PTC Inc (PTC) 2004 Q3 法說會逐字稿

Good morning, ladies and gentlemen and welcome to PTC's third quarter fiscal 2004 results conference call. At this time, all participants are in a listen only mode. Later we will conduct a question and answer session and instructions will follow at that time. If anyone should require assistance during the call, please press "star" followed by the "zero" on your touchtone phone. As a reminder, ladies and gentlemen this conference is being recorded. I would now like to introduce Meredith Mendola, PTC's Director of Investor Relations. Please go ahead.

Thank you. Good morning, everyone and thank you for joining us today. We were actually just wondering if there was anything being signaled by them playing "The End Of Innocence" by Don Henley in the hold music. So, anyway, participating on the call today will be Richard Harrison, our President and Chief Executive Officer and Neil Moses our EVP and Chief Financial Officer. In addition, Brian Shepherd our SVP of Product Management is here to participate in the Q&A.

Before we get started, I would like to remind everyone that during the course of the conference call, we will make projections and other forward-looking statements regarding future financial performance, business trends and other future events. We caution you that such statements are only predictions and that actual results might differ materially from the results projected in these statements.

We refer you to the risks detailed in the company's 2003 annual report and Form 10-K, our second quarter 2004 10-Q and in the company's other reports filed with the SEC from time to time. A replay will be available until 5:00 p.m. Eastern Monday, July 26 at 203-369-1778. Additionally, this conference call is being webcast and a replay will be available through our web site at ptc.com until Monday July 26 at 5:00 p.m.

Also on our investor relations web site is a PDF document with financial and operating metrics that we will discuss on this call. As always, after our prepared remarks we will hold a Q&A session. In order to keep this moving, please limit yourself to one question and one follow-up. If you have any additional questions, you may get back in the queue. So, let's get started. Dick?

Thanks, Meredith. Good morning everyone and thanks for joining us on our third quarter earnings call. We are proud of our performance this quarter and year-to-date and are happy to share our results with you. Neal is going to walk through our financial results in detail in a few minutes. I'd like to spend some time discussing our performance and where we are in the context of our overall strategy.

Last year at this time, we told you that we would focus on our operating margins in fiscal 2004. Our performance this quarter enabled us to achieve an operating margin of 15.6%, excluding restructuring charges. Year-to-date, our operating margin is above 10%. We are on our way toward a longer-term margin goal of 20% or more. We are very proud of the substantial progress.

Earnings leverage from our -- from both our cost reductions and revenue growth has resulted in a $50 million turnaround in net income in Q3 year-over-year. We're poised to do this again in Q4. Another byproduct of stronger operating performance, and good execution is the growth of our cash position to $258 million. This is our highest cash balance in three years, and we expect it to grow continually in future quarters.

In the past, we have told you that our fiscal 2005 goal is to leverage our new cost structure through growth. We are seeing signs of this growth earlier than planned. In Q3, we achieved year-over-year growth in the face of a 20% reduction in costs and a challenging selling environment for many of our software peer companies. We are confident in our ability to drive top line growth based on manufacturing trends and our leadership position within the PLM market.

Our business is with manufacturing companies. Every day, we have opportunities to understand their business drivers. As these companies do more and more business globally, it has broadened the customer requirements for product development, including advanced solutions for product design and simulation, distributed data management, and collaboration.

PTC has the best solution set for these requirements. We have aligned our product and services methodologies around customer requirements. We have also aligned our distribution strategy around market trends and customer-buying patterns. Our VAR channel continues to execute well. This is the result of our efforts to diversify our channel to compete more effectively and broadly in the low end of the market.

Additionally, our direct sales productivity is improving, as our reps are more focused in large accounts with a vertical specialty, and we are approaching customers with solutions that are designed to be adopted incrementally.

Our customers have responded to our strategy and solutions with enthusiasm. We've told you in the past about our seven-step adoption road map, which helps our customers adopt PLM solutions incrementally. It is also a methodology to help us more effectively sell Windchill solutions to our large Pro/ENGINEER base.

This strategy is working. This quarter we saw many customers complete step one, which is CAD optimization. This creates a more productive engineering environment. In fact, customers typically improve their design productivity by 20% to 50% after completing this program with direct benefits to cycle time, design quality and cost. Taking these customers through step one is a good launch pad for the other data management and collaboration steps in the roadmap.

Our Windchill sales pipeline has grown as we start customers on these subsequent steps. We demonstrated this in the third quarter with strong sequential and year-over-year Windchill growth. Another signal that our products are strong and our customer relationships continue to improve was a very successful PTC User Conference in June. We had higher attendance than the last two conferences. Customers were upbeat and we received very positive feedback on our solutions. Customer confidence is substantiated in improved maintenance revenue and Wildfire upgrades.

As you know, we are now selling Wildfire 2.0, which delivers enhanced functionality and extends Wildfire's ease of use to Pro/ENGINEER modules. Customers have quickly responded to this new version, and some, like Toyota, have already fully embraced it and deployed it in the production environment. All of these success stories have led to an improvement in our revenue results.

Over the past three quarters, we've stabilized our Pro/ENGINEER revenue and we saw good growth in Windchill revenue in the third quarter. We are encouraged by our successes in the past few quarters and believe it positions us very well for the future. Our significant reduction in expenses, paired with steady revenue improvements, will yield strong operating margin and net income results in the coming quarters.

