Chit Chat Stocks - PTC (Ticker: PTC) Not So Deep Dive

Episode Date: November 29, 2022

PTC Inc. offers software products and professional services that support 3D and AR design. The company was founded in 1985 and is headquartered in Boston, Massachusetts. At the end of the month, we will publish an Arch Capital episode that will cover the company: Autodesk. Listen closely as Brett and Ryan go through the history, financials, and future prospects of PTC. Enjoy the show! ****************************** Interested in becoming a member of 7investing? Subscribe with code “MONEY” and get $100 off your annual subscription for life: https://7investing.com/checkout/ ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (3:48) Industry | (13:40) Management & Ownership | (16:37) Earnings | (19:42) Balance Sheet | (23:04) Valuation | (25:55) Our Analysis | (27:09) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Okay, welcome in. This is the Tuesday Not So Deep Dive episode on Chit Chat Money. We are closing out the Engineering Software Month, and today we are discussing PTC as a preview.

Our last episode in the Engineering Software Month will be Autodesk, and that is a company we own in our own portfolio so full disclosure on that but we'll be doing that uh as well kind of why we own that comparing it to these other businesses uh but yeah over the last few weeks we'll be doing that quick before we get into the show any lessons draws takeaways from having studied now what five different engineering software companies yep and we'll be including six autodesks if we include autodesk but that was you know something we had already known about i believe this is a great hunting ground for potential investments yes when we covered all these a lot of them had premium valuations but i think it's a great hunting ground to put stuff

on your watch list at least um and right i think that all the businesses we're going to cover pgc again here it had the same some of the same qualities where i think there's competitive advantages and there's not going to be one winner all the inherent characteristics of these businesses, these tend to have pricing power because of the high switching costs. Yeah, I agree. A lot of positive shared characteristics among these businesses. And then I went, and we were doing this before the show, we looked at the five-year returns of all these businesses minus Bentley because they recently went public. And a lot of them are very similar, unsurprisingly. And they've basically split the S&P 500 in terms of returns. So they're

generally right around the S&P 500 and slightly better. So probably depends what multiple you paid at the start, but we're going to get into PTC first housekeeping. We're going to say this on every not so deep dive episode, subscribe to the free newsletter to get your charts and show notes to go along with each episode. Anything that's, you know, more analysis related on the show has more numbers that will be, I mean, we're literally reading those from there and getting that information from the notes and the charts we made. So look at those. It can be very helpful. that's the way we look at things uh discussing plus the written work and the charts second let's talk about our sponsor through the end of 2022 that is seven investing our good friends over

there if you want to learn more about them first i'd recommend listening to the shows we've done with them which we've done multiple over the years second go check out their website they have a lot of free information as well but use code money get a hundred dollars off your annual subscription every year for life that means a hundred dollars off every year that could be through 2030 through 2040 you will get a hundred dollars off and as we're recording this it's right around when they get their next picks out we're recording the the show is going to be coming out on november 29th i can't remember how many days there are in november but with anything two three days from now there will be a new recommendation out there is thursday seven yeah seven new research

reports a plethora of information well worth the price that you're paying especially with our code money so use code money get a hundred dollars off all right ryan let's talk ptc uh maybe the most we had to rank the engineering software companies maybe the most buzzwordy out of all uh five yeah i would agree with that um fortunately having now done a couple of these we know what most of the buzzwords mean, but we'll try to make sure that we explain it in a proper way. So PTC is short for power to create, and they own a large portfolio of software that's used in engineering and manufacturing processes. I know that probably sounds pretty vague, probably sounds like a lot of the companies we've already discussed, but they have maybe one big differentiator that I'll talk

about. And then there's another segment that is similar to the other businesses, but they have 10 plus products in total, and they group them into two categories. So the first one is product lifecycle management. That's where I think they're kind of differentiated compared to a lot of other businesses that we've looked at. And then the second is the computer aided design. That's where they bear a lot of similarities to the likes of an Autodesk and Dassault Systems. But let's talk product lifecycle management. So they have seven different products in this category, and each one meets a bit of a different need. But from what I can tell, And they explicitly state this, but Windchill is their biggest product.

That's what it's called. And I think there's also Windchill Plus, which I think is just the SaaS offering. Yep. And that was released quite recently. So it's a developing process there. But within Windchill and product lifecycle management generally, and I think product lifecycle management is maybe the most buzzwordy. It's a very buzzwordy definition or explanation for something.

