PTC Inc (PTC) 2011 Q1 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to PTC's first quarter fiscal year 2011 results conference call. After brief comments by management, we will go directly into question and answer session. (Operator Instructions)As a reminder, ladies and gentlemen, this conference is being recorded. I would now like to introduce Mr. Kristian Talvitie, PTC's Senior Vice President of Investor Relations. Please go ahead.

Good morning, good afternoon, everyone. Before we get started, I just want to remind everybody that this call and Q&A session may include forward-looking statements regarding PTC's products or anticipated future operations or financial performance. Any such statements will be based on current assumptions of PTC's management and are subject to risks and uncertainties that could cause actual events and results to differ materially. Information concerting these risks and uncertainties is contained in PTC's most recent Form 10-K and Forms 10-Q on file with the SEC. All financial measures on this call are non-GAAP financial measures. A reconciliation between the non-GAAP measures and the comparable GAAP measures is located in the prepared remarks document on their investor relations page of our website at www.ptc.com. Here today are Jim Heppelmann, President and CEO, Jeff Glidden, CFO and Barry Cohen, EVP of strategy. With that, I will turn the call over to Jim.

Good, thank you Kristian. Well, good morning to everybody, good morning here from snowy Boston where we have a foot of fresh snow on the ground. But the PTC management team, being very loyal and committed, all found a way to get to the office.

I'd like to say we're very pleased with what we think was a very strong first quarter and a very good start to our fiscal 2011 year. We really see a good balance of revenue strength across almost all of our product lines, across our direct and indirect channels, across our different geographies and so forth. It was really pretty much solid across the board. We also saw good continued momentum with domino wins, and we'll talk about it. We saw pretty good progress in monetizing some of the previous domino wins as well.

So, I would like to start with some comments regarding the automotive industry in general and the win at Hyundai Kia motors company in particular. So, just to give you some background context, automotive is the biggest vertical within the manufacturing industry. That said, the automotive segment has been a historical strength of some of our competitors, Siemens and Dessault in particular. And relatively speaking, PTC has been underrepresented in the automotive industry over the years.Now, at the same time, we felt that with the competitive strength we have in PLM, we ought to be able to fix that to our advantage. We should be better represented in the automotive industry. I think right now, and really over the last six quarters or so, we are starting to see a lot of good progress of PTC taking share in this very important automotive segment.

If I look at the last 18 months or so, we have had competitive displacement wins, many of which we have announced at places like Volvo truck, which is one of the world's biggest truck companies, at Continental, as well, separately at Scheffler. And I think some of you know that Continental and Scheffler are merging together to become the world's biggest automotive supplier. We had a very important win at Cummins, at Harley-Davidson, ArvinMeritor and a number of others. But really prior to this last quarter, what we hadn't succeeded in doing was penetrating one of the passenger vehicle automotive OEMs. And the passenger vehicle automotive OEMs are by far the biggest segment for enterprise PLM.

Now, we had some presence with CAD and power train, and we had some presence with our Windchill software next to the CAD software we had sold. But in terms of enterprise PLM, PTC really didn't have a single automotive OEMs account we could point to. And of course, that held us back because whenever we got in an engagement, we didn't have a good automotive OEM reference to use. So obviously, we're very pleased to announce what is a tremendous win at Hyundai Kia motor company.

Now, Hyundai Kia win, HKMC as we call it, is extremely important because HKMC is the envy of the automotive industry right now, particularly the OEMs. They are currently the fifth largest in the world, and they are the fastest-growing. So, at current speed, by next year, they will be the fourth largest, passing Renault and Nissan in the progress. So, to put that in perspective, Hyundai Kia is bigger than Ford, than Daimler, Honda, BMW, Chrysler and a long list of others. This is a big, successful company and a big, important win that will be watched carefully by the entire automotive industry.

So, what happened at HKMC is that two years ago, HKMC decided they really needed a better PLM strategy, and they begin a competitive benchmark process. PTC was represented as was Siemens, Dessault and SAP. The incumbent strategy that they were looking to upgrade was a Dessault and ENOVIA strategy. So, they went through a comprehensive request for proposal process. Then, separately, they did many months of hands-on software evaluation, testing the software against the HKMC requirements at the HKMC site. So, PTC was pretty happy after this two years of competition last quarter to come away with a victory.