In fiscal 2005, we expect to deliver accelerated top line growth by executing our product strategy, leveraging our distribution model, and benefiting from increased PLM spending. We will invest strategically in growth-oriented R&D, sales and marketing programs.

We will augment these organic growth initiatives with a renewed focus on corporate development activities, such as strategic partnerships and M&A. For PTC, the outlook is positive. We've exceeded our short-term profitability targets, strengthened our balance sheet, and improved our competitive position. We are now poised for growth. Now I'll turn the call over to Neal to discuss the financial and operating metrics. Neal.

Thanks, Dick. Our financial and operating metrics are available on our website. So, I'll just take a few minutes to add some color to our performance and then follow up with our guidance before we open the call up to questions. Regarding margins, as Dick mentioned, we continue to perform well. Our operating margin, excluding restructuring charges was 15.6%, and is 10.5% on a year-to-date basis.

Our gross margin for the quarter was about 73%, and that reflects the work that we've done to improve consulting service's profitability and also to grow license revenue. Our total revenue for the third quarter was 168.4 million, and it breaks down as follows: License revenue was 52.4million, which represents 3% sequential growth and 8% year-over-year growth. This is a very positive sign for the health of our business.

Consulting and training services revenue was 34.6 million, which is in line with our expectations, given our cost reductions in this area, and maintenance revenue was 81.4 million, showing both sequential and year-over-year growth. This is also a very positive sign for the health of our business. By geography, our revenue was as follows: North American revenue was $59.8 million, which is stronger than it has been in recent quarters. European revenue was $58.5 million, which is slightly weaker than it has been recently, and Asia Pacific revenue was $50.1 million, which is stronger sequentially, and flat year-over-year.

Foreign currency moved against us in a sequential comparison, but still benefited us year-over-year. At constant currency, European revenue declined 1% sequentially and 10% year-over-year. Asia Pacific revenue grew 6% sequentially but declined 4% year-over-year on a constant currency basis.

Our reseller channel continues to perform well, with 13.4 million in license revenue contribution for the quarter. This is down slightly sequentially, but up significantly year-over-year, and our total channel contribution, including services revenue, grew both sequentially and year-over-year. With one quarter remaining in our fiscal year, we're very confident that the channel will meet our goal of 20% revenue growth for the full year.

Moving on to our revenue breakdown by product line, total design solutions revenue was $121.6 million, which declined slightly sequentially and year-over-year. Design solutions license revenue was $35.9 million, down 6% sequentially and year-over-year. Seats were down slightly sequentially and ASPs were flat. Our high-end seat revenue was down this quarter due to lower revenue from large deals. This was partially offset by stronger low-end seat revenue as we continue to improve our competitive position versus low-end and mid range MCAD vendors.

Additionally, with the introduction of Pro/ENGINEER Wildfire 2.0 this quarter, our upgrade revenue increased sequentially. Design solutions consulting service revenue was $16 million, flat sequentially and down 13% year-over-year due to strategic reductions in our direct services delivery capacity. And design solutions maintenance revenue grew again to 69.6 million, reflecting continued improvements in customer satisfaction and in Wildfire adoption.

For Windchill, our revenue was as follows: Total Windchill revenue was $46.8 million, showing 12% sequential and year-over-year growth. The main driver of this growth was in licensed revenue, which increased 27% sequentially, and 56% year-over-year. This was the result of a combination of more large Windchill transactions and stronger seat sales from new and follow-on orders.

Windchill consulting service revenue was $18.5 million, and was up 4% sequentially, but down 15% year-over-year for the same reasons as our design solutions consulting business. And Windchill maintenance revenue continues to grow, and was $11.8 million in the third quarter.

Now, I'll move on to our spending. Operating expenses were $142.1 million, excluding restructuring charges. This is down 21% year-over-year and slightly lower than we had expected. Headcount was 2,984 at the end of our third quarter. In the third quarter, we did record restructuring charges of $3.5 million for severance and facilities charges associated with our cost reduction program. Of this amount, $1.7 million was for severance and $1.8 million was for facilities charges.

Our tax expense this quarter was higher than we planned at $6.3 million, due to higher taxable income in Asia. As a result, we believe it's wise to raise our guidance to a quarterly tax provision of about $6 million to cover foreign entity tax liabilities and indirect taxes in some Asian entities. As a reminder for the foreseeable future, we will not have a tax burden on US income due to our cumulative net operating loss position.

Moving on to the balance sheet, cash was $258 million, up from $222 million in the second quarter. This is higher than we anticipated, due primarily to our improved operating performance and strong receivables collections. Those collections also helped improve our receivables DSO from 85 days in the second quarter to 77 days in the third quarter. Our deferred revenue was $202 million and that was down from $214 million in the second quarter as a result of typical seasonality of deferred revenue from annual maintenance contracts.

Our guidance for the fourth quarter of fiscal quarter 2004, which ends September 30 is as follows: Revenue of 165 million to 172 million, and operating expenses of 145 million. We expect earnings per share on a GAAP basis to be between 5 and 8 cents. Cash has improved to approximately $280 million in the fourth quarter. We expect consulting service and maintenance revenue to be similar to the current quarter results, so our license revenue will, again, be the main determinant in our Q4 revenue performance.