These systems serve a number of different functions. And I'll try to talk about each one. So CAD data management is a big part of this. And so that's basically, it's not the computer aided design software itself, but it's all the functions that go, that occur after the actual authoring or the building, or maybe I should, I got to use the right words here, designing of a product. So this includes things like who gets to access it, going and looking at the different version history. So when you're trying to build a prototype or you're trying to test, or you're

trying to get approval to start working on something, that whole system and that whole process is occurring in that PLM or that windchill product. And so there's a lot of different functions around the CAD data management. And you can kind of go in and you can see they use the term metadata, the data on the actual file itself. So it's the workarounds and all the processes that go beyond the actual CAD file. And then other things that are included there, document and release management, bills of material management.

So the actual invoicing and stuff that goes into the process prior to actually building it and even during the process of building it. And then planning for the actual manufacturing process is included in that windshield product or product lifecycle management. Also, you also have things like like making sure that your suppliers or your vendors are approved.

You think about a big organization, you have to have the right suppliers and vendors. You have to communicate with them. You could do that all from the dashboard. And there's more to it as well. But the product lifecycle management component and Windchill, most importantly, accounts for 55% of overall revenue. So it is actually the larger segment within PTC. The second one is computer-aided design.

Uh, this is probably the category that people are more familiar with. Um, and they actually use kind of a cool word for it that I haven't seen yet. They, they say CAD software is used for product data authoring, similar to just designing products. Um, but this is where PTC is really similar to solid works or other computer aided design software providers like Autodesk. They have four different products under their CAD category, but the biggest one is Creo or maybe it's Creo.

I think it's Creo. And that's the oldest, too. It's competed with SolidWorks, which if anyone, any listener can remember, that's the big product over at Dassault Systems. Yeah. And if you're reading the show notes on our newsletter, Brett actually linked to a one of the relevant links at the bottom is Dassault or SolidWorks versus Creo. very similar softwares, actually. The only, I think, difference that I read predominantly was that Creo is potentially used for more complex parts, even though you could really use SolidWorks both. They're both kind of interchangeable, but that's a testament to the sticking power, the staying power of businesses like these is once you're acclimated to it, there might be other softwares that are similar, but there's no need to switch because it provides a lot of value

to you. And so Creel is sort of the big one there. It allows you to a lot of manufacturing businesses to build the parts they need or design them. And speaking of customers, PTC services, some of the largest manufacturing companies in the world. I went through a lot of their customer case studies and there's tons of businesses, tons of oil and gas producers, general retail and consumer products companies, industrial companies, basically all the major automotive of manufacturers. So Volvo, GM, Mercedes, John Deere was their first customer. Caterpillar is a big customer for them. GE, there's endless manufacturing companies use a lot of PTCs, either product lifecycle management software, or even their Creo product, which is that CAD,

the CAD software that they're most known for. The other thing that I'll mention, like the other engineering software companies we've studied in the last month, PTC has gradually been shifting to a cloud-based recurring revenue model. And this has been a little easier for the product of lifecycle management since it's not quite as computationally intensive is maybe the word I'd use. That's correct. Yeah. So today more than 90% of their revenue is recurring, which means PTC, and we've tried to discuss this during the financials of the other shows as well, it recognizes revenue ratably over the life of a contract. So though the cash might come in the door up front. They're not actually recognizing the revenue until you service that contract. So

you're going to have a bit of a gap between billings and actual revenue. I'm sure people are more than familiar with that now that the software is such a common business. We should note though, and we'll talk about this later, they are not a pure software as a service company yet. They made the transition to recurring revenue, but given the complications with the engineering software industry, they are still making that transition to software as a service. And that's a big thing they're highlighting. We'll probably discuss the positives, negatives, whether they are going to be correct on their assumptions going forward.

And I think that covers the basics of the business. Maybe something else that I mentioned is they employ their own sales force, but they also have a lot of distribution partners. So people that are kind of in between businesses that are selling to the end markets as well, that accounts, I think, for 25 to 30% of revenue. So they've got sales partners as well as their own sales force. And then let's talk history.

