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Edited Transcript of PTC earnings conference call or presentation 19-Jul-17 9:00pm GMT

Thomson Reuters StreetEvents

Q3 2017 PTC Inc Earnings Call

NEEDHAM Aug 13, 2017 (Thomson StreetEvents) -- Edited Transcript of PTC Inc earnings conference call or presentation Wednesday, July 19, 2017 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Andrew D. Miller

PTC Inc. - CFO and EVP

* James E. Heppelmann

PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board

* Timothy M. Fox

PTC Inc. - VP of IR

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Conference Call Participants

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* Jay Vleeschhouwer

Griffin Securities, Inc., Research Division - MD of Software Research

* Kenneth Richard Talanian

Evercore ISI, Research Division - Analyst

* Kenneth Wong

Citigroup Inc, Research Division - VP

* Matthew George Hedberg

RBC Capital Markets, LLC, Research Division - Analyst

* Monika Garg

Pacific Crest Securities, Inc., Research Division - Research Analyst, Vertical Software

* Robert Cooney Oliver

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Saket Kalia

Barclays PLC, Research Division - Senior Analyst

* Sterling Auty

JP Morgan Chase & Co, Research Division - Senior Analyst

* Steven Richard Koenig

Wedbush Securities Inc., Research Division - Analyst

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Presentation

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Operator [1]

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Good afternoon, ladies and gentlemen. Thank you for standing by, and welcome to the PTC 2017 Third Quarter Conference Call. (Operator Instructions) And I would like to turn the call over to Tim Fox, PTC's Vice President of Investor Relations. Please go ahead.

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Timothy M. Fox, PTC Inc. - VP of IR [2]

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Good afternoon. Thank you, Christine, and welcome to PTC's 2017 Third Quarter Conference Call. On the call today are Jim Heppelmann, Chief Executive Officer; Andrew Miller, Chief Financial Officer; and Barry Cohen, Chief Strategy Officer. Today's conference call is being broadcast live through an audio webcast, and a replay of the call will be available later today on our Investor Relations website.

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. Information concerning factors that could cause actual results to differ materially from those in the forward-looking statements can be found in PTC's most recent annual report on Form 10-K, quarterly reports on 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, July 19, 2017, and PTC assumes no obligation to update these forward-looking statements.

During the call, PTC will discuss non-GAAP financial measures. These non-GAAP financial 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 Investor Relations website.

With that, I'd like to the turn the call over to PTC's CEO, Jim Heppelmann.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [3]

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Thanks, Tim. Good afternoon, everyone, and thank you for joining us. Our Q3 financial performance was solid, and overall, we continued to make important strides against our major strategic initiatives during the quarter. Revenue and EPS were at or near the high end of our guidance. And momentum around our recurring revenue model progressed further in Q3, with total deferred revenue growing 38% year-over-year and annualized recurring revenue, or ARR, growing 11% year-over-year. Our license and subscription ARR crossed the $300 million milestone in the quarter.

However, after 6 quarters of very strong bookings momentum, sales execution issues in Japan drove bookings results below our guidance range. Japan missed its plan by $11 million and bookings declined $12 million from a strong Q3 last year. Year-to-date, Japan's bookings are down $20 million versus last year, which is an issue that's been a drag on otherwise great bookings performance so far this year.

While in the first half of the year, exceptionally strong performance in the Americas and Europe was able to offset weaker performance in Japan, in Q3, that was not the case. There were a few more large deals in play in the Americas and Europe that could have offset our Japan performance, but we were unable to close them in the quarter.

Let me take a moment to provide some color on Japan and the steps we've taken to remedy the situation. About a year ago, we reassigned our Japan country manager to the U.S. to drive some larger global initiatives and to further his professional development. During his 7-year track record running Japan for PTC, this executive grew bookings at a CAGR of 14%. When his job changed last year, we thought he had adequate bench strength in Japan. However, it became apparent that we did not because the leadership change exposed the sales execution issues that affected this quarter and their performance year-to-date. To address this, we've already relocated the former country manager back to Japan, where he is leading the team there through a full remediation plan. This leader knows our Japan business well and it has prospered under his leadership, so we are simply reverting back to what was a very successful configuration. We're confident we can get this region back on track in the coming quarters.

In terms of the macro situation, the PMI in Japan was 52 in June, which was a 10th quarter of modest expansion. While 52 is not particularly strong, we believe it suggests the challenges are mostly internal to PTC and, therefore, under our control. We do not believe there's been any change in the competitive landscape in Japan, and the deals that didn't close remain in the pipeline.

As we address Japan, we're pleased with our performance in the Americas, Europe, and in our global channel. Year-to-date in constant currency, Americas bookings growth is in the high teens. Europe's bookings growth is in the mid-20s. And our channel has grown in double digits for 6 consecutive quarters. What does this all mean for Q4? Our Q4 pipeline is very strong, and our forecast is not dependent upon us fully fixing Japan in the fourth quarter, though we'll get started. Taking everything into account, our current Q4 forecast and guidance is essentially unchanged from last quarter, and we believe our long-term business model remains intact.

Now back to more specifics on Q3. To summarize my comments regarding how our business is performing, I will again frame the discussion around the 3 key initiatives that we focus on to maximize long-term shareholder value. As a reminder, they are first to increase the top line growth; second, to convert to a subscription business model; and third, to continue our margin expansion.