Our sales pipeline is healthy, and our competitive position is strong. Additionally, as we are in our fourth quarter, we have natural incentives to close deals in the pipeline. However, when developing our revenue guidance, we have tried to strike a balance between our enthusiasm for our business prospects and dampened expectations in the software industry as a result of the weaker performance we saw in many other software companies this past quarter.

On the earnings side, we're poised to deliver a net profit for fiscal 2004, a turnaround of more than $100 million compared to last year. We are very proud of this performance, and also of the 2005 earnings power we now have due to our recent top-line growth and reduced cost structure. We look forward to reporting our progress for the fourth quarter and full year in October. At this point, I'll turn the call back over to Meredith.

Great. Thanks, Neil. All right. I think we're ready to open up the Q&A. So remember, one question, one follow-up, and then if you got any more follow-up questions after that, you can get into the queue. Thank you.

Thank you. We will now begin the question and answer session. If you would like to ask a question, press "star" "one," you will be prompted to record your name. question. To withdraw your question, press 'star" "two." One moment, please, for the first question. Our first question comes from Jay Vleeschhouwer of Merrill Lynch. You may ask your question.

Thanks. Good morning. Dick, since you highlighted in your remarks a number of occasions the issue of growth for PTC. Let's start with that. To the extent that you have been relying for the last many quarters largely on repeat business, about 90% of your revenues coming from existing customers, when does it become necessary or feasible for you to try to pursue newer business outside of your base, or is your improved expectation for growth through next year largely still a function of being able to mine the base and do expansion business, follow-on business for, let's say, Windchill, in the Pro/E base? That's question number one.

Jay, yes, I think we have some optimism. I don't want to give any guidance for next year, but we're doing a plan right now that will capitalize and build upon the focus on profits this year. And one where we can start to grow again. I think we have some upside in the channel as we continue to expand that and attract new resellers in terms of new accounts in the small and medium sized business space.

And then opportunistically, we have targeted over the last year or two some new opportunities. If you look at some of our largest revenue generators these days, companies like Toyota and Boeing and others, they weren't necessarily thought of as sort of PTC-based customers.

So I think that there are some opportunities for us with this product development system that we're out there deploying and deploying well, to capitalize on that, and get some new large customers to sort of supplement what we've been doing. However, our focus does remain primarily on the base. There is a huge opportunity for us to expand the base with collaboration and PDM and even Pro/ENGINEER seats.

So, our principal focus will continue to be the base in terms of services and software and so forth. And then opportunistically, we do have a part of the sales force, the direct sales force in these vertical markets which are calling on what I might call, hard head accounts where there is very little Pro/E or Windchill presence but there is an opportunity to penetrate those.

All right. The follow-on concerns the growth opportunity or expansion opportunity for Windchill as well as competition. You've seen a sequential improvement in the dollar amount of Windchill license revenues. I think the highest for the year to date, probably the highest in close to two years.

So maybe you could talk about the expansion or deployment experience your customers are undertaking to expand their utilization of Windchill and production. And a number of the accounts that you highlighted, like Toyota and Boeing, do, of course, use other competitors' technology for a variety of applications.

So to what extent, again, do you think you can encroach upon or displace existing other incumbents? (inaudible) seems to have issues still, of course, with the Novia, but judging by last week's Unigraphics or UG analyst meeting here in New York, they do seem to have made some architectural and sales improvement at UG over the last number of years. So if you could talk about that competitive environment as well?

Well, I think that, you know, this is a pretty good Windchill quarter; and, hopefully, we can build on that. Again, as Neil was describing, there are some things going on in the software business, which make predictions even more sort of difficult these days. It is sort of a malaise out there, I think; and in the context of that, we actually had a pretty good quarter. We're really focused on this adoption roadmap that we've described a few times. It's really sort of a formula.

There are 7 steps. Get the engineering department organized around Pro/ENGINEER and productive. And we have this program, called "Proficiency," where they can give themselves as self-administered test and rate themselves, and then go in and improve their use of Pro/ENGINEER. So that's what we talked about in terms of step one. We have had a lot of progress with our customers in going in and auditing how they arousing Pro/ENGINEER and then helping them get more productive. Having done that, it gives us sort of a basis to talk about improving the way you manage the CAD files in the engineering department.

And INTRALINK has been our primary solution there for the last seven or eight years; but increasingly, customers are looking at PDM Link the Windchill solution to begin to manage the Pro/E files and, incidentally, other heterogeneous CAD files, such as CATIA or Unigraphics, CATIA-4 -- because no one is really using 5 -- AutoCAD and others. This represents an opportunity to go into the base and grow the Windchill business as a solution in the engineering department to manage those files.

The benefit of our story is to start to then expand out inside these customers -- these same customers out of the engineering department with a common data management solution -- Windchill, PDMLink -- that now sort of displaces their Legacy configuration management systems, their Legacy change management systems and others. And that's where the Windchill, sort of, ProjectLink, PDMLink solutions can be adopted in the other five steps of the roadmap, which we've described in the past; and if you want to, I'd get into.

So, having said that, there's really good opportunity, I think, for us to expand, as we make Windchill easier to use and as we have better support and services packages that reflect the solution; we can go in there and incrementally have the customer adopt these new solutions. And we're increasingly, you know -- we go out there -- and really that's our sales message -- a little bit of it is take your time, let's grow you, let's have some successes -- you know, we're not out there trying to do the big bang theory in terms of a big deal.

