PTC Inc (PTC) 2014 Q2 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to PTC's second-quarter FY14 results conference call. After brief comments by management, we will go directly into the question-and-answer session.

(Operator Instructions)

As a reminder, ladies and gentlemen, this conference is being recorded. I would like to introduce James Hillier, PTC's Vice President of Investor Relations. Please go ahead, sir. Thank you.

Thank you, Roanne. Good morning, everyone, and thank you for joining us on today's second-quarter FY14 earnings call. As a reminder, today's call and Q&A session may include forward-looking statements regarding PTC's products, our anticipated future operations or financial performance. Any such statements will be based on the current assumption of PTC's management and are subject to risks and uncertainties that could cause actual events and results to differ materially.

Information concerning these risks and uncertainties is contained in PTC's most recent Form 10-K and 10-Q on file with the SEC. Unless otherwise indicated, all financial measures in today's call are non-GAAP financial measures. A reconciliation between the non-GAAP measures and the comparable GAAP measures is located in the Q2 2014 press release and prepared remarks documents on the Investor Relations page of our website, at www.PTC.com.

With us on the call this morning is Jim Heppelmann, our President and CEO; Jeff Glidden, our CFO; and Barry Cohen, EVP of Strategy. With that, I'll turn the call over to Jim.

Thank you, James Hillier. So good morning to all of you, and thank you for joining us here on our Q2 earnings call. I'm pleased that we were able to report a solid second quarter, with license revenue up 8% at constant currency, total revenue up 5% at constant currency, and earnings per share up 18% at constant currency.

These results are primarily organic in nature, with acquired businesses contributing just $4 million of revenue, together with a modest earnings headwind, due in particular to investments we've been making in the ThingWorx business to position it for strong growth.

Our most recent quarter is the third consecutive quarter where we've seen organic license growth rates increase, taking us from the mid-single-digit negative growth territory of four quarters ago and progressing along a vector toward the double-digit positive growth rate we hope to achieve as we get into 2015. This, of course, assumes the economy continues to solidify, as it has been of late.

While the manufacturing economy does appear to be improving in general, we still felt some challenges in the quarter, and these challenges are reflected in our results. Our business in North America was strong, and our European results showed good improvement. But we posted a relatively weak quarter in Japan and in Asia-Pacific. The Japan issue appears to be mostly deal timing related, as we have a very strong Japanese forecast for Q3.

The situation in Asia-Pac is more complicated, with PTC joining a list of tech companies who have been posting relatively weak results in Asia-Pac, due to a combination of economic slowdown and turmoil associated with new policies being implemented by the new Chinese government that took over in 2013. Even with the Asian challenges that I've described, PTC has sufficient pipeline strength to deliver a strong quarter. Similarly, for the balance of the year, our pipeline data gives us confidence that we're in a good position to deliver the updated guidance that we issued in yesterday's earnings release.

In terms of market segments, we're pleased to see strength rebuild within our core CAD and extended PLM business segments. Our CAD business was up 3% at constant currency, which is the third consecutive quarter of year-over-year growth. Extended PLM was up 6% at constant currency, with license sales up double-digits. SLM was up 12%, which is a continuation of the strength we've seen in that business over the past two years, even during times when the manufacturing economy was struggling.

We believe that our newer businesses, such as SLM and Internet of Things, will continue to develop secular, rather than cyclical, growth patterns. That brings us to ThingWorx, or our new Internet of Things, or might I say, IoT business segment, and the big opportunity that PTC has in helping companies apply this new type of technology to further transform how they create, operate and service their products.

Over the past five years, PTC has increasingly differentiated itself by repositioning the Company to reflect what's happening in the world of manufacturing, where value that product companies create has been migrating from hardware to software, migrating from product to service, and now from embedded to cloud. Our traditional competitors have taken a very different path over that time and focused on very different things than PTC.

So our strategy of adding value in this new world of smart connected products has become very unique to PTC, and our customers increasingly see PTC as one of their top strategic business partners. With the major investments in ALM for the smart part of product development, SLM for the after sales service optimization, and now, IoT for connectivity, which for the first time ever gives customers true closed-loop product lifecycle management, we at PTC are more than five years and $1 billion of investment ahead of our traditional PLM competitors in this world of smart connected products.

We believe that forward-thinking manufacturing companies are beginning to appreciate how important it is to have a strong partner and a trusted guide, who can help them to transform and modernize their strategies and processes accordingly. In our first 90 days of owning ThingWorx, we've generated a tremendous amount of customer interest, activity, and pipeline.

There are now more than 100 significant ThingWorx opportunities being actively worked, with more than half of them contributed by PTC at large firms in the first 90 days that we've owned the company. In Q2, we even closed our first field PTC deals, with start to finish sales cycles that ran within the quarter.

Customers understand that the strategy of using Internet of Things technology to close the loop on product lifecycle management really does transform the way that products are created, operated and serviced. Because this message resonates with an executive audience, we've had little trouble calling high and working top down.

But perhaps most exciting, the feedback on this ThingWorx technology is universally positive, which means the bottoms-up approach with the technical experts is working quite well, too.

ThingWorx is a well-architected product and there's nothing quite like it in the market today. Many long timers at PTC say this situation is reminiscent of the early days of Pro/ENGINEER, back in the late 1980s, early 1990s, where interest levels were high and nearly everybody who saw the product wanted to buy it.

Remember, though, that we're starting from a small acquired revenue base, that we're working with customers to prove out a brand-new technology for the first time in their business, and that we're primarily using a subscription revenue model.