Let me start by discussing progress against our growth ambition. We remain focused on and committed to achieving sustainable double-digit growth by returning our core business to mid-single-digit growth consistent with the more mature CAD and PLM market, while growing our IoT business in the 30% to 40% range, consistent with the faster growing IoT market. That combination would create low double-digit overall growth for PTC. So against that goal even with headwinds from Japan, based on our Q4 forecast, we expect our CAD and core PLM businesses to achieve bookings growth at or slightly above the market rate for fiscal '17 and our IoT business to achieve bookings growth above the 30% to 40% range this year. In IoT, we had another solid quarter with strong contribution from customer expansions, which accounted for over 40% of our bookings. And the number of 6-figure deals grew sequentially and year-over-year, primarily driven by these expansions. New bookings continue to come from a variety of vertical markets and use cases with the manufacturing, operations, optimization use case taking the lead, followed by service optimization for smart connected products. During the quarter, we closed expansions with a leading food, beverage and snack company, several global aerospace and defense OEMs and a number of leading medical device companies. Even though these customers are generally still in the early days of their IoT journeys, adoption is gaining momentum as customers drive increasing value from their IoT initiatives and are relying on PTC to be their IoT partner.

This momentum was on display at our LiveWorx event in May, which continues to set the standard for IoT events across industry. More than 8,000 attendees from 44 countries were exposed to some incredible new innovations from PTC, including a growing stable of industry-specific solutions from both PTC and our IoT partner ecosystem and plenty of tangible evidence that IoT is becoming a strategic lever for the industrial economy. At LiveWorx, we introduced ThingWorx 8, further solidifying PTC's position as an IoT platform leader. Building on the success of ThingWorx Navigate, we introduced a new lineup of apps for manufacturing that are easy to deploy with a rapid ROI. We believe these apps provide PTC with yet another powerful set of solutions to address the significant industrial IoT opportunity for optimizing manufacturing operations.

We also announced that ThingWorx Studio now supports native authoring and publishing of augmented reality experiences for the Microsoft HoloLens. Recall that ThingWorx Studio is our codeless authoring environment that enables content creators to quickly create, deploy and then consume interactive AR experiences. The HoloLens is currently the industry's most powerful wearable device, and Studio can deliver amazing experiences on it, so we're very excited about this new development. ThingWorx Studio has been generating incredible customer interest overall as evidenced by our trial program, which now has over 3,000 enterprises test driving the technology, with an accelerating pace of customers moving Studio into production deployments.

A vibrant partner ecosystem is key to any platform strategy. And the ThingWorx team delivered some key wins in Q3, including an agreement with Vodafone, who is building ThingWorx-based solution for smart city applications. We closed a significant deal with another global communications company, CenturyLink, that plans to leverage ThingWorx for their smart city use cases as well. And finally on the partner front, we secured a multiyear agreement with Analog Devices, who plans to go to market with ThingWorx-based solutions targeting a range of industrial and agricultural use cases.

To close on IoT, we recently received 2 Compass Intelligence IoT Awards, including IoT Company of the Year. Our strong technology and market position received further validation from a top-tier industry analysts when IDC published their MarketScape report on IoT platforms, which placed PTC squarely in the leadership category and recognized PTC as the IoT market share leader.

Turning now to our Solutions business. I'd like to preface my comments by reminding you that we had very strong solutions bookings performance in Q3 of '16, which grew 30% year-over-year, creating difficult compares, especially across our core business. And of course, weakness in Japan this quarter pressured our Solutions booking performance as well.

That said, when we take a deeper dive into Q3 performance, we saw a positive momentum in several important areas of the core business that I want to highlight. In our CAD business, a resurgent reseller channel continues to benefit from our go-to-market initiatives, delivering 20% constant currency year-over-year bookings growth. From a geographic perspective, we saw a strong CAD bookings in the Americas and in Europe with bookings growth of 19% and 25% year-over-year, respectively. And when we look at our CAD bookings globally on a year-to-date basis, we have outpaced market growth rates despite the Japan headwinds. In core PLM, bookings were up 5% sequentially from Q2 '17, driven primarily from strong performance in the Americas. Year-over-year, PLM was down for the quarter, as expected, due to a tough compare against the megadeal last Q3. Year-to-date, core PLM is in the mid-single-digit range. And based on our Q4 forecast, we expect core PLM to grow at or slightly above the market growth rate.

The PLM business continues to benefit from sales of ThingWorx Navigate, which you'll recall is our combined Windchill and ThingWorx offering that enables customers to deploy PLM technology to a broad set of end users across the enterprise. In Q3, we landed ThingWorx Navigate bookings across a variety of vertical markets, including automotive, aerospace, med device and high tech, which supports our view that this offering will resonate across thousands of enterprise Windchill customers, creating a significant long-term opportunity to drive continued PLM growth.

Lastly in our Solutions business, we continue to see lumpiness and variability in SLM with SLM bookings down year-over-year. To close out on the growth front, given the very strong bookings performance for the first half of the year with our Q4 guidance and the broad strength across Americas, Europe and channel, we believe we remain on track to achieve our long-range growth plan.

Let me turn now to our second top-level initiative to drive shareholder value, which is our transition to a subscription model. The Q3 '17 mix of subscription bookings was a little below our guidance due to our bookings performance highlighted earlier. We also had one large IoT deal that closed as a perpetual license. Subscription adoption continues to gain traction. And based on our forecast, we expect the subscription mix to rebound in Q4 to 68%. With our plans to move to a subscription-only model in the Americas and Western Europe beginning in Q2 of '18, and with additional subscription programs coming online each quarter, we remain confident in our long-term subscription mix and recurring software revenue targets.

Let's turn to our third top-level initiative to drive shareholder value, which is to further increase our operating margins. In Q3, our operating margin was within our guidance range, with operating expenses down $1 million from last year. As we look across the balance of the year, our expectation still holds the fiscal year '16 was the trough for full year operating margins, with an improvement of 100 to 200 basis points expected this year. Beyond fiscal '17, we expect to deliver even more rapid margin expansion as the subscription model begins maturing, and increasingly, the revenue we've been deferring begins to contribute to each quarterly period. Andy will take us through the guidance details later in the call.