Now, just in the waning days of the quarter, we started what's a pretty typical phase one deployment. Now, you'll remember we gave you this monetization model that says most of our deployments start with a relatively small first phase where we are trying to prove out the solution in the customer's environment with actual users and actual data and actual production work processes. When we're successful with that, then these things tend to expand. They expand again and again and again over time and we have taken you through that model. So, the actual win has relatively small revenues in this first phase and should get a lot larger over time.

So, in the press release and in our prepared remarks, we talked quite a bit about this term contract accounting and how it caused a one-time $0.03 to $0.04 EPS hit that we'll make up in the back part of the year. Now, I'm not an accountant, and many of you are not accountants, so I'm going to try to give you a plain English explanation of why this happened and what it means for us. Okay?

We won the benchmark. Clearly, HKMC believed PTC had the best solution relative to their requirements, but at the same time, their requirements are very aggressive. HKMC is a leader, not a follower, so they have very aggressive requirements. They came back to us with a list of additional enhancements they'd like us to make to the solution. Now, that's not unusual at all for a large customer to give us a list of enhancements. Let me add, it's particularly not unusual when you're entering a new segment like we are with automotive OEMs for the first time.

PTC looked at these enhancements and we said the bulk of them look like good things to do to the product for the benefit of all of our customers, certainly all of our customers in the automotive industry. So we said, okay, we're willing to incorporate those enhancement requests into future product road maps, and that's something that we would -- a conversation we would have with many customers. Now, the difference is that Hyundai is a pretty good negotiator, and they said we would like you to commit to those delivery time frames and so forth in the contract. So, after some back-and-forth on that, we agreed to do it.

The accounting treatment is once a commitment is made, that these deliverables must be delivered per this contract. Then the cost of all that R&D work gets assigned to that one contract, okay? So, when you take on all this incremental R&D cost that would have just been run rate R&D and you assign it in one fell swoop to this one contract and you add those costs on top of the deployment costs of actually putting that phase one deployment in place, then you get into a situation where the costs of phase one, when counted that way, exceed the revenue of phase one. Then the accountants say, okay, now you need to take the excess costs as a loss in the current time period.

So, the net effect of all of this is that we've taken $0.03 to $0.04 of R&D monies we would have spent in Q2, 3 and 4 and we have basically accrued that cost here in Q1. So, as we actually incur that cost in quarters 2, 3 and 4, it won't show up because it has already been more or less prepaid. It's very important that you understand that these costs are not incremental to the PTC FY 2011 spending plan. It's really just a reprioritization of existing resources and not incremental spending. So, the $0.03 to $0.04 of costs is essentially, as I said, a prepayment or a front loading of costs that has no effect on the full year and therefore, we left our EPS guidance unchanged for the year at $1.20 to $1.25.

Now, I think it's very important is that we don't let this discussion around accounting sort of obfuscate the more important thing, which is that HKMC is a tremendous strategic win for PTC. It is the most important account we were pursuing here in fiscal 2011, and we won it. This is going to do a lot to reinforce our momentum. It will start an unbelievable number of new conversations in the automotive industry at all levels, and it will further cement our claims of PLM leadership in the industry.

Moving on to the rest of the customers, we were very successful in securing two other domino accounts as well in the quarter. So, that puts us at a count of 22 versus our full year target of 30. We're doing very well against a target and we're confident that in the end, we will meet or potentially exceed that target of 30 domino accounts. The other thing, and Jeff will give you some detail, we are seeing how domino accounts previously won are contributing in a pretty meaningful way to the big deal pipeline now. About a third of the big deals that came in in Q1 came from domino accounts previously won.

So, our enterprise numbers, I think overall, look very solid though you all realize you need to look a little bit closer to see that. Because the enterprise numbers look much better when you take into account the very tough comparable from Q1 of last year when we had what was essentially a blowout quarter, and the blowout came from enterprise license revenue. Which basically came in $20 million higher than our guidance and our expectations, okay?

Now, on top of all that, I was very pleased, I think we all were, to see really pretty strong desktop strength and as well, solid SMB or retailer strength. I attribute those two things to a combination of factors. Really, on the one hand, good economic rebound that has now worked its way down into the SMB segment, and on the other hand, a lot of momentum and excitement around Creo. Creo has driven a much higher level of sales activity than we have seen previously in CAD for both the direct and the channel resources. There are many, many customers who want to hear about it, understand what it means, how is it different and better? It's just driving a lot of activity, and you're seeing some of that fall through as revenue. So, I'm pretty happy with the desktop side, and I think we're set up to have a pretty good year on the desktop front.