Therefore, our goal in the near term is to generate pipeline and bookings and capture customer projects and market share. As we've suggested previously, the impact on revenue will not be that significant in the back half of FY14, but we expect the bookings to continue to grow quickly and revenue to follow as we get into FY15 and beyond.

With ThingWorx primarily following a subscription model and our new managed service business also following a subscription model, we're building a growing portfolio of subscription-based businesses that are distinct from our support or maintenance business. These areas represent a faster growing part of our business overall, particularly if one tracks customer acquisition to bookings, rather than revenue.

Because the majority of our overall business uses the traditional license and support model, the perpetual model, we believe it appropriate to stick with that model for financial reporting. But as these new subscription growth businesses take on a larger slice of the overall PTC pie, it's likely that we'll consider adding subscription bookings to our guidance and reporting models at some point in the future, in order to provide better transparency to what's going on in this exciting part of our business. We'll consider that as we prepare for FY15.

In summary, I hope you can sense that we feel good about the business in the long term; and in the near term, we're balancing our optimism about the pipeline with an ongoing need to be cautious, due to economic concerns in Asia and perhaps elsewhere. But at the midpoint here of FY14, we're certainly on track to meet or probably even exceed the original goals that we laid out going into the year.

So to close out, in response to a lot of inbound investor interest, I'd like to remind you that we're hosting an Investor Relations webcast at 10:00 Eastern Time on Monday, May 5 to respond to a high level of interest in ThingWorx and PTC's new IoT strategy.

So during that approximately hour-long call, we're going to provide a deeper look into our strategy, and then we'll provide several online demonstrations geared to show you how PTC will use the ThingWorx technology to help our manufacturing customers transform their business for this exciting new world. I look forward to having many of you join us again at that event.

And with that, I'll turn it over to our Chief Financial Officer, Jeff Glidden, for a few of his comments.

Thank you, Jim. As Jim said, we are pleased with our financial results for the second quarter. Revenue grew to $329 million, and non-GAAP operating profit increased 27% to $80 million. However, a higher tax rate in Q2 of 2014 resulted in non-GAAP EPS growth of 17%.

As previously discussed, we expect our FY14 tax rate to be approximately 25%, as compared to 21.6% in FY13. This higher tax rate is principally due to a shifting mix of geographical profit, driven largely by an increase in revenue from our US operations. In addition, our FY13 tax rate was benefited by the reinstatement of the US R&D tax credit by Congress for both 2013 and 2012.

Our Q2 non-GAAP operating margin increased by 440 basis points, to 24.4%. This increase is attributable to continued expense management discipline, coupled with higher gross margins in our Global Services operations. We continue to have very good cash collections from our customers and generated $111 million in cash flow from operations. We ended the quarter with cash of $270 million, paid down $50 million in debt, and repurchased $40 million of PTC stock.

Clearly, a highlight has been the acquisition of ThingWorx, which was completed on the first day of Q2. In January, we expanded our credit facility to $1 billion and extended the maturity into 2019. So all in, we completed another very busy quarter and a productive quarter. And at the mid-year, we have delivered earnings per share of $0.98 for the fiscal first half, for a year-over-year increase of 26%.

Now looking ahead to our outlook for Q3 and the full year. Macro indicators suggest that we're in the early stages of an economic recovery, with improvements expected from manufacturing output in the US and Europe, but continued softness and uncertainty in the Pac Rim.

Given this background, we expect Q3 revenue to be in the range of $325 million to $340 million, and we expect to deliver non-GAAP EPS of $0.48 to $0.52. For the FY14, we have increased our full-year guidance by $5 million and we have increased our non-GAAP EPS to a range of $2.05 to $2.15.

Again, we appreciate you joining us today, and I will now turn the call back over to James Hillier.

Thank you, Jeff. Roanne, we're now ready to begin the Q&A process.

Thank you. We will now begin the question-and-answer session.

(Operator Instructions)

Thank you. The first question comes from Sterling Auty. Please go ahead.

Yes. Thanks. Hello, guys. Given the commentary around ThingWorx, can you give us a little bit more detail in terms of the contract structure? You mentioned subscription. But what do you think the average contract lengths, based on these early discussions, might look like?

And secondarily, based on the interest that you're seeing so far, what is the type of environment that ThingWorx is going into? Meaning, is there a particular type of technology that you're already seeing a trend that's embedded on the products that ThingWorx will actually manage the data coming back off of?

Okay. Good questions. And good morning, Sterling. So first of all, on the contract length. If you look at the deals that are closing in the ThingWorx world, they tend to be either one- or three-year subscriptions. Prior to us acquiring the company, they were signing people up for a one-year. And we said, wouldn't it be a better idea to sign them up for three? So they switched to that model without much pain. So was one, shifting to three.

What we tend to have, in terms of contract size, is a lot of proof-of-concept projects. People are excited, but they need to go do something, shop it around the company, show it to their boss, et cetera, to do a bigger project.

Now there are some companies who have been doing connectivity for a while, maybe under the heading of condition monitoring, or something like that. And these people, I think, can move more aggressively, because they say, hey, that's just a better tool to do something we're already doing at scale.

But there's a lot of projects that are, just to be clear, not huge; but if we win those projects, we then become the vendor that grows with them as their program grows over time. So not huge contracts typically, but important design wins, if you will, that lock us into that business going forward, and then taken over a period of 36 months, if it's a three-year commitment.

In terms of where they're coming from, definitely the sweet spot right now is industrial. A company buys some things on the edges, maybe some electronics, maybe some commercial vehicles, things like that. But typically, expensive business-to-business type assets that live for a while and need to have routine service and maintenance and monitoring and so forth.