To wrap up, PTC continues to make strong progress on our 3 levers to drive significant shareholder value, top line growth, our subscription transition and our profit expansion. On the growth front, our strong technology position and broadening partner ecosystem puts us in a good position to capture our share of the exciting high-growth IoT market. We made significant improvements across the broader business over the past 2 years as exemplified by our year-to-date constant currency bookings growth in the Americas and Europe of 17% and 26%, respectively, and by our double-digit growth in worldwide channel. We believe we have the right team and plan in place to fix Japan, and we expect that issue to be a temporary bump in the road.

On the subscription front, having exited the trough and seeing the revenue and earnings growth starting to fall into place as expected, it's clear we're in the final stretch of our business model transition. And on the margin expansion front, financial discipline remains one of the cornerstones as we drive toward non-GAAP margins in the low 30s post transition.

With that, I'll turn the call over to Andy.

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Andrew D. Miller, PTC Inc. - CFO and EVP [4]

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Thanks, Jim, and good afternoon, everyone. Please note that I'll be discussing non-GAAP results.

Bookings of $90 million were $5 million below the low end of guidance due to sales execution in Japan, where at the end of the quarter, the forecast dropped significantly. On a year-over-year basis, Q3 bookings decreased 13% constant currency. The decline is almost entirely due to performance in Japan, but also due to a tough compare against a very strong Q3 '16 when we delivered bookings growth greater than 30%. Year-to-date, bookings were up 7% constant currency despite Japan impacting year-to-date growth by almost 800 basis points.

Subscription comprised 64% of bookings versus our guidance of 68%. The shortfall from our guidance is due to the bookings miss and due to one large IoT deal that closed as a perpetual license. The weighted average contract length remained approximately 2 years.

Total deferred revenue billed plus unbilled increase year-over-year by $251 million, or 38%, to $909 million as of the end of Q3 '17. Billed deferred revenue was up $40 million or 9% year-over-year. Note that we believe total deferred revenue, billed and unbilled combined, is the most relevant metric, as there is a seasonality to the timing of our recurring revenue billings throughout the year and due to the timing of our fiscal quarter ends.

Subscription adoption trends were generally consistent with Q2 '17 with the exception of Japan. In our Solutions business, SLM and PLM led the way with subscription mix in the 70% to 80% range, and our direct CAD business was in the high 70s.

Our support conversion program continues to gain traction. In the third quarter, 29 customers, including both very large customers and about a half dozen midsize channel customers, converted their support contracts to subscription at an ACV uplift that was once again over 50% above the prior annual support amount. Additionally, for those large enterprise customers who did not convert this quarter and signed new support contracts instead, their ACV increased more than 20%. And I'll remind you that we do not include this increased support ACV in our bookings results. We believe that the conversion opportunity within our customer base is substantial and will play out over many years as we introduce new incentive programs, including a channel conversion program launched at the beginning of July and a new conversion program targeting our enterprise customer base that we'll launch at the beginning of FY '18. Q4 has an especially large pipeline of these large enterprise conversion opportunities. One last point about conversions, recall that we include only the incremental ACV in our bookings results, not the full contract value of the new subscription contract.

Turning to the income statement. Total third quarter revenue of $292 million was at the high end of our guidance range and up 2% year-over-year in constant currency, despite a year-over-year decline in professional services revenue of $7 million. Q3 was the second quarter of year-over-year revenue growth since launching our subscription program at the beginning of fiscal '16, highlighting that we have exited the subscription trough. Software revenue was up 5% year-over-year constant currency despite an increase in our subscription mix, including 133% growth in subscription revenue and 11% growth in total recurring software revenue. Approximately 87% of Q3 software revenue was recurring, up from 81% a year ago.

Operating expense in the third quarter of $174 million was down $1 million from last year. And Q3 operating margin was within our guidance range of 15% to 16%. EPS of $0.28 was at the higher end of our guidance range.

One note on currency in the quarter. We saw the dollar weaken against the euro, but we also saw currency movements in countries where we have little revenue yet significant OpEx, such as India. Also recall that we hedge near-term results locking in prior rates. As a result, currency ended up having an immaterial impact on our results in Q3 as well as on our year-over-year comparisons.

Moving to the balance sheet. Cash and investments of $311 million were up $19 million from Q2 '17, driven primarily by $78 million of adjusted free cash flow. During the quarter, we repurchased 35 million of stock.

Now turning to guidance for Q4 and the full year. But first, as a reminder, we hedge foreign currency, so much of our Q4 FX exposure was hedged before the dollar weakened in Q3. And for our unhedged exposure, our guidance assumes approximately current rates.

As we enter Q4, our pipeline is very strong. While we are not counting on immediate improvement in Japan, we feel very good overall about Q4. We expect bookings in the range of $120 million to $130 million, and a subscription mix of 68% for the fourth quarter. We expect total revenue in the range of $303 million to $308 million, including $84 million to $86 million of subscription revenue, an increase of approximately 110% year-over-year. At the midpoint of our guidance, Q4 recurring software revenue is expected to grow 12%. Total software revenue is expected to grow 9%, and ARR is expected to grow 12%. We expect our services margin to be 18%. And we expect OpEx in the range of $173 million to $176 million, down 4% at the midpoint from last year. This results in non-GAAP operating margin of approximately 18% to 19% and EPS of $0.33 to $0.38.

For the full fiscal year '17, our Q4 guidance results in a bookings range of $395 million to $405 million, which is a $10 million reduction at the midpoint, reflecting our Q3 bookings. Excluding the $20 million SLM booking we closed in Q4 '16, in constant currency, this represents 4% to 6% growth. From a subscription perspective, our full year guidance is now 67%, simply to reflect the 64% mix in Q3. For fiscal '17, we expect total revenue in the range of $1.163 billion to $1.168 billion, which at the midpoint represents 2% growth and is in line with our previous guidance, despite Japan's Q3 bookings shortfall. This includes subscription revenue growth of approximately 130% and total recurring software revenue growth of 10% at the midpoint. We expect our services margin will increase by about 150 basis points to 18%, and we remain committed to a 20% services margin in fiscal 2018.