It feels like every company we've looked at kind of started in a similar way. So in this case, PTC was started by a Russian immigrant named Samuel Geisberg or Geisberg in 1985. He was working or he left his work at Computer Vision, which was another CAD company at the time to begin developing his own CAD product. uh so he started by forming a company called parametric technology corporation and they launched their first ever software which was called pro engineer that would eventually become their their core product today as well called creo uh in 1988 and they landed john deer as

their first customer that year and they got off to an extremely hot start so in 1989 a year after first launching, they went public under the ticker PMTC, I believe it was. And by 1991, PTC already had $45 million in revenue. I saw a stat that by 1997, they had $800 million in revenue. So they grew really, really quickly. And Creo specifically, or I believe it was called Pro Engineer at the time, received tons of accolades, technology of the year, I believe it won multiple times. And then throughout the nineties, that's when they began making their acquisitions and they really haven't stopped since. We're going to talk about it in a little bit, but they're very acquisitive. And one of those big acquisitions was what would end up being

Windchill product lifecycle management. And that was developed in 1998. So it's been 25, 30 years of successful growth for those two core products that they offer, the product lifecycle management in Windchill and CAD files in Creo. And then since then, it's kind of been more of the same. The only other thing maybe worth noting is that in 2018, Creo and Ansys signed a pretty big partnership. So with Creo Simulation Live, Ansys' simulation technology, which we talked about them on a show previously,

they're one of the premier simulation software providers, is now integrated into Creo's solution for native testing. So kind of helpful, I guess, for both businesses there and it really boosts PTC's value proposition. Yep, and they made some acquisitions over the last few years to help go through their transition to cloud and SaaS, but we'll talk about that in the future growth opportunities and highlights and lowlights.

All that industry and competition, they compete in PLM, computer-aided design, And then also some smaller products that they're hoping to really push into the market over the next decade are their industrial augmented reality and industrial Internet of Things products. So let's go through each of those, kind of see if we can look at any sort of TAM stuff or any sort of industry size. So the global PLM industry is valued at around $25 billion. Now, PTC is a smaller subset because they're just mainly engineering PLM. But that market is expected to grow at, say, mid-single digits this decade. The big competitors out there are Autodesk, Dassault Systems, Siemens, and a few others.

Now, if we look at the CAD industry, that is valued at just under $10 billion a year. And this is for strictly computer-aided design for engineering, I believe, is how they're defining it. And that is expected to grow at mid-single digits this decade. So similar to the PLM, kind of a steady, durable growth, but not hyper growth. And the big competitors here are both Autodesk and Dassault Systems. Dassault Systems is the leader in that category by a long shot, while Autodesk has similar market share to PTC. But within PLM, PTC is the number one.

They have the number one market share. Now, if we look at AR, augmented reality, analysts out there from whenever I looked up, and again, trusting these research reports, they always love being bullish or optimistic. The analysts are extremely bullish on the industrial augmented reality market, though. If the hardware makers like, say, Meta, Microsoft, others can improve the technology significantly, it wouldn't be surprising to see the market grow by solid double digits this decade. I guess what I'm saying is this could be a benefit for Meta's reality lab investments if they really execute on some industrial VR, AR use cases. competitors out there. Microsoft has a software competition, which is interesting with the HoloLens stuff. TeamViewer, ScopeAR, it's a very immature market compared to CAD or PLM.

So I guess, I don't know if it has to be a part of your thesis here, but there's a ton of uncertainty of how this market will shake out. Now, the other one that kind of connects to AR is Industrial Internet of Things, which if you're looking at any of their reports, they abbreviate this to IIoT. Now that market is estimated to be in the hundreds of billion of dollars a year, but that includes the hardware, the sensors,

and all the stuff associated with that. And it's expected to grow by 10% plus a year, say this decade. Now PTC is only attacking a small part of that with our software overlay and the connectivity for users. Competitors within the Internet of Things software market are Amazon, Oracle, Siemens, and SAP. So not their traditional engineering software competition, but some other big time software providers. Now let's move to management ownership compensation.