So equipment, HVAC, elevators and escalators, electronics stuff you'd find in a big data center, and then trucks, buses, things like that that similarly need to be monitored and maintained and so forth. So that's probably the tip of the spear. Those people are most eager to get going.

I think that the big automotive companies are all formulating strategies, but of course, they need to be a lot more careful about it, and they're taking their time and trying to decide what's going to be proprietary and what do they want to buy for the market, and so forth. So they're probably a step behind.

Okay. And then my one follow-up question would be, you called out both extended PLM and SLM. In particular, the extended PLM, can you give us a little bit more insight into where you saw the pick-up in strength and the pick-up in demand within the extended PLM portfolio, and if you think that's sustainable from here?

Yes, a lot of it was follow-on deals with customers that have already purchased with us. We see extensions in PLM, per se, that would be the Windchill, as well as extensions and add-ons with ALM, and with some of the other quality programs and so forth.

So I'd say large customers, really, I think with a higher level of confidence, Sterling, that�s fine. We got a couple of additional deals that became mega deals that upsized during the quarter, and was really reflective of customers being more confident about extending what they already have and then looking at adjacent revenues streams.

Yes, just to add a couple of comments, without naming names necessarily. A large European automotive firm OEM gave us a pretty substantial expansion. A large German industrial company gave us a pretty substantial, relatively new order. We had done a little bit in the company, but the whole company committed to this technology going forward. A large US automotive supplier gave us a very substantial order. Again, that was an expansion of a program we had started some time ago.

So this sort of follows the pattern that sometimes the first order isn't that large, but like in the case of this US automotive supplier, you circle back and you get a couple more pretty substantial orders over time, as this thing spreads across more users, more divisions, more functionality and so forth.

Got it. Thank you.

Thanks, Sterling. Operator, next question, please.

Thank you. The next question comes from Matt Hedberg from RBC Capital Markets. Please go ahead.

Thank you. Thanks, guys. Nice quarter. Really nice to see the growth in CAD, I think the third straight quarter, as you mentioned, of growth there. Can you remind us again where we are in the Creo upgrade cycle, and maybe talk a little bit more about when a large customer, say Caterpillar, migrates to Creo, what that means for the ecosystem of that particular customer?

Yes. Well, good morning, Matt. And that's a good and interesting question. So I think at the last earnings call, we said we were sort of at that tipping point, the 50-50 point. Now we're at the, let's call it the 60% point or so where the majority of customers are now on Creo.

And I got to tell you, our Creo R&D team has really done a fantastic job, because customers who go through this migration process are so happy with both the result that they have when they're done, but also the process of going through it.

More than one customer has told me this is the single best major technology migration we've ever done because it was not very painful, and everybody is so happy. So in fact, Caterpillar has gone to Creo 2.0. And they're pretty happy with it. Pretty good results.

And so to your question, what happens is then Caterpillar says to the supply chain, hey suppliers, we're using Creo 2.0 now, and please upgrade yourselves, because while we can take your Pro/ENGINEER data and use it, you can't take our Creo data back into Pro/ENGINEER. It's sort of forward compatible, not equally reverse compatible, as is typically the case in software. So then all the Caterpillar suppliers upgrade.

Now it turns out that a couple of quarters ahead of Caterpillar, John Deere did the same thing. So suddenly now you get the whole industrial vertical, both the OEMs and the suppliers, starting to all converge on a Creo environment, because it's just better for everybody.

And again, it's a good story, because people are pretty happy when they get there. That's not always been the case with technology in general, and it's quite frequently not been the case with CAD migrations in our industry. So for us, that really unlocks then this upsell opportunity with all the new stuff.

That's great. Thanks, Jim. And then maybe for Jeff, the Service margin�s impressive. I think they were almost 19%. I know you talked about targeting at least, I think you said greater than 15% for FY14. Clearly, you're beyond that now.

Can you remind us where those can get to longer term? And then I think even more importantly, how much more Services revenue can be offloaded to the partner ecosystem? I know that's been an initiative in the past.

So a couple things. The long-term target that we've put out there is to get to 20 points, 20% margin, in the Services business, and as we've said before, to continue to build out the partner ecosystem really to give the customers more choice, and that's also a piece of our enhancing our margin business.

I just wanted to make a comment on the quarter. It was an excellent quarter. There were some discrete items in the quarter that caused the margin to be higher than we had anticipated. And so I'd just be a little bit cautious. We're pretty -- very comfortable we'll get to 15 points this year for the full year. I think there's some upside to that, Matt.

But the almost 19% was an unusually strong quarter. We were very pleased with it, but would be a little bit more cautious on the next couple of quarters, in terms of the outlook, but I think very confident about building that. I think Matt Cohen, who's taken over that business, is a great leader and will continue to very strongly drive to those goals and beyond.

Matt, Jim here, if I could just add. Within the mix, we're talking about a Service business that overall is going to have slow growth to little growth. If you break that into subsegments, as we reported, it includes this Managed Service business, which is really subscription revenue. But we need to put that in one of our reporting lines. And it's not maintenance, and it's not license, so that's where it ends up. So that we'd like to grow fast.

And then there's also an Education business, e-learning and training and so forth. And that's a high-margin service business we quite like, and we'd like to grow that fast. So inside -- and the third element, just to be clear, is let's say, the professional services consulting fees.

So inside an overall business that's flat to low growth, you've got two elements we're trying to grow fast, and one that, quite frankly, is declining in size, intentionally, as we offload that to the partners, because that's the low margin piece that we'd like to continue to farm out to an ecosystem.