Fiscal 2017 operating expenses are expected to be $680 million to $683 million flat year-over-year at the midpoint. We continue to expect our fiscal 2017 operating margin to be in a range of 16% to 17%, representing a 100 to 200 basis point improvement in operating margin over last year.

We are assuming a tax rate of 8% for the full year, resulting in non-GAAP EPS of $1.17 to $1.22 per share, which is an increase of $0.01 per share from our previous guidance at the midpoint.

We continue to expect adjusted free cash flow between $158 million and $168 million. Adjusted free cash flow excludes about $40 million of fiscal '16 restructuring payments and $3 million of legal payments from matters previously accrued in fiscal '16.

With that, I'll turn the call over to the operator to begin the Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question is from Saket Kalia of Barclays.

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Saket Kalia, Barclays PLC, Research Division - Senior Analyst [2]

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First, maybe to start with you, Andy, I think it was mentioned in the prepared remarks that the fourth quarter pipeline is strong. And the bookings guidance is roughly consistent with what was implied last quarter. And so can you just talk about whether you assume some of those slipped deals from the third quarter, specifically in the Americas and Europe, are going to close? I guess, why the confidence? Maybe more broadly, why the confidence in the fourth quarter bookings guide being roughly similar to before?

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Andrew D. Miller, PTC Inc. - CFO and EVP [3]

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Yes. So the confidence is based on the size of the pipeline as well as our analysis of the stages of the deals in the pipeline. We are not counting on Japan returning fully in the fourth quarter. We also recognize that there -- we have a fixed sales capacity and there's only 91 days in every quarter. So we don't believe that the deals that moved from Q3 that we closed in Q4 are going to be suddenly uplift that enables us to recapture the Q3 miss and have that be incremental to Q4, only a certain number of days to sell. If you actually look at it, our Q4 bookings as a percentage of our full year represents about 31% of the year, which is right in the range of history as well. So every way we surround it, it makes sense. And the only other thing I did mention when we have a very strong pipeline also of conversion deals, which converting people who, frankly, were previously on our volume purchase agreements. And that is -- provides us a compelling event, and that also, we think, is extremely helpful as we look at the forecast.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [4]

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And Saket, if I could just clarify one thing, the deals that slipped in the Europe and the U.S., I referenced that in my commentary. It's not so much that they slipped, but that we weren't able to accelerate them to backfill the late developing situation in Japan. So I don't want you to think that they slipped more than we weren't able to accelerate them to save the day quite frankly with the problem in Japan.

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Saket Kalia, Barclays PLC, Research Division - Senior Analyst [5]

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Understood. That's helpful. Maybe for my follow-up for you, Jim, in your prepared remarks, you talked about that same long-term formula driving double-digit bookings growth. And so the question is do you think that the hiccup in Japan could maybe impact that model as you look out to fiscal '18?

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [6]

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No, not really because, again, it's not like we have a problem in Japan and no leadership to go fix it. We simply need to reinstall the leadership profile. We have reinstalled the leadership profile that was exceptionally successful. If you go back, we really have had pretty consistent successful business in Japan for 7 years. And that's when the current leader -- the leader...

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Andrew D. Miller, PTC Inc. - CFO and EVP [7]

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Came over here...

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [8]

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Yes. Well, he joined 7 years ago. He did a fantastic job of guiding our Japan business for 7 years. We basically promoted him. And then ended up with a backfill problem. So we told him, "Take one for the team here, we need you to go back and fix it." So there's no person in the entire world more prepared to reinsert themselves in our Japan operation and get the machine running again than the guy who successfully built and operated the machine for 7 years. So we have a high degree of confidence, but it could take a little bit of time.

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Andrew D. Miller, PTC Inc. - CFO and EVP [9]

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Saket, I also want to put the miss in perspective as far as how it influences our long-term business model. We basically missed our ACV by just over $3 million, so it's $758,000 a quarter is the revenue impact. Now what we don't disclose in bookings, I mentioned how the -- how -- when someone doesn't -- we've had in the VPAs, we've had about half of our customers defer doing a conversion and instead sign up for higher support, where we typically get 20% to 25% more from their support. We never record bookings for that, but it does increase our ACV. So for example, that's something that mitigates the exposure that we have from this ACV miss. The fact that next quarter's guidance is intact, the ACV we expect it to be what we expected to be before, we basically have just over $3 million a year challenge that we have to fill, and we've got plenty of ways to fill that.

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Operator [10]

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Our next question is from Matt Hedberg of RBC Capital Markets.

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Matthew George Hedberg, RBC Capital Markets, LLC, Research Division - Analyst [11]

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So Andy -- I guess my first is for Andy. It's kind of a 2-part question. Last quarter, you talked about the idea of using a carrot more so than a stick within the enterprise, with the good, better, best program, I believe you called it, in terms of conversion to subscription revenue. So I guess a 2-part question would be, can you give us a little bit more color on some of the new conversion plans that you mentioned? I think in the enterprise the start of fiscal '18, I think you mentioned the channel the sort of July. And then the second question, what would you have to see for the idea of more of a stick mentality? Is that something that's still maybe a ways off?

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Andrew D. Miller, PTC Inc. - CFO and EVP [12]

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Yes. So let me first share the 2 programs. So in the channel program, which started July, July 2, I guess, essentially, there are 4 Creo extensions that are -- that previously generated very little in revenue, but there's things that customers desire -- like. And so you can pick 3 or 4 of those for an increase in your ACV over your maintenance contract of 25%. Now the list price for those is much, much higher. So our conjoined pricing study shows about half our customers in the channel were interested in that. So that's an interesting program there. So it's a [Take 3], I think is what that program is called. In the enterprise space, we have essentially a program, that good, better, best. The better is pretty much like what we play -- the play with what the largest customers. You get a restack and remix and all these other benefits from enhanced support offers and e-learning at the 15%, which we do not intend to introduce initially. When we start this in the beginning of '18, you would not get the restacked, which is one of the biggest things people value. And at the 35%, there was an interesting cohort of customers interested in that for essentially enhanced support capabilities and e-learning capabilities that really don't cost us anything. So that's what those programs are. The stick. The Autodesk carrot and stick, I think their situation is a little different from ours. I believe it's because they have customers that may not be on maintenance. And this carrot stick gets those customers to actually be paying for the technology every single year. And our situation is a little different from that. Most of our customers are already on maintenance, so we don't need the stick just to get them onto paying us every year. It's more of giving them something they value that they're willing to pay more for. We'll watch their program closely. I understand it's going well so far. We'll watch it closely and see if there are aspects of it that might make sense for us though.