I do believe there are really good Windchill opportunities, both in our installed base and outside, which we've demonstrated in the past, you know, to market Windchill, to manage the enterprise in accounts that have not committed to Pro/ENGINEER; and I think we'll see more of that in the coming year.

The competitive situation is such that -- you know, I think, we've talked about that before -- we feel pretty good about where we are in terms of the competitive situation. We believe that manufacturing companies really want to look at sort of the engineering or the product development process from the initiation of the conceptual design with mechanical, electrical and software components, and so forth; and we think we have a leg up on sort of the standalone PLM vendors with our integration, with our CAD solutions.

And then, in the Europe, I think, there we still have some work to do in terms of really showing their PLM solution, you know, that it's working effectively outside the engineering department; and we'll have to see what happens with Unigraphics. They are a little bit more difficult to analyze, as they have gone private; but I still think they have to reconcile iMAN versus Metaphase and the fact that those are two discrete products from different companies with different architectures and data models.

And, increasingly, as we deploy PDM Link in the engineering department and the same solution in the enterprise, there is going to be pressure on our competitors to have one common tool to do project elaboration, change management, configuration management, and CAD file management. So I think we are setting the bar in the competitive benchmarks today for a common tool that's easy to use -- you know, why do you want two or three solutions if one does a better job.

And so, I know, Meredith might chase me off here; but if to that last point, UG does in fact hit their product roadmap of integrating iMAN and Metaphase into a unified teams and architecture cycle within the next 18 months, as they are talking about. You know, how would that change things potentially for you competitively?

Well, I think that would make them more competitive; but it' s -- I'm not really sure what that would entail, because if they go to a new third architecture, then both the iMAN users and the Metaphase users are going to have to do a major conversion. In other words, all of their files are going to be incompatible, they're going to have to go through an entire migration from their current system to the new one; and that's going to open up opportunities for us, because migrations from a Legacy system like Metaphase to a new architecture are just as difficult, they might as well go to Windchill, which is more established.

So that's a major problem. If they then choose to iMAN or Metaphase, independently, one of those, as the sort of foundation for the new solution, the third-generation solution, it is going to leave the one that wasn't chosen with a major migration problem. So any way you look at it, this movement to a team center architecture or for any company to a next generation system, there's an incompatibility with the data and a major requirement to migrate, to port the data, a big services tax, and so forth; and I think when that happens, customers will look around at other solutions. So I think it's a big opportunity for us.

Thanks.

All right. Great. Next question, please?

Our next question is from Mr. Richard Davis from Needham & Company.

Hey, folks. It's actually John Miata (ph) for Richard Davis. I'm not sure if this question is particularly for Neil; but I think the question is -- right now, I guess, we're at about 8% in terms of the percentage of revenues that the VAR channel composes, you know, as a percentage of the total. Is there an optimum percentage of total revenues that the VAR channel would comprise sort of in the ideal looking in the out quarters?

Yes. The way we look at it, John -- it's Neil -- is that we're going to end the year with our VAR revenue representing about 20% of our license and service revenue. Your 8%, I think, adds in maintenance revenue?

Yes.

So -- well, we think, about -- from the license and service revenue perspective, it's about 20%; and we do expect that number to continue to grow. You know, it's grown from 10% to 20% in the last three years. I suspect it will continue to grow towards the 30% range over the next three to five years; and, you know, somewhere in that range is probably where we'll max out, would be my guess.

OK. Great. Thank you.

Mr. Philip Alling of Bear Stearns. You may ask your question.

Thanks very much. I wanted to get a sense as far as you had a good quarter certainly with respect to showing some growth there in Windchill; and that's what you've identified in the past as the growth driver for this business, going forward. What assumptions are you making, you know, when you are giving guidance as far as the mix shift between Windchill and MCAD, going forward? You know, you had -- my calculation is about 28% of your revenue now from Windchill in this quarter and that's up from about 25 in last. You know, what are the expectations as far as the fiscal fourth quarter?

Yes. So we don't get specific guidance. This is Neil on Windchill growth versus Pro/E growth; but, you know, just kind of at a high level, and thinking about not quarter-to-quarter; because when we look at our business on a quarterly business, you have seen in the past, the Windchill number has moved around quite a bit, and sometimes the Pro/ENGINEER number does too. So we try to look at kind of trends in our business as opposed to the quarterly numbers.

But I think, you know, most analysts out there today, when they are thinking about PLM, first of all, there have been better results in the PLM market in the last few quarters, which we're optimistic about for the industry and for PTC. I think most analysts kind of peg that PLM growth opportunity, moving forward, in the low double-digit range, maybe; and most people believe that the MCAD growth opportunity is in the low single-digit range.

And, you know -- so I'm not saying that that is an expectation for next quarter; but maybe that is how we're thinking about what the industry opportunity is for those two segments. And then of course, our opportunity, vis-à-vis those numbers, would be, dependent upon how we position ourselves competitively. And we'd like to think that we've got a better opportunity than that. But that's how we think about the growth opportunities from an industry perspective in both of those segments.

So do you remain comfortable with your prior expectations of say, 15% to 20% growth in PLM and longer term and 0 to 5% for MCAD?

I think that those are probably reasonable expectations, yes.

