we're increasing our fiscal '24 guidance range to 11% to 14%. Moving on to cash flow. Our results were solid and ahead of our guidance with Q4 operating cash flow of $50 million and free cash flow of $44 million. For the full year, our free cash flow was $587 million, up 41%. When assessing and forecasting our cash flow, it's always good to remember a few things. The majority of our collections occur in the first half of our fiscal year and Q4 is our lowest cash flow generation quarter. And on an annual basis, free cash flow is primarily a function of ARR rather than revenue. Q4 revenue of $547 million increased $39 million or 8% year-over-year and was up 6% on a constant currency basis. For the full year, revenue was $2.097 billion, up 8% or 12% on a constant currency basis. As we've discussed previously, revenue is impacted by ASC 606, so we do not believe that revenue or EPS are the best indicators of our underlying business performance. But we would rather guide you to ARR and free cash flow as the best metrics to understand our business and cash generation potential. Moving to Slide 15. We ended the fourth quarter with cash and cash equivalents of $288 million. Our gross debt was $2.322 billion with an aggregate interest rate of 5.7%. During Q4, we paid down $43 million of debt, and at the end of Q4, we had $1 billion in high-yield notes, a $500 million term loan, and approximately $202 million drawn on our revolver. In October of '23, we made the final payment for the ServiceMax transaction totaling $650 million, including $30 million of imputed interest, which will be included in our Q1 '24 free cash flow. We funded this payment with cash on hand and our revolving credit facility. The deferred payment was also included in debt on our Q4 balance sheet and also factored into our debt-to-EBITDA ratio, which was 3x at the end of Q4. Also in October, we drew an additional EUR 85 million on the revolver related to the Pure Systems acquisition. We expect to be below 3x levered at the end of Q1 '24 and remain below 3x throughout the remainder of fiscal '24. We're prioritizing paying down our debt in fiscal '24. We expect to use substantially all of our free cash flow to pay down our debt this year and end the year with gross debt of approximately $1.7 billion. We've paused our share repurchase program, and we expect our diluted share count to increase by approximately 1 million shares in fiscal '24. Heading into fiscal '25, we'll revisit the prioritization of debt repayment and share repurchases. Our long-term goal, assuming our debt-to-EBITDA ratio is below 3x, 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. Next, turning to Slide 16. Let's take a quick look at how we did against our initial guidance for the year. Summarizing our fiscal '23 financial results, in a challenging market environment, we executed well in all four quarters and consistently delivered solid top and bottom line growth. With that, let me move on to fiscal '24 guidance. Turning to Slide 18. We provide ARR on both a constant currency basis and on an as-reported basis. You can see on the slide how FX dynamics have resulted in differences between our constant currency ARR and as-reported ARR over the past 8 quarters. Clearly, as-reported ARR embeds a lot of FX volatility. We believe constant currency is the best way to evaluate the top-line performance of our business because it removes FX fluctuations from the analysis, positive or negative. That's why we provide ARR guidance on a constant currency basis. For fiscal '23, we provided constant currency ARR guidance for the year and constant currency ARR results for all four quarters using FX rates as of September 30, 2022. For comparative purposes, we also provided constant currency ARR history at these FX rates. Next, on Slide 19, we're taking the same approach for fiscal '24. Our as-reported Q4 '23 ARR was $1.79 billion based on actual FX rates as of September 30, 2023. That rate is our baseline for our fiscal '24 constant currency ARR guidance. For comparative purposes, we've recast our constant currency ARR history at these rates, which you can see on the upper half of this slide and is also in the data tables posted on our website. With that, I'll take you through our guidance on Slide 20. For fiscal '24, we expect constant currency ARR to grow from $1.979 billion to $2.19 billion to $2.25 billion, which corresponds to growth of 11% to 14%. Our Q1 constant currency guidance range of $1.995 billion to $2.01 billion corresponds to year-over-year growth of 22% to 23%. Note that we closed the ServiceMax acquisition right at the start of Q2 '23, so Q1 will be the last quarter we exclude ServiceMax from our organic growth rate. On cash flows, we're guiding for free cash flow of approximately $725 million in fiscal '24. Note that our cash flow guidance is not on a constant currency basis, so FX fluctuations can have an impact in either direction. For fiscal '24, our guidance for operating cash flow is $745 million. We're assuming CapEx of approximately $20 million. It's worth noting how consistent and solid our free cash flow results have been since completing our transition to a subscription business model. In addition, we maintain consistent billing practices, and we've optimized our AR, AP, and budgeting processes over the past few years. The predictability of our cash generation is tremendously helpful as we manage our business and invest for growth. For example, we're able to maintain core long-term investments even in a turbulent macroeconomic environment, which is great for customers and employees alike. Beyond our core investments, we adjust our shorter-term or more discretionary investments accordingly given our business performance and outlook. The net result is solid and consistent free cash flow growth. In fiscal '24, we expect approximately 55% or more of our free cash flow to be generated in the first half of the year, which is less than we've seen over the past three years. This is primarily because in Q1 of '24, our free cash flow of $180 million includes a $30 million imputed interest payment related to the deferred payment on our acquisition of ServiceMax. Finally, on this slide, we're continuing to provide revenue and EPS guidance to help you with your models. But as a reminder, ASC 606 makes revenue difficult to predict in the short term for on-premise subscription companies. More importantly, revenue does not influence ARR or cash generation as we typically bill customers annually upfront, regardless of contract term lengths. Also, since revenue is impacted by ASC 606, it's important to remember that margins and earnings per share are also impacted, so we do not view these as meaningful indicators of the performance of our business.