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Matthew George Hedberg, RBC Capital Markets, LLC, Research Division - Analyst [13]

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Got it. And maybe just one quick follow-up for Jim, I just want to make sure we're crystal clear on Japan. I think am I correct in saying that you don't think there's anything macro related? Do you think this is all internal execution? I'm just getting a few e-mails on that. I just want to make sure we sort of understand sort of the macro aspect of Japan. I think you mentioned PMI in Japan.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [14]

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Yes. PMI was 52. Yes, we think this is an internal problem, not a macro problem, therefore a problem we can fix.

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Operator [15]

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Next question is from Steve Koenig of Wedbush.

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Steven Richard Koenig, Wedbush Securities Inc., Research Division - Analyst [16]

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I'd like to start with the Japan execution. Maybe could you guys drill down one more level and talk a bit about -- I understand that you had the personnel change, and that you're changing the former leader back in. Can you talk about what sorts of issues the leader will address? I mean was it involvement in individual deals? Was it involvement in visibility, process changes? Maybe just a little bit more color there.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [17]

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I think you nailed the key points. I mean, definitely, his personal involvement in the larger deals and cultivating the customer relationships, I mean, he had always done that. I think the backfill guy was not near so good at it. But I think also just the sales hygiene, to make sure that we were expecting things and the things were progressing as they should. And the things a good sales manager does, to our surprise, weren't really getting done.

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Andrew D. Miller, PTC Inc. - CFO and EVP [18]

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To make sure a deal every week is progressing toward the finish line. So he's implementing a methodology called [Medic] that PTC has -- PTC I think -- I understand started it 20 years -- 20, 30 years ago. So that's been already reimplemented in there, trained all the sales reps on that, (inaudible) of the message, all the basic blocking and tackling in enterprise software.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [19]

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And let just give you a little more context again. In Q1 in Japan, we were very disappointed. And I started talking about, is this a problem or was it just a 1-quarter blip in a transition to the new guy, and so forth. Q2 was only a mild disappointment, much better than Q1, but still not quite at plan, so -- but we were feeling like maybe this is getting better. And then Q3 was a disappointment of a larger scale than Q1 and Q2 put together. And that's when we said, okay, it's got to be changed right now. So we immediately implemented the change. The leader completely understands what he needs to do and why he needs to do it. And quite frankly, he's going back there to sort of salvage his reputation and rebuild kind of the excellent operation he had going there. So I think we're in good shape, but we're disappointed that this snuck up on us. It shouldn't happen that way. It's on us. We own it. We're going to go fix it.

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Andrew D. Miller, PTC Inc. - CFO and EVP [20]

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It was actually the worst Q3 in 7 years, which is how far back we checked.

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Steven Richard Koenig, Wedbush Securities Inc., Research Division - Analyst [21]

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Which is -- I'm sorry, which is what, Andy?

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Andrew D. Miller, PTC Inc. - CFO and EVP [22]

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It was the worst Q3 as far back as we could find numbers quickly, which is 7 years, for Japan, for Japan only.

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Steven Richard Koenig, Wedbush Securities Inc., Research Division - Analyst [23]

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Okay. Got it. For Japan. I was going to ask if you can remember -- I can't remember anything in that specific region that suddenly came to roost that suddenly, so that's helpful. I did want to ask on IoT. Can you tell us a little bit more about on how things are going with your major partnerships in IoT? And how that's translating to revenue? And kind of what your outlook is for your sales mix working with those partners?

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [24]

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Yes. Andy, I think we're still at a place where about 2/3 of the IoT business is generated through the PTC channel and about 1/3 through partners. Now we did land a couple of very big partners, Vodafone and CenturyLink, our -- and National -- Analog Devices, are very substantial companies who are placing very large bets on IoT and looking to ride our horse as they do so. So that's mostly looking forward, but I think we continued in the last quarter to see the sort of success we had previously seen. We'd love, of course, to see partners take on even more without seeing the PTC channel give anything up. That's our aspiration. But I think it's -- I don't want to say we're satisfied because I'm not sure we ever will be or should be satisfied, but I think we're making progress.

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Andrew D. Miller, PTC Inc. - CFO and EVP [25]

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By the way, all 3 of those, it wasn't just signing the agreement. They all bought this quarter.

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Operator [26]

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Next question is from Sterling Auty of JPMorgan.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [27]

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I want to ask the question this way because we're all getting hit with the same email questions. Take Japan out of it, if you look at your plan in Americas for bookings and your plan for Europe, did those 2 regions meet or exceed plan? Or did either of those regions fall short as well?

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Andrew D. Miller, PTC Inc. - CFO and EVP [28]

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I think the 2 of them together were over the plan, yes.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [29]

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Here's some math on it, Sterling. I mean, we did 90 in bookings against the guidance of 95 to 105, and Japan fell 11 short. If Japan would have landed on plan, we would have been at 101, the upper half of the range. If Japan would have missed by a couple of million, we would have been in the middle of the range. So we really feel like it's a concentrated problem in one area. And it's a problem that's 3 quarters deep. We got to go solve it.