OK. Just with respect to the VAR channel. The license number was down just modestly on a sequential basis. You did make a comment that the -- that you had some strength at the lower end selling your lower-priced Pro/E Wildfire solution. I suppose I would have assumed in that instance then that the VAR channel license number might have been up if you were selling more of the lower-priced solutions. What should we expect with respect -- I mean, do you expect to see the VAR channel license numbers to moderate up going forward?

The answer to that is yes. I mean, our VAR number is up in a very significant way over the last year. It's true that on a sequential basis, it declined very modestly. But I don't view that as a trend in the making.

And just a tiny little question to finish up. Are there any restructuring charges implied in your fiscal 4Q guidance. Is the earnings number you gave there -- I noticed that what you reported this quarter is about a million and a half below what the guidance figure was for the restructuring charge this quarter?

Yes, our cost reduction program is basically complete. We do need to look each quarter at part of our restructuring charges based on facilities that we have gotten out of and are trying to remarket. And so it's possible that there could be a, you know, a modest restructuring charge. It would certainly be less than we recorded this quarter, we think, based on that review. I don't think you should think of that number as being a real material number for the fourth quarter. Does that help?

Would a million and a half be the right figure for us to use for our models?

That's probably not an unreasonable assumption.

Good enough. Thank you.

Yes.

Next question, please.

Mr. Gene Munster of Piper Jaffray. You may ask your question.

Just in terms on the competitive side, the low end CAD, are there any specific vendors you guys, will be picking up tracks with, and second, can you remind us just kind of the long-term operating margin target? Thanks.

Yes, the operating margin target, I think Dick talked about it at the outset, but just to remind of our meet, we do have a longer term operating margin is target to exceed 20%. That's our goal. And we've been at roughly 15% for the last two quarters. And we hope to continue to build on that. I'll turn it back over to Dick for your first question.

I don't think there have been any real changes in the competitive landscape on the low end. We see solid works and Inventor primarily down there. We've had good year-over-year growth and I think its because we've been able to attract new VARS. The number of VARS that we have has increased pretty substantially. The number of feet on the street therefore has increased substantially.

And you know, the people like the Wildfire product, and right now they like Wildfire 2, and it gives them an easy-to-use solution that can scale up and do larger things and connect with the OEMs easily and so forth. So I think we have a nice product advantage today, and the resellers look at that as an opportunity to potentially, you know, make some more money. I think they're interested in the links ultimately, as we get into next year. We may selectively -- we have done that with a few resellers, start to introduce the links down into the small and medium accounts.

I think we'll do more of that, carefully, and I think they see a nice services opportunity as they can expand that business as well. So I think that the sort of morale and the channel is pretty high. As a matter of fact, I think we have a conference call Monday with all the channel partners. There's a pretty good level of excitement going forward there.

Great.

Another thing that is really interesting on the low end is that as we have been doing this 7 step adoption roadmap, in that first step where we're talking about CAD optimization, there's a very clear value proposition for customers to do some cleanup work around getting all of their CAD users on to Pro/Engineer, and we've had several customers that had a mixed environment. And you know, were maybe using both Pro/Engineer and SolidWorks or both Pro/Engineer and Autocad or Autodesk Inventor clean up those other CAD packages and replace them with Pro/Engineer, and that's been a very nice byproduct of that first step of the adoption road map.

So Inventor, just kind of running that two for one promotion, you guys haven't seen that impacting the low-end business, it sounds like?

Not right now.

Our pricing at the low end is staying stable.

Great. Thank you.

Mr. Keith Gay of Thomas Weisel Partners. You may ask your question.

Can you give us an update on the number of direct reps that you have, the direction where that is heading and you mentioned some improvement in productivity per rep. Can you just kind of discuss that trend?

Yes. Today we have 300 direct reps onboard. We're under head count a little bit in terms of where we want to be, so we're out hiring right now. It is our goal to sort of end Q4 in the 325 range. And we should make a good run of that, absent any turnover or a lot of turnover or more than normal turnover, let's say, but Q4, there is generally not very much turnover in the sales force. So we want to move it back up towards 325. That's sort of where we're budgeted. And I think we will do that. What was the second part of the question?

Second question, Keith was -- this is Neil, was about productivity. So our productivity has increased about a little over 20% this year alone from a direct rep standpoint. And that's due to a combination of a couple of things. You know, one is obviously a greater percentage of our revenue is coming from the VAR channels today than it was a year ago. That's helpful in that respect. And secondly, as part of that cost reduction program, the number of direct reps that we have has decreased pretty significantly. Meredith, do you have the figure of where it was at the start of the year?

Number of direct reps, at the end of Q4 we had 360.

We had 360 and we are at 300 today. And we don't mean to be at 300, longer term, but -- so we're down about 20% in terms of the number of our direct reps and our revenue is relatively flat. So, you know, that's a pretty good formula.

OK. And then, one follow-up, just to more of a macro question around what you're seeing in terms of year to year in substantial demand, you mentioned the software environment. Did you see any delays in larger deals, longer end of quarter signoff process, and if so, does that give you more or less confidence in your pipeline?

I don't really think that -- maybe Neil you can talk about what you saw as well, but I don't think that we saw -- our forecast held pretty well throughout the entire quarter, really, plus or minus a few million. And you know, there are always a few little deals that might or might not happen and so forth that are on the edge. And then they move to the next quarter, but we didn't really see again much change in the forecast. And it was pretty predictable not only in total, but by geography. So from that standpoint, we didn't really see it.