Jim Heppelmann, CEO

Maybe I can add, Neil. Just if I could. In the fourth quarter, we actually did transactions with five auto OEMs. The big one with Volkswagen and then smaller, in some cases, foot-in-the-door type transactions with other global OEMs. At least three of those, we have no meaningful CAD, PLM, or ALM business with prior to this Codebeamer win. So, I mean, certainly, we can upsell from the ALM position we had and sometimes from the PLM position. But what's really exciting is that we're knocking down big name new logos that we have no previous relationship with.

Neil Barua, CEO-elect

Thanks for the question. We indicated in a press release a large strategic relationship with Volkswagen across their entire enterprise where we are deploying Codebeamer to their enterprise users for all the use cases that we talked about. One of the themes that we're seeing is this is actually a tip of the spear and an enabler for getting into new logos, particularly in the automotive segment. What we're seeing is that a displacement of other tools in the marketplace now Codebeamer, with its differentiated capabilities and the element of the tieback to PLM within PTC is actually creating the momentum that we spoke about, and that will continue to push over the course of this year as well.

Kristian Talvitie, CFO

Candidly, I'd say I think there's even more room to continue to improve from here, albeit it will be at a more muted pace than it's been over the past three years or so.

Andrew Obin, Analyst

Neil, Jim. Just a question on PLM and specifically Windchill. You guys have been very successful with growing the business. And I guess the question I have as your customers digitize their operation and there's this build-out of this digital value chain. What's the opportunity to monetize beyond existing users, right, as more people touch the digital thread? What are the revenue opportunities? Are there sort of opportunities to charge people for different services? If you could expand on that?

Neil Barua, CEO-elect

As I mentioned, one of the drivers we've seen over many years now is around Windchill's adoption within our customers. What we've also seen is that expanding not only within engineering, but as you mentioned, it's now going to other groups that are tied closer to engineering, like supply chain, like quality as an example. As Kristian said, we're seeing this migration of Windchill becoming more of an enterprise-wide system of record. That will take some time, but we are seeing the trends moving towards that, particularly as we think about model base and the digital thread that is pushing on this lever. Jim?

Jim Heppelmann, CEO

Our rule of thumb has long been that when a customer first adopts an engineering and then expands to a broader enterprise deployment, there's generally 10x to 15x more users across the broader enterprise than there are in engineering. So as companies digitize, they're basically saying, we need to have everybody in the enterprise logging into the system and getting real-time data as opposed to working with data that's been exported out of the system. So I think that there is a real opportunity.

Kristian Talvitie, CFO

No, there isn't. When we discussed some of the factors at play, it means that interest payments are expected to decrease while cash taxes will increase. Otherwise, it's primarily about running the business.

Neil Barua, CEO-elect

Thank you, everyone, for joining us today. Kris and I will be both on the road in the weeks ahead, participating in investor conferences. Kristian will be at the RBC Conference in New York in mid-November. Kristian also will be going to London in early December, and will be at the NASDAQ and Berenberg conferences. I'll be at the Barclays Conference in San Francisco in early December. We also have two bus stores coming to visit us at our Boston headquarters in early November. Those visits will be hosted by Kristian and Mike DiTullio; reach out please to BofA or Baird if you're interested. And on behalf of the team, thank you again, and we look forward to engaging with you.

Operator, Operator

Thank you. Ladies and gentlemen, that concludes today's call. Thank you all for joining.