Overall, just reflecting on all this, I think we have a great start on the year. We are ahead of plan on revenue. We are actually on our plan for EPS after taking that $0.03 to $0.04 hit, or I should say we feel like we are $0.03 to $0.04 ahead, just to be clear on that. We are confident that our FY 2011 revenue and guidance remains achievable, and we think we are in a good place relative to our longer-term plan for 20% sustainable revenue growth through 2014. So with that, I will turn it over to Jeff for a few brief comments.

Great, thank you very much, Jim. I'm just going to give a little bit more color on some of the business metrics in the quarter. I will talk about cash and cash flow and then turn to our guidance for both Q2 and the balance of the year.

As Jim cited, a terrific highlight of the quarter was the large deals and obviously, 22 large customers generated $51 million in the quarter. This compares to 10 customers generating $50 million a year ago. So, this really speaks to very much the increased breadth and depth of our business. Last year, obviously, the average of the 10 customers was about $5 million each. That was reflective of a handful of a very large deals that are a very difficult one to forecast and do give us the hard compare. I think the health of the businesses is really reflected very much in the 22 deals with an average of just over $2 million. That's been a very consistent metric for us, and I think that's where we expect to be going forward.

I think another key point is about a third of these accounts were dominoes. And that's just very important in building our annuity base, having the dominoes not only being major wins in a current period, but generating incremental revenue and a continuing revenue stream as we build these annuities. So, highlight there. We've really talked about the direct enterprise revenue. That was $106 million, or 40% of total, and that compared to $111 million in FY 2010 for the same quarter. As we've articulated, looked at about $20 million of upside in that prior period, our year-over-year growth, excluding that upside of about $20 million would be 16% on enterprise and 36% year-over-year growth.

Again, I think as we look at it, the pipeline of enterprise PLM opportunities is strong and growing. Jim has said we have closed three dominoes in the first quarter, and we feel very comfortable with the target and goal of 30 for the full year. Highlights again were CAD, desktop and channel. So desktop CAD revenue was $146 million, up 8% year-over-year with license growth of 36%. Channel revenue was $77 million, up 7%, license growth of 26%. This is really a continuing trend, very healthy for us. Both Q4 was up, Q1 again, and I think it's a reflection of both improving economics and really, market customer and partner response to our Creo strategy. It's been excellent. We were concerned as we went into the quarter that we might see some stall. We've seen the opposite. We have seen growth and strength in that which reflects, I think, a very strong story and a very strong strategy in the Creo announcement.

Turning now to cash and cash flow, cash did decrease by $57 million in the quarter to $183 million. Recall that we have a litigation settlement of $48 million that was consummated at the end of -- really at the beginning of Q1. That was paid out, so that's a major piece of the decline in Q1. I would say the good news is Q2 was probably our strongest cash quarter. We expect cash to increase in Q2 by $77 million, such that we'd end the quarter with $260 million of cash. And this is before any stock repurchases. So, just on a cash basis, we'd expect to close the quarter -- the current quarter with $260 million in cash.

For the full year, cash flow from operations-- and I'm going to exclude the $48 million settlement. The cash flow from operations without the $48 million settlement would be $165 million. That's a significant number for us. It's great, it's up year-over-year from FY 2010. We also plan to purchase $55 million worth of stock in the coming quarters and in the full year, and we expect to end of FY 2011 after $55 million worth of stock purchases at $275 million. So, we have got a very strong balance sheet with excellent cash flow.

I will close with our guidance. Just reiterating, our guidance assumes $1.37 US to the euro. This is consistent with both our simple average for 2010 and our guidance at the end of last year. So, we're holding to that. As you know, the euro moves up and down fairly significantly within the periods, but we feel right now we don't forecast currency. We really just live with the flows up and down as they come. Guidance is based on this. So, for Q2, we expect revenues to be $260 million to $270 million. This would be year over year growth of 8% to 12% and non-GAAP EPS of $0.22 to $0.26. For the full year, we expect revenue growth of 10% to 12%, or $1.11 billion to $1.13 billion and non-GAAP EPS of $1.20 to $1.25. We thank you very much for your time and your interest, and we'll now open it up for your questions.

(Operator Instructions)

Our first question comes from Sterling Auty of JPMorgan.