Just to add to that, I think we felt pretty good about the fact that since our forecast pretty much held throughout the quarter, you know, we didn't feel like we needed to think about, you know, quarter-end discounting, if you will, which sometimes takes place among software companies. And we felt like we could hold the line and if the revenue fell in Q4 as opposed to Q3, so be it, because we were pretty much on target.

OK. Thanks.

Yes. Having said that, you know, I think that we were probably as surprised as you were as we read about some pretty good companies that missed, and missed substantially. And, you know, and so I think in the back of our minds, you know, we're wondering a little bit what's going on out there. I think the PLM market is pretty strong. So we'll see. I think this quarter will tell us a lot.

Our next question comes from Gibboney Huske of Credit Suisse First Boston.

Thank you. Just first, I don't know if you have provided the rough mix between the foundation value seats as opposed to the Flex 3C.

Meredith has that, I think.

And I think you gave it last quarter. While just as she is looking, the real question is, you've had some big strategic deals with Boeing and Toyota. And I know some of them were much more consulting oriented up front. Are you starting to see the mix shift, so you are seeing more new seats coming under those programs and maybe the consulting side kind of coming down? And I'm not addressing any specific customers but just broadly speaking on these bigger deals?

I don't really see the consulting. Our consulting number, the services number around implementation has been pretty constant in the range of $35 million a quarter. I mean, I don't see that coming down, even in the large accounts. I don't see a pattern. We have some large accounts that may have higher levels of consulting during early deployment, and then it might come down.

It depends on how successful we are in terms of moving outside of a particular department or function, and that can keep the consulting up, but I haven't seen any trends there. I think again, the consulting revenue is pretty flat. We had a little bit of year over year growth that was probably license, for the most part.

Yes. Probably the trend is a little bit of growth in new is a lot from the little seed side and fairly stable from our consulting side.

OK.

And Gibboney - the split between high end and low end is about one quarter high end and three quarters low end this quarter.

OK. Great. Thank you very much.

You're welcome.

Mr. James Keller of NSI. You may ask a question.

Good morning. I was just wondering, you are doing a great job on expense control on the service line of the business. I have two related questions. If you could just comment to what extent service could start to contribute to overall profitability, and have you reached an expense run rate that you are comfortable with and you can you start to grow the service from there?

Yes. Jim, that's a really good question. This is Neil. We actually are -- that is one thing we have been trying to do. We had a -- services business last year, it basically was break even from a profitability perspective, and we thought we deserved to get more out of the business, and we willing to sacrifice some revenue in order to achieve margins that we thought were attractive, and I would say that this quarter marks probably the quarter that we feel like we've got a revenue run rate that we understand and a margin performance on the services business, which I think we'll see a little bit of an uptick on the fourth quarter, but we feel good about our services margin for the third quarter.

We think it's going to grow incrementally to a certain extent in the fourth quarter and I think we'll have a launching pad for next year which says, OK, how can we grow this business profitably -- kind of keeping those kind of margins intact, and I think we feel pretty comfortable with that, and I think we will plan overall growth in our services business next year. Now that we've got that business from a profitability standpoint where we want it.

OK. So growth going forward won't come at the expense of margin contribution, I know, plus or minus?

Yes, that's true. As a matter of fact, we'll probably anticipate a slightly improved margin performance next year versus our service business, but certainly not the kind of turnaround we saw this year, and we'll expect incremental growth to accompany that.

OK. Thank you very much.

You're welcome.

Our next question comes from Jay Vleeschhouwer of Merrill lynch.

Thank you. Few follow up questions for you some on the technology side. To Dick at the user conference few ago in beautiful downtown Nashville.

Yes.

You gave a fairly detailed product road map or Brian did anyway as Jim did last year, for the next couple of years with the XPOD and K-3 releases, for example. The question is do you have any evidence that being so explicit is in fact getting customers to stay in place and re up on maintenance, and is it being so explicit, even though you risk ticking off your competitors, however, helping you to pin down your base?

Jay, this is Brian. I did get a lot of such feedback at the user group, that they were -- that customers that there were very pleased to get a longer-term road map from PTC. It helps them with their long-term confidence in the direction of our solutions. They like what we showed them in the product with Wildfire 2 and Windchill 7, and they liked the direction and the pace at which we're moving, so from that standpoint, I think that benefits in better customer relationships outweigh the risks.

OK.

Jay, the customers want to feel like they have a partners that does have a vision, and that the vision is connected to where they want to go. And I don't know if you saw that demo of Windchill 7.0 and connected with Wildfire 2 and so forth, but that whole product development system and the road map. I mean, customers really do appreciate that they feel actually pretty excited about what they see and where it's going. And I think the other knock that we were getting a little bit last couple of years or maybe a lot was the financial performance and the lack of profitability.

You know, we were investing heavily in this new PDS, and so our competitors were saying that we were financially not too sound and so forth. That's pretty much gone as we produce the kind of results that we've had in the last two quarters and will again in the fourth quarter here. And I think again next year. So you take the product road map and the financial performance, the growth in cash, I think our customers, big and small, feel pretty good about how we're doing.