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Andrew D. Miller, PTC Inc. - CFO and EVP [30]

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And the other thing critical to know, you've got year-to-date booking growth, 17% in the Americas, 26% in Europe, double-digit in the channel. I mean it's -- the business is strong broadly at this point with a significant problem that we're dealing with in Japan. Finally, the other thing we looked at is if you look at the volume transactions, the volume of transactions is actually up from a year ago, up in the high single digits.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [31]

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Right. So we did 10% more transactions than we did a year ago when we had substantially higher bookings, which is a good thing. It means that customers aren't not buying our software. It's just that concentrated problem around longer -- larger deals in one geography.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [32]

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Yes. So sorry to be nitpicky, but Andy, you said Americas plus Europe, just to drill that next layer...

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Andrew D. Miller, PTC Inc. - CFO and EVP [33]

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I think one was up by a couple of percent -- I mean, down by a couple of percent. The other one was up by more than that. It was smaller but I mean, it was close.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [34]

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In terms of -- yes, because Europe in some ways in terms of bookings, but I...

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Andrew D. Miller, PTC Inc. - CFO and EVP [35]

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It's okay. In fact, a deal can move it either way and either geo. So this is software.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [36]

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No, I understand that, but I'm getting specific questions around the Americas. Because it's clear based on the growth rates that Europe accelerated in the third quarter. So there's questions that I'm getting just wondering, did Americas fall short? And is there anything that we should read into that?

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [37]

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I mean, Americas had a decent quarter, Europe had better-than-decent quarter and Japan had a terrible quarter. And China was kind of somewhere in the mix. So that's the story. Had Japan delivered its part of the plan, we would have been in the upper half of the guidance range.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [38]

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Now that's clear. Last question. Within Japan, is there any particular focus, whether it was weakness in CAD versus PLM or just across the board?

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [39]

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Across the board. But where it wasn't was the channel. So the channel performed well. It was the direct business across the board.

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Andrew D. Miller, PTC Inc. - CFO and EVP [40]

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Yes, although the channel is much smaller in Japan than the rest of the world.

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Operator [41]

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Next question is from Jay Vleeschhouwer of Griffin Securities.

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Jay Vleeschhouwer, Griffin Securities, Inc., Research Division - MD of Software Research [42]

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I'll ask a Japan question, too. Let me ask it this way, which is what is it about Japan that makes your business there so susceptible to who the country manager is? It's been a long time, but if I think back over the last couple of decades, we've seen this before. I mean long before you were CEO, Jim, but this has happened before, as you probably recall. So what is it about the local market there where this really matters who's in place? And that's -- and we see it also with some of your peers in Japan, so it's not only you. So that's the question number one, and I've got a follow-up.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [43]

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Well, Jay, you and I have discussed Japan many times, but quite frankly, not for a while. So if you go back, PTC did -- if you go back more than 7 years, PTC was struggling on and off with Japan. The main problem we had is that we always relied on an expat, partly because we never had a local Japanese leader with good enough English skills whom we trusted, who trusted us, who could communicate effectively with us. So the easy answer was send an expat over there. Now Japanese culture and Japanese business culture is very different than anywhere else in the world, and Japanese companies and executives only do business with people they deeply trust. They do not trust expats. They see them as temporary solutions, they can't build a relationship with because in 2 years, this person won't be here anyway. So the guy we hired 7 years ago was a Japanese national. We poached him out of Oracle at the time. He was the #2 person from Oracle. He has decent English skills. He quickly built a good strong relationship with the PTC management team here in Boston and quickly built good strong relationships with the customers in Japan. And we then had a period of pretty decent stable consistent growth in Japan, at which point, we more or less promoted the guy. And he wanted and we wanted to give him an international experience and so forth for career development reasons. And he backfilled with a person that we didn't know as well because we always had this great executive standing between us and this person. And we collectively missed an understanding of what was happening and didn't catch it until it had bit us. But now we've got it and again, reverted back to the previously successful configuration and we think that's a winning recipe, proven recipe, we should be able to fix it.

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Jay Vleeschhouwer, Griffin Securities, Inc., Research Division - MD of Software Research [44]

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Okay. My follow-up for Andy, actually a 2-part bookings question, would it be fair to say that, to date, the support conversions bookings, the way you count it had been not quite 1/10 of the total LMS bookings number? And then secondly, could you say what your PLM bookings momentum would look like if we were to strip out Navigate?

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Andrew D. Miller, PTC Inc. - CFO and EVP [45]

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The first question is like for like, because as we've mentioned, we got more than 50% more this quarter and actually the prior 2 quarters as well. About half of that is the like for like typically. So that 25% uplift is just the conversion. And then they are buying more software at the same time, which is taking it up to over 50% for the last 3 quarters. So if you just look at the like for like, it tends to be in the low to mid-single digits range as far as how many millions of bookings. So it would be probably closer to the 4% to 5%, but of course, we're selling more software at the same time. I don't have the PLM growth rate without Navigate. As the way I would look at it, I wouldn't look at it that way because it's all -- we...

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [46]

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Yes. I mean, the sales team spent their time selling Navigate mostly in the existing PLM accounts, but as new functionality that brings new users onboard.

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Andrew D. Miller, PTC Inc. - CFO and EVP [47]

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Right.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [48]

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So in a way, this Navigate solution isn't any different than any other capability we might come out within the new release that we would be able to sell into the base to expand the user account. So we could strip it out. What we've done, Jay, that we think is more appropriate is we allocate be bookings credit and the revenue half and half. We say that, in fact, it should be accounted as PLM revenue to a degree and it should be counted as ThingWorx revenue to a degree, so we're very transparent and that we allocate 50-50 and that, to us, is the most reasonable, genuine way to report it to you...

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Andrew D. Miller, PTC Inc. - CFO and EVP [49]

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Yes.

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Operator [50]

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Next question is from Ken Wong of Citi.