Thanks. Yes, thanks. Good morning, guys, from snowy New York. We're suffering right along with you. Let's start with the contract with Hyundai. So, I want to make sure I understand, there was no revenue that was actually recognized in the quarter. Was that also because of the way that the contract was constructed?

Sterling, I will take that one. So, we signed this contract really late in December. And so, it's really -- basically, the structure here is contract accounting, and we'll be recognizing revenue on a percentage-completion basis. So, as we sign the contract, we're into deployment now. We'll begin recognizing revenue -- the revenue stream really in Q2 and beyond. Based on contract accounting, what we did is an estimate of all the costs to complete this, and what we booked in the first quarter was the excess of costs to complete, versus the contract value for Phase One. So, Phase One revenues will start being accrued in the second quarter.

So, just to add a little color to that. Because we were doing this percent-complete contract accounting, we are not able to extract out the license revenue and recognize that, as we would do in a traditional deal. And then, if you say, well, what percent-complete did we get to? Well, the answer is zero; we just started in the waning days of the quarter. So, that's really the story there.

I think there's a lot of us that follow other companies that use this in other segments, so I don't think it will be that foreign, but maybe one clarification. Is this completely unusual for you guys to use percentage-completion, or have you done that with any of the other domino deals?

It's a rare occasion. I think we've done this on a couple of occasions where we've made commitments, and where the services is the vast majority of it, we would use 81-1 or contract accounting, so it's very consistent with past practices. That said, 97-2, or software revenue rec, is the vast majority; 95% to 98% of our businesses is software revenue rec.

Yes, what is very unusual is for us is to make commitments around product development. Now, normally a customer gives us some requirements, we look at those requirements, and we say sounds good. We'll try to work it into our future product road map, but we're not committed to it. So, even if we normally would do a percent-complete, you wouldn't really see it that much. What's strange here is we made the product enhancement commitment, and that brought in all of this cost from future periods in one big lump, which is why it looks strange. I've not seen that happen prior at PTC.

Got you. One of the other items that we saw, and I got questions from investors, is also looking at the license revenue as a whole, kind of towards the lower end of the guidance range. If you had used 97-2, if you didn't have the commitments, is there any quantification that you can give us as to what license revenue might have looked like? And then, the follow-on to that is, would you get all of -- are you going to get all of that license revenue during fiscal 2011 under the percentage-completion for this Phase One, or does it stretch it out even longer than that?

So, let me pick up on this. There wouldn't -- we're under contract accounting. And let me just say that the license piece of this is a small number of licenses up front, and that is in Phase One. We expect that to broaden significantly in Phase Two and Three. So, there will be significant amounts of additional revenue recognized in future periods on Phase Two and Three, once we complete Phase One. So, it's a very small amount of license that would have been in this, and that's not uncommon for our domino programs were there will be a lot of services up front to get a deployment complete, and then we see a rapid expansion of license seats after that.

Yes, and this Phase One does not fully complete within this fiscal year. It's more like targeted at a calendar year.

Correct. Yes.

Okay, and last question and I'll get back in the queue. Just to keep beating the dead horse, in terms of the expenses that you were forced to recognize, were 100% of those expenses in the R&D line? Or, when I look at the cost of services, and I look at the services margin -- it's in services.

It's in services. So, there's about $5 million in services. It's recognized there because that's a services contract, and it did have a 2 percentage point impact on gross margins in the quarter, as well as on the bottom line. It had the $0.03 to $0.04, but that really bridges, I think, what was a very good quarter in overall margin; good services margins, excluding the HKMC deal.

So again, just to be perfectly clear, what essentially happened to a large degree is future R&D costs got characterized as current period services costs. That's what you're going to see happen here over time.Higher services costs now means lower R&D costs later.

Got it. Alright, thank you guys.

Our next question comes from Yun Kim of Gleacher.

Thank you. So, I think Sterling did a good job of asking all the right questions regarding the Hyundai Kia contracting accounting deal. So, just go on to something else. It looks like you mentioned the desktop CAD business had a very good quarter. How do you account for such a strong business in front of a major release coming up; Creo products, in about six months? And then also, you hear some pull-through effect that's happening from some large PLM wins that you had last year; basically, Windchill driving some ProE sales right now? Thanks.

Okay, you had a couple of questions there. I think, again, the desktop CAD number was strong for two main reasons. One is there were some large deals that contained desktop CAD. Those were probably more a function of renewals that came up and got renegotiated than any special connection to Windchill or anything else or Creo. And then, there was just good robust strength in the SMB channel where most of the new buying behavior happens. And there, Creo is helping us a lot because as you remember, the Creo story on one hand is very interesting.