So that's the way you ought to think about it. If you look at the all-in number, a little bit of growth. If you were to break it into the constituent pieces, two things growing, one's shrinking by design.

Great. Thank you. Very helpful, guys.

All right. Thanks, Matt. Operator, next question, please.

Thank you. The next question comes from Ross MacMillan from Jefferies. Please go ahead.

Thanks a lot. And my congratulations on the quarter, as well. When we look at the data on large deals for the last three quarters, it's been really, really strong. I think this quarter it was up 35%, and I think on average over the last three quarters, up 20%. So obviously, growing much faster than the group average, if you will.

Can you just describe maybe the dynamics that are driving that? And if we look below the large deals, what's happening in this core rump of business, and is there something changing in your model or is there some reason why we've got this dynamic that's playing out right now? Thanks.

Yes. So thanks, Ross, and good morning. The main dynamic that's playing out right now is the economy is getting better, and that causes deals to get larger. Now if you look at this large deal activity, and the discussion about three mega deals and so forth, let me first say for everybody's benefit that we define a mega deal as greater than $5 million. So if it's $4.9 million, it's not a mega deal. If it's $5.01 million, it is a mega deal.

All three of these mega deals were just barely over the line. So they weren't $10 million, $15 million deals. They were small mega deals, if you will.

If you look at the data in the prepared remarks that we send out, if you compare year-over-year, you can actually see the average deal size of the large deals is down slightly, which tells you that the real strength wasn't in mega deals, but it was in a lot of the between $1 million and $5 million deals that would fit into this category. If you look sequentially, it's up just a little bit. And then of course, year-over-year -- the count, I'm talking about here -- year-over-year, the count is up nicely.

I attribute that to the economy, because when the economy is difficult, we'll press to get a deal done, even if it's smaller size. Okay, you can't do that deal, can you do a deal half that size, and so forth.

When the economy gets better, people feel a little better about spending money, they tend to agree that let's make this deal a little bit bigger, because I have some budget and it's a good time to use it, and so forth. So I think it's mostly the economy that does this.

I think if you look at the strength in big deals and then you looked at the category below it, you could say, well, there appears to be less deals in the category below it. I would say only because a bunch of them migrated into the big deal category. So personally, I don't think there's any issue here. I think it's all goodness.

We actually do like big deals and mega deals, I want to remind everybody. We've tried to be careful around how do we guide and so forth. But I don't want anybody to think we don't like big commitments, mega commitments and so forth. That makes for a great company, when our customers say, hey, I really do want to get married and move in with you.

So we do like that concept. We just have to be cautious about when we give you guidance, what are our assumptions about a couple of big deals closing or not closing, such that if we're wrong, or the timing's slightly different, then we don't disappoint you.

That's very helpful. That makes a lot of sense. A couple of quick follow-ups. Just one on the CAD business and Creo. We've seen that license grow for the last three quarters. Aside from basically driving -- I guess the question is, should we see any change in support revenue growth or support attach or seat growth, or do you think that's really more in this consistent level that it has been for some time? Specifically on the CAD business.

Yes. I think our Q2, first of all, is always a seasonally weak, or challenged, quarter for our support business in general. But I think we do expect to see modest seat growth in the CAD business. Again, I think our offering's pretty strong right now.

And it's not just for design, but right now if you watch Airbus put together airplanes, or Embraer put together airplanes, they may model the components in CATIA, but when it's time to do a digital mock-up, the software they use is called Creo. And that's expanding into Volvo, and we've talked about our win at [Emion] and so forth.

So more and more, truck companies, automotive companies -- if you watch Hyundai put cars together, half of the car is modeled in Creo, half of it's modeled in CATIA. But when -- maybe even one-third, two-thirds -- but when it's time to say, what does that entire car look like, all that stuff comes into Creo.

So I think that we're starting to get some mojo back in our CAD business. I don't want to get ahead of ourselves, because it's still a mature market. But the question is, can we hold our own in this mature market? And I'm feeling better about that on the strengths of how good this Creo product really is, as compared to the predecessor Pro/ENGINEER.

That's great. Last one, just on ThingWorx, I heard you describe the business model as a subscription model. What are the -- how do you price the product? What are the things that determine how you scale with a customer from a pricing perspective? Thanks.

Yes, Ross. That's a great question, too. So ThingWorx is principally priced according to how many things are connected and how many people are connected. So in one deployment, you might have 10,000 connected things and 100 connected people. In the next deployment, you might have 100 connected things and 10,000 connected people. It all depends on the nature of the business. So that's the basic model.

Where it gets a little tricky is if those 10,000 things are jet engines, you're having one discussion. If those 10,000 things are toothbrushes, you're having another discussion. So it ends up being a bit of negotiation to take that pricing model, which people generally agree with, but sort of adjust it to the practical realities of the situation at hand. But that's the basic approach.

Very good. Thank you.

Operator, next question, please.

Thank you. The next question comes from Yun Kim from B. Riley & Co. Please go ahead.

Thank you. Congratulations on another solid quarter, Jim, Jeff and Barry. Following up on Matt's question before Ross, so where are we in terms of traction with large system integrators from sales perspective? Are we getting to a point where they may be potentially coming to you with opportunity, or are we still at a point where they're just simply helping you out with a closing of a large opportunity out there? And also in that regard, how much of your large deals were influenced by system integrators? Thanks.

Yes. Good morning, Yun. Another interesting question. I think you got to look at the different elements of our business. If you look at PLM -- well, let's first just tick off CAD. System integrators don't play a role in the CAD business. There's not much services to be done.