OK. Now, follow-up on something else you said earlier in the call, this is the Interlink -- the PDM Link issue. You have a fairly sizable base in Interlink attached to your pro E base, and to the extent that some of your competitors may have migration issues related to architecture, wouldn't you necessarily have the same at some point? I would assume at some point that you will scale back if not completely discontinue the development and support of Interlink to try to give to customers to PDM Link. Is that a more or less difficult migration issue for you and your customers than any of your competitors might have to go through?

So Jay, right now we have migration capabilities to move customers that want to move from pro Interlink to the greater capability that is Windchill PDM Link available via our services group, and that will be available to customers more broadly with the release of Windchill X5 next year, and that will allow customers to migrate from Interlink to PDM Link if and when they desire to do so.

But, then, Jay, to add to that, yes, it'll represent a migration. I think that customers are a lot more comfortable, and they don't like migrations at any level. It's one thing to migrate the data in your engineering department, and it's another thing to migrate all of your Legacy data in your enterprise system, and those are -- take the engineering department and multiply it by some factor if you want to start to do a conversion for the entire enterprise. It's much more complex and generally much more alarming to the customer as they have to do that.

We have some really great Windchill reference accounts these days, so to the extent that our competitors might have to introduce a migration, they're going to have to sell their installed base that their new solution really is mature, that it's been well installed and it's working well in a lot of places, which is hard to do if it's new.

And again, since the customer is going through that migration, they may as well take a look at really the market-leading product that's out there today, and some will move and some won't, but I do think it represents a pretty good opportunity for us both in terms of software opportunities and services, and we're well positioned with this incremental approach to let them do that.

They don't have to do it in a big bang way. They can choose to adopt Project link or PDM Link for a certain problem like change management or configuration management and move from there. So, I do think there's going to be some opportunity, and I think that -- I know our competitors are very concerned about how they reconcile multiple enterprise configuration management solutions and what's going to happen there.

All right. Now, turning to sales and channels for a second. But first -- at the end of the last quarter I remember right you had 315 direct reps and you had hoped from that number to begin to have growth starting in the third quarter, which apparently didn't happen. sSo why did you, in effect, under perform some of the head count objective for sales in Q3, although the change was smaller than in previous quarters, and then, with respect to your VAR numbers, it was down only slightly, as you said, sequentially, but your matching machine is indicating that there seeing sequential improvements in the PTC business, and certainly year-over- year increases, so if that's right that, would suggest some larger sequential decline elsewhere in the channel, perhaps here in the US. Is that, in fact, occurring?

I'll take at least the second part of the question, Jay. Yes, I mean we did have an increase in our matching machine revenue in this quarter. And to your point, our North American revenue did decline from our VAR channel. I don't think it's necessarily a trend it certainly hasn't been a trend this year. So as I said you've got to be careful in terms of drawing -- conclusions based on quarterly date.

Jay, the biggest piece of the VAR license revenue decline was the fact that last quarter we had a little bit revenue from Eastern European ran, and this quarter we didn't. That's the biggest change.

OK.

America was down like $200,000. It really wasn't that much.

OK. It's fine.

One of the influences sometimes Jay and we've gotten a lot of tighter on one of this credit with the resellers and we'd much rather have good revenue, there's probably more revenue there that wasn't bookable and wasn't real revenue in our minds because we have some pretty reasonable but tight credit limits on these channel partners. So that's part of what we have to work through. And we're interested in having good solid clean revenue that we're going to get paid for.

And on the recruiting side, I think, there's a couple of things going on there. First of all, maybe to this point, we've been relatively cautious because we've been looking for our revenue trajectory to change and it has just started to and we feel good about that. At the same time, recruiting is probably getting a little more difficult because of the notwithstanding some of the pre announcement activity this quarter, people do feel like the economy is improving. So we've certainly stepped up our efforts but it's probably a little bit of a more difficult proposition today than it was six months ago. But we're certainly in fully invested in it.

And Jay, I don't really remember, just to be if we were at 315, I don't really remember, to be honest with you, saying that we're really going to grow the head count because it's sort of the budget for us all year has been in that 320, 325 range. You know, in terms of where we think we're going to be from early on and sort of managing that. It may go up a little bit next year, but I don't really feel like going into Q3 we were saying, we're going to grow but at least not substantial.

No, you're right. It wasn't going to be a big increase?

Well, that's the 325. Yes.

And then lastly...

I think to be honest with you what we just had there was a little bit of an execution issue in terms of recruiting, which sometimes happens. The managers get out there closing deals and we've got to go back to the whip a little bit with the sales managers in terms of hitting their head count numbers.

Right.

And they haven't sent us to do that.

And then lastly, your Asia-Pac number being up sequentially is interested in so far as that you have had an unusually good Japan quarter in March with one or two accounts, one being Toyota, the other being another automotive supplier, apparently. And we had not expected that strength in Japan to recur in the third quarter. So are you in fact otherwise seeing in Japan better business than you had anticipated?

I think, yes, the business in Japan is just solid, and over the course of the year, it's probably better than we anticipated at the beginning of the year, but it's been pretty consistent. And it's not just Japan; it's the whole Far East. One of the things, we didn't really get into a lot today is the impact.

We've talked about it a little bit in the past, but the impact of companies going global and I think we're going to see, to be honest with you, the globalization of engineering, of product development, much like we saw with software, going globalization as sort of a proxy for offshore. But we saw the globalization of call centers and software development and right now, we are seeing the globalization of product development.