On the other hand, it's fully upward-compatible from the existing stuff. So, excitement about Creo, even though it's not delivered today, actually does translate into a purchase of what's available today because it's upward-compatible. So, I think that what's happened is the number of conversations that we get included in has increased dramatically as a result of Creo and all the marketing that we've done around that.

Okay, great. Thanks. And also, Jim, you mentioned about a third of the large deals were follow-on deals from existing domino accounts. Is that where we can expect the level to kind of trend for a while, or do you expect that level to pick up or maybe even dip a little bit? How consistent would that level be going forward?

Well, just to be completely honest with you, I don't have that data in front of me for prior periods, so I can't comment as to the trend. That feels to me to be probably relatively normal, maybe increasing a bit over time. Kristian tells me it is increasing over time. But we don't -- I don't have the data from prior periods sitting here to compare it to, so --

Just as a general view, I think we're building these annuity accounts, the domino wins are terrific, and then our clear goal is that they generate not just a deal up front but a continuing stream of revenue over three, five, many, many years. So, I would expect as we build the annuity accounts, we will see more of that domino revenue flowing through as well.

And I think, just again to add some more color, clearly, we've taken you guys through this domino-monetization model that says most of these dominoes are not upfront big purchases. Occasionally they are, but that's the exception rather than the rule. So, the rest of them become small engagements up-front dominated by services revenue, and over time they translate into more and more license revenue, and then a building stream of maintenance. And if I look at this portfolio of the 22 domino wins to date, they're all more or less on the exact path with the exception of a few that gave us big orders up front.

Okay, great. And then, I just want to make sure, the closure rate on these follow-on domino deals are much higher than the initial contract, right? That's probably a fair assumption?

Yes.

Okay, great. And then, Jeff, there was a pretty sizeable sequential jump on deferred revenue in the quarter. Is that all maintenance renewal, or was there some pick-up in the consulting work or even some license revenue?

A big piece of that is the maintenance renewal. That's a -- it's a big, big Q1 event, which is terrific, and that's what also drives the very significant increase in cash flow in Q2.

Okay, great. And then, the final question for me, can you give us an update on the interest level of large system integrators -- towards working with you in terms of signing the next big PLM deal? Are there more outside consultants being trained on Windchill? Any -- if you can share with us any specific plan that you have to get these large system integrators to ramp-up? Thanks.

Well, this is Barry here. One thing we've done now is we've created a model for what the service economy needs to look like in 2014, and we've assigned this as a goal to the service organization. So, we've really resolved the strategic issue going forward where we're going to be ramping up the SI community with a greater investment and support in the years coming, and we are seeing that as to be very well received by the SIs out there. So, we'll expect that economy to grow significantly over the next three or four years.

Okay, great. Congratulations on the signing of that Kia Hyundai deal. Thanks.

Thank you.Just before we move on, if we could keep questions to one question and one follow-up, that would be great. Thanks.

Our next question comes from Blair Abernethy of Stifel Nicolaus.

Thanks, can you hear me, guys?

Yes.

Just on the domino wins to date of the 22, Jim, I'm wondering if you could just help us out a bit in terms of characterizing the backlog on licenses. If you look at the group of 22 now, what -- how much of them could you bucketize as in the first phase versus second phase versus a final phase of implementation?

Yes, well, I think we began the program -- began talking to you guys about domino accounts in mid-2009 or so. So, you could say that the earliest wins are what, six, seven quarters under our belt? And the latest wins, of course, are our days under our belt. So, I think that says that all of these accounts are somewhat in their early days. Because this is a multi, multi-year phenomenon that takes to run its course. And quite frankly, we've never actually had one on its course, so we're not sure when they do end. It just becomes an engagement where we become a strategic partner, and we continue to do incremental business with them year after year. But just trying to get back to your question, I think that I would characterize all of them as having ample additional opportunity from where we now stand, and most of them are starting to be pretty meaningful.

I would add that when you mentioned the final phase, in actuality, we don't think of having any final phase because one is the rollout of Windchill and PLM, but there's also the expanding footprint of PLM. I think most of you heard and saw how we're expanding into the service market within our accounts with our SIS ArborText offering. So, we see these as really sort of never ending annuities.

Okay, great. And then, on the win with Hyundai, if we look past this and say, okay, what other automotive OEMs are out there looking to do a major overhaul as well at this point? Do you have -- are their other ones in your pipe now?