But if you move to extended PLM, there's a substantial amount of services that can be done. I think in PLM -- because that market's sort of middle-aged, let's say, not mature, but not nascent, either -- I think the system integrators, by and large, want to be neutral. They want to tell the customer, you pick the technology, I'm happy to deploy it.

I think, though, if you switch to some of our newer stuff, like SLM and Internet of Things, we're starting to see a different behavior. System integrators would love to be our preferred partner for SLM, because that's a highly differentiated story.

And similar thing with IoT, or even if you want to just call it connected SLM or something like that. I think there's much more interest there. So I think that they're probably following us in the core business of extended PLM, and more helpful in helping us beat the bushes and drum up business in SLM, and prospectively, in IoT.

Okay. Great. And Jim, do you see any interest from customers regarding the ThingWorx business from deploying it from a cloud or hosted model perspective? And if that's the case, do you see yourself building a little data center to support that?

Another interesting question. So I think most more significant customers don't want that. And the reason why is, let's say you're a large equipment manufacturer. The data coming off your equipment is highly valuable. Most people want to bring that data right into their data center, own it, control it, whatever.

So to be frank, most customers appreciate the fact that this is software, not cloud. Because if it was cloud, they'd actually push back and say, I'm not giving you my data. And if it's not their own data center, they outsource it to Amazon or something like that. They're not looking for a cloud. They're looking for analytics and application capability to put in that cloud.

Incidentally, we're not that far away from Splunk, who also has a similar model, selling software that you put into your cloud of choice.

Now that said, all that said, we do anticipate there will be some, probably minority in the near term, but we'll see over time, some set of customers who would like a hosted solution. And as you know, we have this managed service business now that's doing both SLM and PLM. So there is actually an effort underway to prepare an offering for ThingWorx in the cloud, if people want that. I'm just telling you from my own experience being on dozens of sales calls, I'm not, amongst the bigger companies, seeing a lot of pull for that yet.

Okay. Great. That sounds very good. And Jeff, deferred revenue came in very strong than normal. I think the sequential increase is almost double the historical rate. Is that simply driven by better renewals in maintenance business, or was there some one-time item in there, or anything? Thanks.

So renewals are very good. One of the things that's a little funky is in the quarter, our quarter, last quarter, prior quarter ended on December 28. There's a bunch of renewals that occur on the 31st, or the 30th. Those actually land in our second fiscal quarter. So if you looked at it, sequentially we were down and deferred a bit at the end of Q1. And I said, don't worry about it, it'll come in strong in January. And that's exactly what we saw.

Okay. Great. Thank you so much.

Thanks, Yun. Operator, next question, please.

Thank you. The next question comes from Raimo Lenschow. Please go ahead.

Thanks, and congrats from me, as well. Just briefly, if you look at the number of sales guys, you talked about that you were slightly below par. And I saw in this quarter now you start to ramp up again. How do you think about the ramp up on the sales force now as you go through the year, especially given your comments that the economy is getting better? So what's the discussion you have on expending a little bit on the sales and marketing line again?

Yes. We did mention last quarter that we had accidentally fallen a little behind, and there has been a push to begin a process of catching up, and some progress has been made. Raimo, what I would say though is, we need to balance that with our aspirations around improving sales productivity as part of our aspirations around improving our operating margin.

For us to get to the, let's say, 28% to 30% operating margin, the targets that we talked about, we need a little bit more sales productivity. We've actually had quite a bit in the last four years or so. But we need a little bit more.

So I think what you should expect is that we would be growing sales capacity slightly less rate than we're growing revenue, license revenue, in particular, with the difference being improvements in productivity.

Okay. So if you think about your productivity, where -- are you at -- I don't know how difficult it is to put a percentage number on where would you see that. How much room is there for a productivity increase?

I think we give you the data that you can reverse engineer our productivity. We give you the number of sales reps. We give you the license revenue. If you go run that math and compare it to our peers, there's ample room for productivity improvements.

Okay. And peer, you look more at the direct industry peers or more the software?

More -- let's say, particularly enterprise software peers. But you can even take a blended average. If you compare us to some desktop peers and allocate 40% of our business to that, and you compare us to enterprise peers and allocate 60% of our business to that, that's kind of the way we tend to look at it. And you'll see that we're substantially below average, at this point, and therefore, ample room for improvement.

Yes. And then the other question I had is on the PLM side. So double digit license growth again, which is great to see. If you look into the rest of the year, or if you look at the outlook, you obviously mentioned already like the economy, people are getting happier to do bigger projects again. Are there any other factors, like renewals or volume license deals, et cetera, that kind of play a role here as well that we should be aware of?

Well, I think the biggest factor is the economy. The second biggest factor is a good product that customers like. I think that other big deals come and go. And if we have a renewal, we'd certainly try to leverage that.

But that's not leveragable if you don't have an opportunity to deliver some real value and you haven't proven yourself and so forth. So that's a compelling event, to go try to get a transaction done in a given quarter or whatever; but that's no basis to buy software, if the customer doesn't feel like they like the software and aren�t getting great value from it. So that, to me, is a factor. I wouldn't consider it to be a primary factor.

Great. Okay. Thank you.

Thanks, Raimo. Operator, next question, please.

Thank you. The next question comes from Jay Vleeschhouwer. Please go ahead.

Thank you. Good morning. Jim, I'd like to follow up on Raimo's question a moment ago about sales capacity. At the analysts meeting in December, you gave a nicely detailed table showing your capacity by region and function, such as FPL and PD and so forth. To the extent you do add in sales capacity, in which functional or geographic area do you think you might tend to add relatively more?