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Kenneth Wong, Citigroup Inc, Research Division - VP [51]

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You guys characterized the Q4 pipe as a good conversion pipeline. And you guys typically kind of call out in your pipeline as, hey, it comes in as perpetual and will soon goes out as perpetual. Can you maybe elaborate a little bit on the dynamics there that make you guys feel it's a better conversion pipeline?

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Andrew D. Miller, PTC Inc. - CFO and EVP [52]

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It's because of the -- we have more customers and more dollars relative to volume purchase agreements that expire in this quarter than in prior quarters. So those are the ones where we have a stick.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [53]

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Right. So again to take you through this, let me just step back. A volume purchase agreement means sometime in the past, a customer purchased a large volume of software and negotiated a low maintenance run rate as a package. But that was for a period of time, generally, 3 years, sometimes 1 or 2. So at the end of that period of time, the maintenance discount expires and they should return to standard off-the-shelf rates. Now of course, they don't want to do that. So in the past, we would try to get another perpetual booking from them. Say, we'll buy more volume and we'll lock you again in that rate. And they frequently did Now what we're saying is we don't want a perpetual transaction. We either want you to convert to subscription and then it will be more because there's an uplift...

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Andrew D. Miller, PTC Inc. - CFO and EVP [54]

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25%.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [55]

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Plus typically we'll upsell. Or you're going to have to renew your maintenance at a higher rate, typically 25% more. So the key thing, though, is it forces them to make a decision in the quarter. So they're going to make some decision, that's the so-called compelling event, there's going to be a contract signed here. It's only a question of what the contract says, not if there will be a contract. Because these are large companies that are not going to let maintenance expire. So if they choose to extend maintenance and pay more, that actually is not a bad thing. It is not. And Andy said this and it's important to understand, that additional maintenance that they pay, we do not count as a booking. Now it does show up downstream in the revenue number, so it's a very good thing, but we don't call it as a booking. We only count it as a booking if they convert to subscription, and then only the incremental above and beyond the run rate that had been in place is considered to be a booking. So extending the maintenance is good. Converting it to a subscription is even better. The key thing is something is going to happen because they're not going to let it expire. So the combination of having a good pipeline in general and then a fair number of these bigger deals in the pipeline having this compelling event attached to them tells us that we've got a lot to work with and some good things in our favor.

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Kenneth Wong, Citigroup Inc, Research Division - VP [56]

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And then if you think about that conversion opportunity with the end of life coming in, in calendar year '18, I mean what's the early feedback then? Any pushback? Any potential last chance buying from customers?

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Andrew D. Miller, PTC Inc. - CFO and EVP [57]

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Again, because most of our customers on maintenance -- are on maintenance, it's hard to figure out who would go after that last perpetual buy because they already have access to the next version of the product as long as they had stayed on maintenance. I'm sure there is something there. We have -- we frankly don't know what it is. We do not believe it is likely to be anything like what Autodesk or Adobe experience way back when, simply because of the fact that our customers are on maintenance. So it's not like there's as strong of a compelling event when we -- end of life perpetual. If you look at it, our large deals like this quarter, every large deal, except one, was subscription. Last quarter, every large deal was subscription. I think the quarter before that, every large deal was subscription. So our largest customers are already buying this way. And in Americas and the channel, 75% of the bookings this quarter were subscription. So we've made so much progress that we think that this is just the catalyst to kind of get the -- get those that aren't paying attention across the goal line, frankly, to have a subscription business model.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [58]

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One little point I want to clarify there, too, Ken, is we will still renew maintenance contracts. It's just that new orders we'll only take as subscription. So just not to alert anybody. If somebody has a maintenance contract they've renewed 5 times, we'll allow them to renew it in a sixth time and a seventh time and an eighth time. But when they want to buy more, we'll tell them it's time to buy the more in a subscription model.

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Operator [59]

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Next question is from Rob Oliver of Baird.

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Robert Cooney Oliver, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [60]

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Just a follow-up on Ken's line of questioning. Maybe just to touch on the ThingWorx deal that closed as a perpetual license deal, can you give us a little more color on that? And then any sense that maybe, Jim, your announcement last quarter of the end-of-life perpetual for solutions in IoT is may be causing some people to think about perpetual license for IoT deals ahead of that deadline? Just maybe a little more color on that deal.

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Andrew D. Miller, PTC Inc. - CFO and EVP [61]

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First off, the color I gave you is we have done large IoT deals in the past that went perpetual. Usually, it's the first big deal with the customer and in the past, every deal after that has been subscription and that's a fully what we expect in this particular case as well. So we will take down an IoT deal to make sure we get the business. But at that point in time, once it's built into their solutions, et cetera, we will do everything we can to make sure every bit of business after that goes subscription.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [62]

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Yes. If we would have stood our ground and only taking a subscription deal, to be frank, we'd still be talking to customers about it because they simply weren't prepared to move forward. And we didn't see any reason to keep talking about it. So that's that. There's a second point I want to clarify a little bit, which is our subscription mix. If you look at the bookings we did on the perpetual side as compared to the guidance, we basically execute on a perpetual side just as we guided. The shortfall is really on the subscription side. And that's because it's mostly larger direct deals that were framed up as subscription. So...

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Andrew D. Miller, PTC Inc. - CFO and EVP [63]

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In Japan.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [64]

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In Japan.

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Andrew D. Miller, PTC Inc. - CFO and EVP [65]

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If you actually look at our subscription mix across the world, our mix in APAC, which Japan's the biggest country there, actually declined from last quarter and from the year ago by double digits. And that's simply because the subscription business didn't close.

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Robert Cooney Oliver, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [66]

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Got it. And are the customers -- it sounds like -- it makes sense you guys will take that business on perpetual to get that business and show your value. Are customers going to be ready to make that decision on a subscription starting Jan 1?