I don't want to predict that we're going to close another one soon. I think what's going to happen is we're going to start being taken seriously in the evaluations that they do. You know, General Motors ran an evaluation last year, and they didn't include us in the evaluation, and I was a bit dumbfounded and actually flew out there and asked them why. Why would you not include the leader? And they said, you're not a player in automotive. And so, okay then; it is what it is. That's no longer true.

General Motors watches extremely closely what's happening at Hyundai.And now, I don't want to speak specifically for General Motors, but in companies like that, they're wondering if they haven't maybe been leapfrogged. Because Hyundai didn't follow their strategy, they leapt ahead with a new strategy with the now current market leader, and I think a lot of these automotive companies moved from defending what they're doing to questioning what they're doing. But now we've got to start the sales cycle that takes some time to run, so I don't think it's going to make an immediate difference, but in terms of working our way increasingly into this industry in the coming years, it's huge.

Okay, great. Thank you.

Our next question comes from Steve Koenig with Longbow Research.

Hi, guys.

Hi Steve. Good morning.

I'm good, thank you. First question and then one follow-up. You've given a pretty in-depth explanation of the contract accounting, which was helpful. Can you direct that, however, specifically to Q2 and talk about the dynamics there, the guidance being a little below the street on EPS? And was it all the Hyundai deal where, basically, it looks like you're now going to be matching your costs with your revenue, so margins on those resources on those activities will be low? Or is there additional -- are their additional items in Q2 that would have affected that guidance? And then I do have one follow-up.

Okay, Steve. So, relative to Hyundai, we won't provide specific revenue and margin guidance, but I would suffice to say that it's baked into our plan and our forecast, and it has a very small effect going forward. The dollars we took in Q1, one, helped to mitigate that, and it will be percentage-completion. Again, the uptick that we expect will be as we move from Phase One to Phase Two with license revenue, so I would say it's a small effect.

As we look at the balance of the year, we're really looking at trends that I think are very important, and that would be continued margin expansion. We'll be building and continuing to invest in sales capacity to drive growth because we feel very comfortable and very confident in the market opportunity ahead. We'll be watching and expecting that our R&D expenses will continue to trend downward over time. And as I think we have cited before, R&D expenses historically were in the 16% range. We essentially increased that significantly over the last two years into the 20% range. We're trending down now, 19% to 18% this quarter. We'd expect over time that'll normalize.

So, I think we've built-in a number of programs, we've got some investments in services that we spoke about last quarter that occurred in the first half of this year, that we'll beget better margins for us on the services side in Q3 and Q4. So, I think most of the programs that we've funded, we feel very good about, and you'll start seeing the small effects of that in Q2 and more as we step-up through Q3 and Q4.

Okay, great. That's very helpful. Then just turning to my follow-up, I'm wondering on the PLM side, you did have a tough compare this quarter. Last year you all spoke about growing Windchill -- growing PLM, I should say, 20% year-on-year and growing licenses at potentially 30% to 40% pace. Do you still see that pace as achievable this year?

Well, I think we definitely believe we're going to hit the 20% overall goal. And I think it will be -- it will take license growth in the 20% and 25% range you're talking about -- I'm sorry, in the -- more in the upper 30s range that you talk about. Now, keep in mind, we had 72% license growth last year in Windchill. So, we see ourselves scaling back to sort of half the license growth rate we had the previous year, attributing some of that previous year license growth to economic recovery and soft comps from the previous year and so forth. So, I think we feel like that 20% growth for Windchill this year is completely doable, and we have the pipeline to support doing it.

Great. Thanks a lot, Jim. Thanks, Jeff.

Our next question is from Richard Davis of Canaccord.

Thanks very much. So, the question I have, as much as I like talking about accounting, is by my reckoning, if you barely allocate expenses to CAD and PLM, Windchill is somewhere between, I guess, breakeven and most single-digit operating margins. And if you look at every other software company that generates, if you cut your revenues roughly in half, $300 million, $400 million, they all have 20% operating margins. So, it's awesome that Windchill is growing, but why are the margins low? How do they get better and when do they get up to industry averages, and how do you think about that? Because if you're able to pull that off, then it could be an awfully interesting story here.