And on the productivity question, how do you tend to balance not overweighting or underweighting a particular product area or part of the company? Historically, PTC has had a bit of that issue, where sales may overweight a focus on one area, underweight in another, and that sometimes historically has affected your productivity.

And then lastly, on the distribution question, with respect to channel, you brought in some new channel management about six month or so ago. Is there anything in the works that might change the revenue profile of the channel business? Is there any thought being given perhaps to unwinding some of the changes you made two years ago vis a vis the channel?

Okay, Jay. That was a series of questions. I'll do my best, and we're going to have to circle back for another loop. So first of all, if you look at our sales capacity. Jay, you've known the Company for a long time. What I would say is over the last, let's say, five years for sure, we've become a lot more analytical. We use a lot more data for planning, and so forth.

What got us in trouble, more than if you go back further than that, actually was one big generic sales force that sold whatever they wanted. And in some years, they sold a lot of PLM and forgot to sell CAD, and in a couple years, they sold some CAD and so forth.

So we've become much more analytical -- and good credit here to Jeff and his finance team -- to say where is the growth opportunity and how should our capacity be deployed, not by ZIP code, but by covering the right growth opportunities?

And so I think what you saw at that December 5 event, I believe it was, was some segmentation happening in our sales force, where we said, we've got some really great, let's call them house accounts. We should have very senior account managers who can sell everything we have to that customer. Because the customer really prefers one face, if they're strategic.

But at the same time, then we need some people selling CAD and PLM, and we need some people selling our service offerings. And now I would say some people selling our Internet of Things offerings. So we're trying to be a little bit thoughtful as to where would we put this capacity. So if I kind of just generalized it now you.

One place you're going to see a lot of sales capacity come online is in the Internet of Things space. And that's going to come in the ThingWorx organization, who's selling to the broader market.

And I think in the PTC organization, that will come into our full product line and our service sellers. Because that's sort of the best place to start the best application for Internet of Things is, hey, if you could close the loop on a product and monitor the operation and the condition of the product, the first thing you'd do is change your service strategy. So there's this tight linkage.

And the second thing you do, by the way, is begin to evolve the design of your product differently. But this first thing is a good linkage between IoT and SLM.

So I think you're going to see us, say, as it relates to the direct guys, could we maybe even have a PLM guy pick up a couple of extra accounts to free up somebody to go penetrate new SLM and IoT opportunities. But we need to have pretty disciplined segmentation in our sales force, so that these people actually play the positions we've assigned them, which I think we now have.

As it relates to the channel, we did bring in some new talent. They have been very encouraging, let's say. We haven't changed the world yet, but that change is formulating itself. I think the biggest thing they're working on right this moment is just better operations.

For example, we don't yet have the channel on salesforce.com. That's troubling to me. Because when I'm looking at that pipeline data to issue guidance, I have it for the direct business, I don't have it for the channel business. That's just one big fat plug.

So I wish we had greater transparency. I wish we did a better job handing off marketing leads into the channel and running those down to did they generate revenue or not and so forth.

So there's a lot of operational things. And I think following that, we'll look for some strategic tweaks. But we've got some operational work to do first.

Understood. With respect to ThingWorx, at the Microsoft developers� conference a few weeks ago, there were a number of sessions hosted by Microsoft on Internet of Things. And while PTC and ThingWorx weren't explicitly mentioned, a lot of the technical language was very similar to what you say, in terms of their technology being used, for example, as a development platform.

They spoke about communications backbone, monitoring data streams, and all of that. So the question is, how do you see them and Intel, which was also at the conference, either as partners or perhaps competitive offerings for many of the same kinds of tools and platforms and so forth that you speak of?

Yes. So the first thing is, neither of those companies I would consider to be competitors at all. If you look at what ThingWorx does -- and please do join us for the upcoming event, and we'll make that clear. Microsoft and Intel don't have products like that. They have products lower in the technology stack. So for example, ThingWorx sits on top of a database. Microsoft is saying, hey, you could use our database technology for that.

So I did look through that. I didn't attend the event you attended, but I did scan through the press release and the announcements they made and so forth. And what I took away from that is Microsoft saying, we have a lot of technology that could play a role in the Internet of Things. And here's our view for how well this technology we have could be meaningful. What they didn't really say is that we have a specific Internet of Things offering that's going to blow your socks off. And that's what PTC is saying.

You could use PTC�s technology, ThingWorx, on top of some of that Microsoft infrastructure and everybody's happy. And then there's other infrastructure, if you want other than Microsoft. And quite frankly, a lot of this stuff is more big-data oriented, Haduc and stuff like that, than it is SQL server-based. But customers will make those kind of choices as they go.

All right. If I could just then squeeze one more in. With respect to the base number -- and I think Ross or Raimo asked this earlier -- but is the sequential flatness in the CAD and SLM and PLM base count numbers largely a seasonal function, or within the CAD number, for example, are you seeing some erosion in the non-Pro/E part of that base? Or there's other, older product that you acquired, is that where you're seeing perhaps some erosion?

Yes, I'm glad you asked that question, because -- I'm sorry, I was thinking you were asking a different question about deal size. You're on seat count.

Yes.

I think we feel like this is sort of seasonal trends. I think if you look at the [243] number, it's down a small bit from the previous quarter. It's up versus the year ago timeframe. If you go back, it's up versus two years ago.