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Andrew D. Miller, PTC Inc. - CFO and EVP [67]

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Yes, the vast majority. I mean, I'm sure -- so long term, we laid out an 85% subscription mix. Because just like any subscription company, you can go to Adobe, they still sell perpetual licenses. So there will be one every once in a while, we're not going to lose the business or delay a strong partnership when -- because we can't agree on the license type on the very first deal. And the other thing that I'd say is that from the broader perspective, customers are used to buying subscription or cloud. It's not like they really even ask about, will you sell this for me perpetual? That's not a common question nowadays because there aren't many companies that sell perpetual licenses.

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Operator [68]

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And our next question is from Ken Talanian of Evercore ISI.

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Kenneth Richard Talanian, Evercore ISI, Research Division - Analyst [69]

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Just as a -- first off, as a point of clarification, you mentioned that there are some of those large deals in Europe and Americas that might have helped you offset the Japan weakness. I was curious, have any of those actually closed since the quarter end? And then where are you in closing those?

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [70]

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So again, I just want to be clear. It's not so much that those deals slipped. It's that we tried to accelerate them because this problem in Japan was coming in as fast and hard, and we didn't want to have this conversation with you. So we tried to accelerate them. The customers weren't ready. We were unable to accelerate them. We expect to close the deals in Q4. We expect to have a strong July. I don't have a report yet actually as to what's closed in the quarter, because it's early and we've been working on closing the last quarter. But we expect to have a strong July. We think we will have a strong July. I mean the sales team is committed to it. Because we want to get ahead of it this quarter and make sure that we don't get surprised again. So again, these are deals we're going to get, to be frank, when we get to this point, we're not competing with anybody. We're competing against the clock. Are we going to get the deal this quarter? Are we going to get it next quarter? That's what we're competing with and we failed to accelerate some things because while we thought the customer might be ready, they weren't. Now the reason we bring that up is because, actually, in Q1 and Q2, we did have some success covering up for problems in Japan with overperformance in the U.S. and Europe, so we went back to that recipe but we weren't able to pull it off.

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Kenneth Richard Talanian, Evercore ISI, Research Division - Analyst [71]

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Okay. And you maintained your free cash flow guidance for the year and there's a nice uptick in deferred revenue. I just wondering if you can help frame essentially the tailwind for free cash flow through the end of the period and into the next.

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Andrew D. Miller, PTC Inc. - CFO and EVP [72]

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Okay. I'm going to take you back. So we only missed the ACV by just over $3 million. And that's the amount of impact on free cash flow in the fourth quarter. But mitigating that to a good extent is the fact that these conversions that went support instead of subscription, we got more than 20% more on those. So it takes it down to like an impact of $1 million to $2 million on Q4 free cash flow. So we didn't need to change our guidance for the fourth quarter. And we had a great strong free cash flow in Q3, $77 million adjusted free cash flow.

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Kenneth Richard Talanian, Evercore ISI, Research Division - Analyst [73]

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Right. You seem to be about 70% or so there already with...

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Andrew D. Miller, PTC Inc. - CFO and EVP [74]

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Yes, we have to do a free cash flow of 35. I have it here. Adjusted free cash flow in the mid-30s in the fourth quarter. So -- and we've been all over that forecast as we've always had. I'll find the number and give it to you.

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Operator [75]

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Last question is from Monika Garg of Pacific Crest.

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Monika Garg, Pacific Crest Securities, Inc., Research Division - Research Analyst, Vertical Software [76]

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First is your fiscal 2021 targets, you've talked about 10% bookings CAGR. Given what we saw in the quarter, do you see any risk in your bookings growth target?

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Andrew D. Miller, PTC Inc. - CFO and EVP [77]

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Well, Monika, first, just to put where we are in perspective, year-to-date, we've got 7% constant currency bookings growth, and that's been negatively impacted by Japan. We're down $20 million in the first 3 quarters, Japan this year versus the last year. If Japan were just flat, we'd have grown our bookings 15% year-to-date. So that's the impact of having the performance we've had in Japan. It's 800 basis points of growth. So we still feel confident in that 10% bookings growth as part of our long-term model. And if we actually look at what we modeled to end recurring revenue and ARR and bookings for this year for that long-range plan we gave out in November and where we expect to end the year now, it's pretty much right on. That's why we feel good about the long-range plan.

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Monika Garg, Pacific Crest Securities, Inc., Research Division - Research Analyst, Vertical Software [78]

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Got it. So is it fair to think that after the Japan issue is fixed, we could see kind of back to the 10% bookings growth?

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [79]

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Yes, we would expect that.

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Andrew D. Miller, PTC Inc. - CFO and EVP [80]

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Yes. Absolutely.

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James E. Heppelmann, PTC Inc. - CEO, President, Director and Member of National First Executive Advisory Board [81]

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Okay. I think that concludes our questions. Thank you, Monika. So obviously, there's a lot of discussion here about Japan, and deservedly so, because we have a problem we have to go fix. We do think it's a very fixable problem. We don't have to find some saviors from the outside. We just have to reinstall the proven savior we have, and we think we're going to fix this problem. If we fix this problem, then we're right back where we were kind of in the first half of the year. Feeling good about things and feeling good about our long-term -- long-range plans and our value -- shareholder value, creation models and so forth. So we think that this new leader is going to give us this trust that we need with the customers and give us the sales execution and discipline that we need with the sales team, and we're going to get right back to business.

So I'd like to thank you all for joining us on the call and spending your time with us this afternoon. We're proud of what we've accomplished on our journey. We're proud of the shareholder value we've created. We think that Q3 shows we're continuing to gain ground on key elements of our strategy, but we have to go fix this problem in Japan. So we think we're going to do that and we're going to get back to talking about growth subscription and profitability expansion that have been working for us.

We hope to see you in the -- sometime in the next 90 days, perhaps at an investor event. And if not, we look forward to talking to you again in 90 days on the call. So thank you very much. And Christine, that concludes our call.

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Operator [82]

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Thank you. And that concludes today's call. Thank you for your participation. You may now disconnect.