So, Richard, this is Jeff Glidden. We understand the question, and where we really start with this is looking at the revenue growth, and then the mix of product and services that are within that. And as we've articulated in many of these accounts and in our Windchill business, a large significant portion of that revenue is services, which has a lower margin mix relative to license and maintenance. So, I think there's, both within existing accounts and over time, we start with a heavy services mix, we watch license revenue grow at a more rapid rate. That'll drive maintenance, and as that overall mix improves, that moves gross margins from today, probably in the 60% range up into the 70s % range itself.

So, that alone -- and I think that's a management -- another piece of the way we manage the business, these strategic partners, channel partners, and other, really, consultants, are an important piece of building that ecosystem to provide that level of service and support to our customers. So, I think you'll see continued mix shift that's very favorable for us on the gross margin line. We're also today, as you know, investing significant amounts of money, particularly in R&D, to leapfrog others with the Windchill program. As I've just said, those will moderate over time, so you'll see leverage in the operating expense side as well. The combination of that will put us into what I think will be industry targets for that Windchill business. So, it's both growth and gross margin expansion and operating margin expansion for the Windchill business.

So, is it fair or logical to conclude that the RNB payoff would be to more productize Windchill such that therefore future deployments, whether that's a year from now, two years or what have you, are less service-intensive? In other words, you can -- you have to do it less up-front effort, or is this a system that requires links to so many different backend systems that it's unlikely that you can fully productize the business?

No, I think your exactly right. That's exactly what we've been working on for some time now and continue to work on, is try to eliminate -- or let's say minimize the amount of services and customization work and so forth. It's never going to go to zero; that's impossible.

But I think people think in terms of a multiplier from license to service revenue. That multiplier has dropped dramatically over the last few years. And we're trying on a go-forward basis to give a bigger portion of that services need to a services economy above and beyond PTC. If you really go back to what Jeff said, it's all about the mix in Windchill, and our goal is to grow license revenue the fastest and to sort of grow maintenance revenue at a pretty good clip as well, and to actually throttle back the services growth. And again, two parts to throttling back. One is throttle back the demand, and then number two is throttle up the supply of the third-party ecosystem. And if we do that, then as we grow, we grow to an increasingly more interesting mix.

And then, we'll also get some benefits of scale, that the R&D as a percent of revenue, for example, can drop. And I think we'll get some benefits of leadership, what I call 'economies of leadership,' which means we'll have shorter sales cycle, higher productivity, better pricing power, all those good things as well. So, I think all that stuff together is really about fixing the mix, and I think it's going to make Windchill very interesting going forward.

Got it. Thanks.

Our next question comes from Ross MacMillan of Jefferies.

Thanks a lot. Jeff, I just wanted to go back, just so I fully understand on the contract accounting. It sounds like you match revenues and costs over the remainder of the contract, but you took costs in excess of that in the first quarter. And I guess my question is, does that imply that you actually have higher costs for fiscal '11 than you would have previously expected because you effectively committed to say, I don't know, two years of R&D or three years of R&D, and its getting stuck into fiscal '11. Is that the right way to think about it?

Your first part on the accounting is correct, the second part is not correct. That is we will -- this is funded through our existing spending programs and plans. So, it's not -- we will not have incremental expense in the year. We'll have some different bucketing of it. We'll have more recorded in services, and we'll have a lower level of R&D over the course of the year. But it's really a function of -- it's already, as Jim said, it's baked into our expense plans. And therefore, despite this impact in Q1, we're comfortable with maintaining our EPS guidance for the balance of the year.

Okay, that's clear. Thanks.

Keep in mind that timeframe of performance for Phase One is pretty short. So, this is not a multi-year thing, it's really a calendar-year thing.

And I just wanted to be clear on one other point on the contract. It didn't sound -- if this had not been contract accounting, it didn't sound like there was a material amount of license revenue associated with Phase One. And so, if it had been 97-2 accounting, would there be much delta, let's say, to the license revenue taken in the first quarter?

We didn't break that out and we won't. I'll just say, it's a small amount of license revenue in the Phase One, which will be followed by significant amounts of license revenue as we anticipate in Phase Two and Three.

Yes, had that happened, we would add a little more license revenue, and we would add $0.03 to $0.04 more EPS this quarter, and we'd add better services margins and all that type of stuff

That's great. And then just -- could you just remind us of the phasing on Creo? There are -- I think as you move to the new product introduction, there are two elements. Can you just remind us, A, when we should expect to see those two elements, and B, if you will, can you explain those two elements and how they kind of relate to, let's say, the existing install base today? Is the second phase, for example, really all incremental new functionality, and Phase One is really going to satisfy, if you will, an upgrade path of the majority of the base? Thanks.