Pretty basic here, a lot of standard stuff. The CEO is James Heppelman. He has been a CEO since 2010 and was the inventor of Windchill, which they acquired back in 1998. So he's been with the company for over two decades. I think you could almost consider him a founder at this point. However, he only owns 0.76% of the company's stock and no other executive or directors own more than 0.1% of shares. Another note on the ownership perspective is that Rockwell Automation has a 9% stake in PTC and that the companies have signed a strategic alliance, which is their words, to cross sell products to industrial customers, specifically with a focus on product lifecycle management, augmented reality, and Internet of Things. there's a very buzzwordy press release that i linked to in the sub stack which you can go check out i think rockwell is interesting there because they are um well they do a lot of things but they are a big sensors company so i think it's an important part of ownership because they're

selling a lot of sensors to these industrial customers affiliate director compensation on the board um only 0.2 percent of gross profit no red flags there total executive compensation was $34.8 million or 2.25% of gross profit in 2021. So not bad. However, I would note that the year before, Heppelman got over $40 million worth of stock awards himself. So watch out for those one-time stock-based things. This was a light year comparatively. And I didn't want to go through every year because it takes a little bit of math to add those up from the proxy statement, but this was a wider year than usual if we look at their executive uh compensation philosophy only a small amount of their executive compensation is an annual base salary and their annual incentive

bonuses the annual incentive bonuses which are cash based i believe are based on uh annual recurring revenue and then non-gap operating expenses which is just they they do a kind of inverse thing where they're really just caring about margin expansion for their non-gap operating margin. Then the majority of their overall compensation is the long-term equity awards. If you look at the long-term equity awards, they have a complicated one, but that gets split into half where half of the equity awards are standard restricted stock units, which have no qualifications to get them. They just receive them basically as their long-term equity awards, and they have, I believe, a three-year tranche. The second half are performance stock units that

are based on hitting adjusted free cash flow targets, which again, it's not the best. At least it's cash, but it's adjusted cash. And then they also have a relative total shareholder return hurdle. If we look at their ownership table, nothing too crazy, a lot of BlackRock, a lot of Vanguard, a lot of outside investors because directors and executives don't own much of this at all. All right. I think that sums up management and ownership. Pretty standard there. Didn't see any big red flags, but we'll talk about maybe the misaligned incentives later in the show. But Ryan, do you want to hit earnings? Sure. Yeah. So they just wrapped up their full year for 2022, which makes my job a lot easier. And they just reported their 10K. So

didn't have to go through too many reports to get their true earnings figures. But total revenue for the last year, 2022, was $1.9 billion. That was up 7% year over year and 11% in constant currency. I guess that's probably a good time now to note that 53% or a little more than half of their revenue comes from Europe and Asia Pacific. So they will see some of that currency headwind that every company in the world seems to be seeing right now. And then they had roughly $1.6 billion in annual recurring revenue. So as Brett mentioned earlier, $1.9 billion in total revenue and just $1.6 billion in the annual recurring revenue. So not all of it is that cloud-based subscription software that you would expect um and that is still growing so it was up seven percent and then

somehow that was up sixteen percent in constant currency so a much bigger discrepancy there i'm not sure why arr has a bigger uh exchange headwind than traditional revenue uh maybe it's would you i think it's because of the because they're annualizing the current quarter so oh okay so So this last quarter is probably the highest. That makes more sense. Right. And then 80% gross margins, they offer professional services. So like things like customer support and integration help, which are extremely low margin.

But because the software is generally quite complex and it's meant to apply to big enterprises, it helps to kind of have a customer service rep. However, that puts a hamper on margins. So it doesn't quite have the gross margins that say an Autodesk would, which has more like 90% range. $460 million in free cashflow, that's about 22% free cashflow margin. So they generate a healthy amount of cash that's grown over the years at a pretty healthy pace as well. They do, however, have $175 million in stock-based comp. They offset some of that with share repurchases. So they bought back 125 million this year. Their long-term goal is to return 50% of their free

cashflow to shareholders in the form of repurchases. They are not doing that currently, but I think part of the reason for that is they, they have a bit of a heavy debt load right now and they are about to add more and they're about to add more with that recent announcement, which I believe is my future growth opportunity. So yeah, save for that. I must've missed that, but I guess. They announced it a couple of days ago. So yeah.

Last thing on earnings over the last three years, last three years, they've spent a billion and a half on acquisition. So a lot of the free cash flow that they generate is not necessarily coming back in the form of free share purchases. A lot of it's going to get spent on trying to diversify the business, trying to become a bigger company through acquisitions. Yeah. If we look at fiscal year 2018 through fiscal year 2022, which was end September 30th, 2022, if I do free cash flow and I include acquisitions into CapEx, which I made a chart of, their total free cash flow. So the sum is negative $170 million. So again, they're pouring it all back. Let's talk balance sheet and liquidity.