If you looked at that Q2 a year ago, it went down slightly. So I think we'd look at that as kind of seasonal. I think Jim's described, particularly on Creo, the adoption of 2.0, the benefits of that. So I think we feel, overall, quite confident in it. But I would describe it -- I think we did describe it as largely a seasonal shift, just Q2 over Q1.

Jay, in the meantime, I found a little bit more specific data here that will also be helpful. So let me share that. If you look at the core Creo, that is the stuff that used to be called Pro/ENGINEER, that number is up, sequentially. And it's up substantially year-over-year, up 6,000 seats year-over-year.

What there is attrition in is some other stuff, CADs and maybe a little bit of attrition in the CoCreate base. And some of those people are trading, because they're flipping over to our Creo and so forth. So I think that's what you see is the core business pretty strong, some of the legacy stuff attriting a little bit, and maybe some of that legacy's attriting simply because it's converting over to the core stuff.

Great. Thanks, Jim. That helps.

Thanks, Jay. Operator, next question, please.

Thank you. The next question comes from Steve Koenig from Wedbush Securities. Please go ahead.

Hello, guys. Thanks for taking my questions. Just two pretty quick ones here. First is, you commented last quarter on close rates, you'd seen them weaken a little bit from Q4. How did they trend this quarter and where do you see those going? And then I have one follow-up

Yes, Steve. Good morning, by the way. So close rates actually weren't much better this quarter. In fact, might have even ticked down a little bit. So we felt like a strong pipeline, our guidance said be careful, prudent guidance was the right way to look at it. That's kind of how we're looking at Q3 and Q4, as well. If close rates were to be stronger, we could do better. But we're not ready to believe yet that they will be.

Another way we look at it is maturity of the pipeline. And we're doing better, as Jim said, having salesforce.com, and that information is very helpful. And when we look at the total pipeline, that's always very interesting, because that's really forward-looking. Maturity is what actually closes in a current period.

And I think we're encouraged by the total billed. And as the pipeline matures, the close rates of that matured pipeline is probably the key. So it's not one dimension, in terms of calling what the close rate is.

Okay. I guess my follow-up there would be, how do you reconcile the weaker close rates with your observations and inferences about your large deal count increasing due to a better economy? Help me reconcile those two things.

And then the follow-up I was going to ask, as well, is what is your pipeline look going forward, as far as large deals are concerned?

Yes, Steve. I'm not sure I have the complete answer. I think that the better economy has definitely manifested itself in the strong pipeline. The close rate, I would expect it to be higher. I think it probably was, if we looked at it regionally.

And I'm sorry, I don't have that data in front of me. I would anticipate it was actually higher in North America and Europe. And probably we gave up some ground in Japan, where some deals slipped out of the quarter, and in Asia-Pacific, for reasons I previously mentioned.

But we're not talking about massive changes in close rates here. But a couple of percentage points actually matters a lot. If you're trying to have $3 in the pipe for every dollar in the forecast, then if your close rate goes up by a percentage point or down by a percentage point, it starts to matter in a meaningful way.

And what do you guys see looking forward in the pipeline as far as large deals are concerned, or potential upsizing of deals that are there?

I think we've been consistent all along that we have a good pipeline of large deals for the year. We've always said it's difficult to know for certain which quarter they'll come in. But that we had more than two hands full of fingers� worth of big deal opportunities in the pipeline. So we still do.

In fact, I think at least one, maybe two of the so-called mega deals we got last quarter actually weren't in the pipeline as mega deals. They just grew during the course of the quarter into that size, just across the line.

So I think we feel like we have a pretty good pipeline in the back half of the year. And again, we're trying to find the right balance of optimism and conservativism, so that we don't get out ahead of ourselves. But we have a lot to work with.

Great. Okay. Thanks a lot. I appreciate it.

Thanks, Steve. Operator, next question, please.

Thank you. The next question comes from Matt Williams from Evercore. Please go ahead.

Hello. Good morning, guys. Congrats on the quarter. I just am curious around ThingWorx and as you're getting into discussions with customers, how ready are these customers from a technological standpoint and from a capability standpoint to really try and harness what ThingWorx brings to the table? And along with that, how much evangelizing are you guys doing around the capabilities and what's possible with ThingWorx?

Well, there's a huge amount of interest, let's start with that. So when we call up people and say, can we come talk to you about it, they say, oh boy, that's timely, because we just had this internal strategy meeting and so forth.

Down in New York City, I think it was two weeks ago, we had a forum where we invited a dozen CEOs. And so a dozen CEOs flew in from all over, in this case, the US to talk about what does the Internet of Things mean to a manufacturing company. And these were big-name companies, big-name CEOs. So that's the kind of attention we can get here.

If I asked a dozen CEOs to come learn about CAD, they'd say, I'm busy that day. But they're pretty darn interested. And they came. And we had a forum here in the Boston area a couple of months ago -- I'm trying to remember if it was March, probably February, I guess it was. And it was dramatically oversubscribed. We felt kind of bad, because we had far too many people in the room, and it was crowded, and the sound wasn't right and so forth. Again, a lot of interest. So let's start with that. A lot of interest.

Now these companies understand this is important. They understand they need to do something. It's not crystal clear to them what they need to do. And I'm not even sure they're entirely ready.

But what ThingWorx does is lowers the bar of entry dramatically. This is a rapid application development environment that allows a business analyst, not even an IT guy, but a business analyst, to sit down and say, let's try something. If we have this combination of rapid, meaning codeless environment for connecting data streams into applications, and you take that with this concept of agile, which is quick iteration, we can sit down with a customer and a couple of days, we've got an honest to God live prototype running.