Yes, so actually, we talked about four key capabilities. AnyMode Modeling, AnyData Adoption, AnyRole Apps, and what's the other one -- AnyBOM Assembly. So, three of those are sort of meat and potatoes things that have much meaning for everybody. Those three are in the first release, which remains scheduled for the June timeframe, so Q3. The next thing, this AnyBOM Assembly. This is a more sophisticated concept that requires changes to ProE, Creo and to Windchill, as well to change the way the two together do assembly modeling. So, this is in the Phase Two release, which is a bit further out, but it's also -- it's not something that will have an immediate impact anyway, because it's a more compelling, but bigger change for a company to make. So, I think if you're thinking about it from a revenue standpoint, that really comes down to our release one in the June timeframe. That is what 98% of the customers plan to upgrade to, et cetera, or anyway, that they are excited about, let's say.

That's very helpful. Thanks a lot.

Our next question comes from Ben Rose of Battle Road Research.

Good morning. Just a couple of quick questions. Jim, what is your sense of how long the first phase will last with HKMC? I'm sorry if you did mention that, I didn't catch that. And also, could you give us a sense of how other verticals look to you over the next six to nine months, ex-automotive?

Yes, so the first one is easy. That's essentially a calendar-year contract -- not contract, but a calendar-year plan that we have with HKMC. So, if we execute per the plan, it'll be wrapping-up come January of 2012. On the second question about the verticals, I mean, you guys can help here because it's just anecdotal information I would have.

If I think, where have we seen a lot of strength, two areas stand out for me, looking back at the past few quarters; one is automotive. In fact, I think we had 27% total revenue growth in the automotive vertical in 2010 over 2009. That's surprising to everybody. And it probably is superior to either of our competitors, who would call that their home-field advantage, and that's before the HKMC win. So, I think that's one. The second is retail. We are seeing a lot of these big, big-box style retail companies buying PLM, and PDC has an exceptionally high win rate in that vertical, and there's a lot of greenfield opportunity. So, we're seeing a tremendous amount of activity in that vertical. That said, I don't see the rest -- I don't see any of them as being laggards, I just see all of them as feeling pretty healthy and two of them sort of being more outstanding than that.

Okay, thank you.

Our final question comes from Andrew Kaplan of Deutsche Bank.

Hi, congratulations on the Hyundai win, that's a huge win. Question -- just a quick question on that. You said it's a one-year execution basically. The plan is to execute their -- adjust their changes that they're requesting within a year. Can you shed some light on the economics, if you don't execute within that timeframe? That's my first question. Second question is, you took a $57 million decrease in the cash position because of a litigation settlement. Any other large looming litigations that are out there that you can comment on?

Okay. So, this is Jeff. I'll just speak to the Hyundai program. This is just Phase One. So, there are some incentives and some contract clauses that we really need to execute and deliver this in the year. We expect this will get that done, and we're accounting for it as such. The real key for us is not any issues on this side on Phase One. It's about how do we get to Phase Two and Phase Three because the -- this is like an iceberg. You know, we see what we see in Phase One, which is a small deployment, and it may be a few hundred seats of Windchill. Over time, we think this is thousands of seats of Windchill, and so that really represents the opportunity. So, I think the vast majority of the opportunity is ahead of us with tremendous upside as we go forward on this.

Your second question was litigation. Now, we've put this behind us. The good thing, having -- and it's, by the way, was $48 million was the net effect of that litigation settlement. I think that's behind us, and that's a good thing. I'd reiterate that we expect very strong growth in cash in Q2 as well as the balance of the year, and I don't -- there are no -- we fully disclose any risks or litigation out there, and I think this was the -- this settlement is terrific to have behind us, and there's nothing else of that ill ahead of us.

Thank you.

And at this time, there are no other questions.

Okay, great. Well, that's been a lot of good discussion, and I'm confident, actually, through the discussion here that you guys see the HKMC win for what it is, which is a tremendous victory with some very short-term accounting discussion, but soon enough that'll be behind us, and PTC will continue to execute what I think looks like a great year. And I think that's the second great year in a five-year great program, and we're well on-track for both of them. So, I'd like to thank everybody for joining us, and we look forward to talking to you all in about 90 more days. Thanks a lot.

This does conclude today's conference call. You may disconnect your phones at this time.