Liabilities, $1.35 billion in total long-term debt. The average interest rate on that is 3.9%. So not too crazy, especially considering that a billion of it is fixed. So $500 million in 2028, 4% senior notes. That's basically, if you bought those bonds, you're getting 4% annually up until 2028. And then, or 4% interest, I should say. And then they also issued $500 million in 2025, 3.625% senior notes. Both seem like, and now it's hindsight 2020 because rates have risen, but they capitalized on the low rate environment and were able to get some cheap debt. However, they also have $359 million in variable rate debt, which is their revolving credit facility.

And over the last year, the rate on that has jumped from 4.1% to 5.7%. If rates continue to rise, you can expect that to rise as well because it's got sort of that LIBOR plus, I think, one and a half structure. So as rates go up, you'll see the same thing. You'll see their variable rate debt go up as well. but most of that is comprised of that fixed debt um did you you mentioned that they are adding some debt as well do they say how they're financing it i can look it up but yeah um as for assets and cash flow they've got 272 million dollars in cash and like straight cash uh and then they did

560 or they generated 561 million dollars in ebada in 2022 so their net debt to ebada which is how their banks that are lending on the credit facility look at the business is under two times. So that means it would take 1.9 years, so just under two years of their current EBITDA run rate to pay off their net debt. So not too crazy as far as debt goes, but I believe you're about to mention something on the debt structure. Yeah. So it is a $1.46 billion acquisition of ServiceMax. I'll talk about that during the future growth opportunities. So don't worry about that. The transaction details. Here's the quote. The transaction will be funded with cash on hand, borrowings under PTC's existing credit facility, and a new $500 million committed term loan. So yes, the credit facility will be added to.

That's a bummer. Well, maybe not a bummer. We'll see. It seems like a decent price to pay for this company. So maybe, yeah, I mean, it's a bummer in a vacuum because of the interest rate. Yeah, I shouldn't say it's a bummer. That will undoubtedly raise their aggregate or average interest rate. Yep, and the interest expense.

All right, I'll hit valuation. Market cap as of this recording, $14.4 billion. Enterprise value, 15.5. 0.5. The three metrics I was looking at is EV to sales, EV to operating income, and EV to operating cashflow. Operating cashflow is going to be very similar to free cashflow. But again, watch the acquisitions. If the acquisitions are heavy, we got to expect revenue growth to be quite, quite high. So EV to sales is about 8.7. EV to operating income is 34.6. And operating cashflow is very similar to operating income. That is 35.6. We're at a premium valuation here.

I don't think there's much else to discuss unless margins expand quite rapidly. This is a premium valuation here. Or excuse me, maybe the valuation isn't that low if you expect the growth rate to be high for the revenue or whatever, but the earnings multiple right now is quite high, especially in this current bear market.

Yeah, and if you tack on that debt that you just mentioned, that enterprise value is going to be a little bit steeper as well. Yep, and the service max will add about, i believe like 150 million plus in revenue so pretty neutral on their multiples but we'll see yeah all right anecdotal evidence uh you want to go first sure no no personal experience uh with the products we're not really in any of those that would be using a plm but i feel that

a plm product will have it's going to have high switching costs but i do not think it is as high as computer-aided design um other sort of design products simulation for the say construction architecture engineering markets because it's not super complex uh it's software comparatively where it has to be connected to all the different companies I mean, it has to be connected throughout your organization, but to me, it's almost like Excel versus Slack or something like that, where yes, there's switching costs and people are using it every day, but the PLM would not be as hard to transition out, especially if someone can offer an integrated offering. Yeah, it would not be as hard of software to replicate, but I think it would still be a pretty big pain to switch for a lot of, for enterprise.

That's why I say high switching costs, but not as high as an Ansys product or Revit or SolidWorks. Yeah, for me, I mean, I'm not an engineer. I've never worked in any sort of manufacturing business. So I've never gotten the chance to interface with any of these products, but my typical go-to is just to go to YouTube and basically look up product tutorials of their different softwares that they provide. And so there's a pretty cool one on Windchill, which I've linked to in the relevant links if you read the newsletter.