And now they'll use that to refine what exactly is their strategy, because this has helped them understand what's possible.

So then we'll go off in a project to figure out, okay, I understand what's possible, what's practical and meaningful and valuable. But at this point, we're locked in.

So for us to get that first project is what's critical. Because it's just like PLM or CAD. If they start with your technology and you become their trusted guide, you're going to be their strategic partner, if you don't stumble somewhere along the way.

So that's kind of what happening. We're in a lot of those kind of conversations. A lot of people want to talk to us.

I will share one anecdote about ThingWorx for the call here. We had a typical PDC customer, mid-market customer, come to a corporate visit here in December. And this company makes scoreboards, like you'd see in a big sports arena. What's the score of the game, who's up next, whatever. And they came to talk about CAD and PLM, and they were pretty interested in SLM. And we told them our vision for CAD, PLM, SLM and our thinking about connectivity.

And they got pretty excited. And then when we announced the ThingWorx deal, our account managers sent them the link to the press release, hey, we just acquired some technology. They said, come tell us about it.

We went in there, went through this process, created a little prototype, showed it to them. And that was one of these 90-day sales cycles that closed within the quarter.

Now, they certainly didn't buy all the ThingWorx from us that they ultimately would buy. But they're off running a real project now that will lead to many more real projects, as they come to understand what's really possible and practical and strategic and valuable and so forth.

Great. That's helpful color. And then maybe just one more follow-up on ThingWorx. I know the plan, at least initially for this year, was to primarily sell it as a standalone solution. Down the road, I think the integration capabilities with some of your other offerings is very compelling.

So any update around what's going on behind the scenes there in terms of trying to help close the loop between ThingWorx and the PLM and SLM offerings, in particular?

Yes. There's lots of projects being made and it's a high priority within the Company. ThingWorx is a very productive development environment, so it's not going to take us a long time to develop the code. It takes more time to figure out what exactly should we build, a little bit like the customer stories I was just telling you.

But we have this large customer event, this PTC Live event, this year in Boston, mid-June. I think it starts June 15. We will showcase a whole bunch of connected PLM, ALM, SLM, and everything else using ThingWorx. There will be a huge showcase.

And we're expecting a lot of attention around PLM, and how does IoT change PLM. And there's a separate event for SLM. And then there's a standalone event for IoT, kind of co-terminus here. A standalone event for IoT for everybody else who's just interested in all the other interesting things you can do with technology like this.

So certainly put that on your calendar. That'll be a great opportunity to see the public unveiling of what we think is going to be some pretty exciting stuff.

Great. Thanks, guys.

Thanks, Matt. Operator, we'll take one more question, please.

Well, or not. Maybe we're out of questions.

Sorry. We have one more question from Ben Rose from Battle Road Research. Please go ahead.

Yes. Good morning. With all the discussion around automotive, I realized that historically it hasn't been your largest segment, but could it in fact become the largest customer segment this year?

And then just a second question around the aerospace -- I'm sorry, the defense component of aerospace and defense, which I know has been weak in the last year or so. Is that particular sub segment beginning to come back?

So Ben, this is Jeff. On the verticals, just in general comment, our largest vertical is core industrial. And that was a very good performance in the quarter. So we saw good movement in industrial.

Probably the fastest growth was in automotive. And automotive is an important vertical and it is growing at a pretty rapid rate. I don't see it eclipsing the core industrial, but it was very strong.

I would add just retail and consumer was also strong. Aerospace and defense was really largely flat, maybe down slightly, with aerospace being probably the commercial side stronger and the defense side slightly weaker. So that would be just the color I'd give you on the verticals.

Maybe just to add, Ben, while automotive is growing nicely, it's half the size of industrial.

Okay.

So it's unlikely it could pass industrial in this year. Maybe longer term. But industrial was actually a real sweet spot for SLM and IoT. So I don't think that will happen.

But what I will say, in our automotive business, our CAD business has some juice. Chances are, if any one of you guys go out in the parking lot and get in your car, you're starting an engine and a transmission designed with Creo. So there's a lot of Creo in the supply chain, and in the OEMs in the powertrain side of their business.

PLM, we're doing pretty well, particularly in commercial vehicles. And as you know, we've got this big Hyundai win a couple of years back that's blossomed nicely.

And then ALM is really interesting in automotive, because automobiles have tons of software in them. This software is safety critical. You don't want to find out your anti-lock brakes don't work because there's a bug in some third tier supplier's code. So there needs to be very careful traceability and change management up and down the supply chain. And that's what our Integrity product was really great at, is really great at.

So Integrity, we've won the ALM business at Hyundai, following our win in PLM. There's three, by my count, European automotive OEMs, two in passenger vehicles, one in commercial, who are moving in the direction of standardizing on Integrity for ALM and so forth. So we have a very compelling story for automotive. It's just it's also very compelling for industrial.

Okay. Fair enough. Thank you.

Okay. I think that brings us to the conclusion of the questions. So I want to thank you all for dedicating your time with us here this morning. A lot of great questions, a lot of good discussion.

I think, in summary, you sense we had a strong quarter. We feel good about the business. We feel like our strategy is more differentiated than ever. We're in a better strategic position, both relative to our customers and relative to our competitors, than it feels like we've been in in a long time.

That said, not everything's perfect in our business or in the economy, and so we're trying to continue to be cautious in the near term so we don't get ahead of ourselves and disappoint anybody. But that's kind of the mode we're working with.

And we'll close out on that. So thanks a lot for joining us this morning. Good-bye.

Thank you for participating in today's conference call. You may now disconnect. Thank you.