Engineering is getting outsourced, and much of it's going offshore and that, we think, is going to be a big driver for a product development systems. For CAD, collaboration, change management, configuration control, so that's one of the reasons, why we have some optimism right now. And going forward over next year, we think this is a real opportunity and the Asia-Pac numbers that you saw I think, are reason for that.

Engineering is absolutely going to go global. People are not going to pay $100 an hour for mundane tasks in the product development space. They may keep core competencies in Europe and the US, but a lot of manufacturing companies have already made a decision where engineering represents, product development represents 5 to 7% of their budget, to find a more cost-effective way to do it somewhere else. And I think that's going to drive these product development systems. You can't go global, if you don't manage the information very carefully.

I'm told, we have one more person hanging on the line for a question, and then we're going to wrap up after that.

Our last question comes from Philip Alling of Bear Stearns.

Yes, thank so much. You guys have made mention of possibility of M&A activity in your prepared comments earlier. Could you give us a sense really, are you looking to bolster your presence in certain geographies? Is there particularly a technology area that you're looking to add and is this really to be more focused in the PLM area, is there the growth driver for you or is there really something in your MCAD area that you'd like to sort of round out via acquisition?

Sure. So, we are getting a little bit more aggressive in that area. And I think, so there's new -- certainly the focus is on -- first of all on the PLM space primarily. And the second thing I'd say as Dick talked a little bit about this core concept of global product development and the opportunities that we see in Asia. So I would say, first and foremost, it's in the PLM area, and secondly, if we can do something to kind of capitalizes on the opportunity that we see in Asia-pacific that's interesting to us too. So those are maybe two areas of focus for us.

And let me just supplement what Neil said. Neil is in charge of that activity, so we have a good time with him. He's got to make some contribution next year.

Because I haven't made any this year.

So we have a pretty good time with him. The sales guys have their goal for next year and the maintenance people, which we're establishing right now, it's not done yet. But I think Neil is heading that up, and we feel like, we've done a lot of work in our core products, Pro/E and Windchill, with the product development system. Windchill has one data architecture for all of its components, you know, one released today. So we haven't sort of cobbled together a solution in our core product offering, and we worked hard in the last couple of years to do that.

Having done that, I think that there are satellite opportunities in the PLM space applications, it could be requirements planning or portfolio management or after-market service, where you can perform some M&As and acquisitions that really are complimentary and the level of integration is less severe than it would be if you were trying to integrate a visualization package or a configuration management application. We're actually pretty excited about the opportunity and it could even be on the CAD side to find some complementary solutions that our customers are asking us for, as we go forward that makes sense.

And would these likely be in the fiscal '05 time frame? Is there -- should I imply that from what you guys have said?

Yes, we're interested right now. Our Bill Beruti [ph], who used to co-head our marketing effort has moved over to run M&A work for us fairly recently. And we kind of augmented that group from a personnel perspective, so I would say, we're fairly active today. And yes, '05 is a reasonable expectation.

OK. And just two really minor questions. One is that there is some variability in the consulting services gross margins. Could you give us a sense of where those sort of may -- sort of level off some or what is the trend, we should expect to see really as far as the margins in the consulting services part of the business?

Yes. I think you should expect a modest uptick in the fourth quarter, and then you should expect to see, again, maybe modest improvement next year off of that number, but not significant improvement.

Did you say, that it wasn't in Q3?

So -- we did, I think. And we say -- you're talking about...

Consulting services, gross margin was I believe 62%.

No, that wasn't for consulting services that was for the whole services business, including maintenance.

Right, exactly.

And the reason why there was a difference from last quarter to this quarter because last quarter, we had a $5 million one-time benefit in cost and service that was not repeated this quarter. And so that's why you saw it go down a little bit. But we actually did improve our performance from a consulting services perspective and the consulting services business itself, the margins for that business grew.

No, no, we actually had modeled it going down based on that information before but it was better than expected.

And just finally then on...

Because of the margin of improvement in the training, consulting and deployment activities.

Yes, the maintenance business is very stable in terms of its operating margin.

And the maintenance business is twice the size of the consulting services business, too. So what we're trying to say is that the maintenance margin will be stable, the consulting service margins will continue to grow albeit probably modestly but probably our ability to grow that 62% substantially going forward, there will be modest growth in it. But again, it's driven by the smaller component of those two businesses.

All right. And just the final question I have is just the relative weakness on a sequential basis in terms of your revenue from Europe. Is there any more color that you can give us there on a going-forward basis as far as that region is concerned?

Well, I think, one issue for us subject to this quarter was that FX moved against us in terms of the performance of the euro. Secondly, we did have, you know, generally speaking among the three regions where we did business, it was the weakest quarter for us. And we're not sure that one quarter makes a trend, but we were a little bit disappointed in our performance in Europe this quarter.

There was actually one deal we thought we were going to get, you know, it was in the $2 million range that we'll get this quarter that would have helped it, so we have to keep an eye on that. I think we are also down on sales headcount in Europe and need to do some recruiting there as well.

That's helpful. I appreciate. Thank you.

Great. Well, I think we're ready to wrap the call up.

Well, thank you very much. We're going to try to build upon a -- really what we felt was like a really good Q3. I hope that you felt the same way. We feel pretty enthusiastic about Q4, and we're going to put a good plan together for '05, which we'll share with you in October. Thank you.

This concludes today's call. We thank you for your participation. You may disconnect at this time.