So feel free to look at that. But it looks like Windchill has a lot of native integrations with Creo, which is their computer-aided design solution. And I was reading through the comments on this guy's tutorial who seemed really well-informed. And he said, it's too long to get into. Someone asked, is it better to go with Windchill if you already use Creo? And someone said, yeah. And the guy basically responded. He said, yes, it's too long to go into, but it makes life so much easier if you use the same PTC product life cycle management software, if you're already using their CAD software. Too bad they don't have the highest market sharing CAD, but it's definitely helpful to bundle. Right. And that also, I would imagine,

helps switching costs if you're using both and there's native integrations. It makes it just, I imagine, just an absolute pain to switch. All right. Future growth opportunities. Ryan, what do you got here i hope you didn't i hope you didn't steal mine i know i know we might we may have a similar one here but i'm gonna be talking service next so maybe no i didn't um and i mean it's kind of hard like with ptc and a lot of these engineering software companies future growth opportunities are a little difficult because it's basically like keep doing what you're doing and maybe acquire um and for ptc that's that's really it is there's there's going to be a continued cloud transition i think you're going to talk about that briefly um but also add some new

customers gradually increase prices and acquire new technology and try to cross sell it um one of those i'll try to or i'll try to highlight two of those and they they bundle these or they categorize these in their financial statements as digital thread growth category um although frankly the core which is your windchill and your creo is growing just as fast so i don't know if they deserve to call it growth but the growth here is a little underwhelming yeah yeah so the two two softwares here are thing thing works and vuforia um thing works is supposed to be internet of things software for industrial companies so think like workforce efficiency and how well one of your manufacturing assets is performing.

Monitoring. Yeah, it's all monitoring. Essentially just monitoring software. And then the second one is Vuforia, which is their enterprise AR platform. I was looking at this product for a solid 25 minutes and it took me forever to get a clear understanding of what they do because of all those buzzwords.

But it sounds like we were talking about it before the show, you could throw on some ar glasses if you have those in your manufacturing facilities and you can look at a product and if it's in the system you can basically see the specs on it is that kind of a good way to describe it yeah not even the specs but just what's running currently what say there's some electricity thing you have to you're tracking you're making sure it's you know what it's supposed to be i think you can also use it with a phone from what i saw one of their videos as so i don't know if you necessarily need the goggles or glasses thing but yeah it's my it's helping a worker in a factory monitor what's going on more efficiently um it's still very

very early stages though so we'll see if there's somebody's need this sort of roi because i also kind of think you can have the internet of things stuff and it can all be centralized on one computer as long as the information is there yeah i agree and together those two are generating $230 million in annual recurring revenue. So not that small. I would have thought it's smaller. I think ThingWorks probably accounts for the majority of that, if I had to guess. But it's growing 19% year over year. So for your growth, quote unquote, growth category, it's not crazy. And that was constant currency. So reported currency is even slower. They said, however, that they are focusing a lot on trying to cross sell those solutions. So

that's a big part of their acquisition strategy is they already have the foot in the door with all those customers. Yeah. And I think you got to expect that revenue for that category to grow quickly to have these acquisitions make sense. Mine is going to be the transition from product portfolio to cloud and SaaS. Now, remember, we talked about that already, but they made the transition to recurring revenue and subscriptions like a lot of software companies have, but they still are under the transition to software as a service because it's a lot more difficult for engineering software. They say this transition is going to take to the end of this decade due to the more complex nature of engineering industrial software. They recently accelerated

this with the acquisition of ServiceMax that is projected to close in early 2023. And ServiceMax offers a SaaS PLM platform. So I'm assuming this will be either all merging together into Windchill Plus or whatever you want to call it. But they want all their PLM software, especially to be in the cloud they offer actually a pure cloud um what i want to say a pure cloud cad platform called on shape that has grown quite quickly but i left a review or sorry a link in the sub stack about a review of them versus fusion 360 which is autodesk cloud platform there is a bit their strategy with their cad cloud stuff which again i know i'm talking a lot of buzzwords here uh it seems a bit flawed um they're pricing it uh high and you have to be only on an internet

browser which a lot of engineers are not liking but again plm is the most important part here and that seems like it can switch over to the cloud pretty easily and they can get that to sas now what are the benefits here because you wouldn't think for shareholders that big of a difference whether the company's doing this according to management from you know the customer studies they've already done and the transitions they've already gone through generally customers are going to pay two times more than previously once they transition to SaaS, which can be a huge driver of revenue growth this decade. So watch out for that. You want to expect that organic revenue growth to continue. But yeah. All right. Highlights and lowlights. Ryan, what did you

dislike about PTC? Yeah. I think we already briefly mentioned it, but the one shared characteristic about all these software engineering businesses is that it's a total pain to switch. PTC is no different. And in fact, if you're a customer that uses both a CAD and a PLM product from them, it's even tougher to switch. So that's really been... I think the switching costs have probably been the biggest driver of stock performance for all these businesses over the last 10 years. Yeah, because they've raised prices. Yeah. A lot of pricing power. Second, clear track record of growth. Brett laid out a bunch of charts in the supplement that we do with the newsletter.

Feel free to look at that. Yeah, let me see any sort of stats I want to throw out for the listeners in case people don't look that up. Software, revenue per share, so it's taking out services. CAGR of 13%. Operating cash flow per share, 15%. So there you go. Yeah, and then I guess the end markets are pretty steady growers. um maybe maybe not rapid growers but you're gonna uh like likely get some some generally

steady growth in terms of potential customers those are kind of my highlights i don't know it's it's not that exciting of a business um but you know some some really strong uh advantages it is an arc investment one really i mean i know qqq is agent of innovation so you're saying innovations a boring rhyme but no i agree i agree with that still well that's for me uh they still hold an equity stake in matterport they had to write this down by a bit um i don't know if they were like gifted these or what happened but there wasn't a whole lot of clear communication from what i saw on the matterport like like rationale for owning it the i don't like when executives try to become fund managers.

And I know they probably know the industry better than I do, but if there's bad returns and there's no clear communication around why, it gets a little frustrating. So this is the only case that I've seen them do that. They're obviously serial acquirers. So they make outright acquisitions, but I've never seen them take like a minority equity stake.

Yeah, I wonder if they have, I didn't see anything about a partnership and they did not talk about that during their investor day at all. Yeah, it was just kind of mentioned on the 10K and I guess not a whole lot of color around it. So just a bit of a low light for me. And then it feels like a lot of capital

has been destroyed in acquisitions and kind of looking through their history, there's a ton of acquisitions that are no longer talked about. Those may have been integrated into some of the existing offerings. Maybe they've been renamed, rebranded, whatever it is. It's a little hard to track

or really tell what the return has been. on some of those some some of those acquisitions so that to me i guess just maybe it just complicates things more than anything else yeah i agree uh let's move to my highlights we talked about the switching costs i think those could even increase if they get customers onto these sas products as well as uh industrial internet of things and augmented reality if you bundle all those together and all the customers are using these products i think it's really really it's going to be even more difficult to switch even if they were before CAD and PLM. Now, other highlight, management has a, generally they've had a long tenure and they seem to want to be around for

many years. They talk about the business having multi-year time horizons. They have a plan out to 2030 to transition everything to cloud and SaaS. Third one here, they have a consistent track record of revenue growth to go along with margin expansion. I would check out the revenue per employee chart that I laid out. It's a lot more impressive than some of the other companies we've covered, even in engineering software, where their employees have barely gone up from 2018 to 2022, and their revenue has gone up a lot more. So software revenue per employee went up from $178,000 to $272,000. That is where the margin expansion has come from, and that's pretty impressive that they haven't had to overload their business with employees to grow.

So low lights, I think there's been an accelerant of acquisitions over the past few years. I think they've made one every year that's been quite sizable. And that adds risk to value destructions because if they're not able to hit their upcoming free cash flow targets, which I think we're going to hit in the bowling bear case, they spent a lot in dollar amounts versus their current market cap and at high sales multiples. So that adds risk to me because the growth expectations, the more of those acquisitions you do, the higher your growth expectations have to be. Second, with the way management has set up their capital structure, it's going to be very difficult for them to return cash to shareholders through buybacks, which means that's not necessarily a bad thing. But for them, shares outstanding are going to start growing at a steady clip over the next three to five years. Over the past five years, shares outstanding are virtually flat while PTC spent $1.4 billion repurchasing its own stock. So think about reversing that. That's just going to go into

SBC now and inflate shares outstanding. Last one here, management compensation being based on that adjusted free cash flow number and is also not on a per share basis is just a bit of an incentive mismatch i think for the the outstanding shareholders so i think they may be too incentivized to pursue acquisitions to boost nominal free cash flow without actually thinking about uh shareholder value first um and that like it's not like it's going to kill the business because some of these acquisitions seem quite smart but there's also a ceiling to that compensation so it's not like yeah that's true uh it's not like they could just eventually have 50 of gross profit going to them but yeah yeah yeah we're not uh uh what's the one that

has the crazy one the tesla one the tesla egg comp plan but looking at that yeah i don't mind adjusted that's not that's fine it's not terrible but i would love to see that as a per share because they talk about, yeah, that would just align themselves, especially Happelman who owns a good chunk of his wealth in this stock with the outside shareholders like potentially we would be. Now, let's move to bull case. Ryan, what do you think has to go? What do you think has to happen for this to be a good investment?

Yeah, I'll let people make their own assumptions about where the growth comes from, but plainly a $15 billion enterprise value, which I think is what they trade at today. I think they have to get a billion dollars in free cash flow within five years for a billion dollars in annual free cash flow within five years for this to be a good investment. That's more than a double from here. It would be tough, but I think that's what it would require for good returns. Yep. And that leads into mine, which at the latest investor day, which is actually quite recent management laid out a goal to hit $850 million in free cash flow by fiscal year 2025, which would be just september 2025 um so what is that three years if they hit that and then get to

a billion dollars a few years later i think it would be hard to lose money but i to be comfortable penciling in say five to ten percent annual returns for shareholders i i think you need to even i think you need to believe that they're going to beat their targets yeah because one you're going to have shares outstanding rise and two like ryan outlined 15 billion dollar enterprise value versus a billion dollars in free cash flow that's about a market multiple a slightly lower today but again you want a little margin of safety there if you're going to have good returns you want you know the the enterprise value is going to have to be higher um yeah i think there's just a lot and that leads to the bear case which again we

i'm going to you know spoil both of ours there's not much to poke holes into with the businesses but with the management acquisitions and then the valuation is kind of the big concern here. No. Yeah. I mean, the bare case is that just growth isn't as much as expected, but I wonder like what the secret sauce is here is, is the moat it's longstanding relationships and like integrations into the manufacturing businesses.

Is it really those relationships or is it the actual software? Because I look at the software and especially with the product life cycle management, like this stuff is archaic. It's not, and it's, I mean, it's functional, which is great, but it wouldn't be impossible to replace. Yeah. It's not hard to replicate compared, like we've talked about again compared to an ANSYS or a Revit or others. Yeah. I don't know. That was kind of a side note, but, but for bear case,

I think anything less than 20% free cashflow per share growth over the next five years, you've probably got an underperformer. I think really the biggest risk here is capital allocation. You kind of mentioned it. The focus, seeing as it's not management's incentive, it's not free cashflow per share, it's free cashflow. So there may be some dilution coming down the pipe and they're taking on a lot of debt to finance this. So I don't know. It just feels like that's really kind of a big risk here. I know engineering software companies love to make acquisitions, but they're doing it at a bigger portion of their market cap.

Well, look at Autodesk this week and they make acquisitions, but a lot of them are small compared to the size of the business. Yeah, I don't know. The acquisitions always complicate things. And when it's at 30 times or more than 30 times, it kind of is a deterrent for me. All right. My bear case, similar. You kind of look at the stock price today and with shares outstanding set to rise, you're probably richly valued even if you hit that multiple. So say at a current market cap of $15 billion, they're trading at 17.5 times their 2025 projected free cash flow.

And that is before considering share dilution. so again you gotta see um you gotta see them beat that target i think to be comfortable um they can hit that target you might see negative returns over that time over that time span uh but yeah we don't need to talk about that forever more or less interested ryan let's close out the show i feel like i've said this for everyone more interested not at this price uh really high quality business, but I mean, I'm, I'll say maybe it's going on the watch list, but I probably will forget to put it there because this feels like one where so many people cover it. It's likely going to be efficiently priced given how high of quality of a business it is. And it's

been around for so long that I just don't know if I'm going to get my opportunity to buy this thing at an attractive multiple. Yeah. Well, never say never that could, you know, that could always happen to high quality businesses. I'm in the same boat. I do like their opportunity, although I'm a bit nervous about IIoT and AR because if you're going to invest a lot in that, it's a bit uncertain. But PLM and CAD seem fine. I don't like their position in CAD, but we'll probably cover more of that on the Autodesk show. But at the right price, this is a good business, but I think that might be... Or excuse me, at the right price, this is probably a good buy, but I think that might be 50% below here.

um all right that's going to do it for this episode we're going to close out engineering software with autodesk next or excuse me this week maybe this weekend uh and then we're going to move on to e-commerce software website website software kind of e-commerce and website software so we're going to have next up uh to start that out mercado libre which is more than the Amazon of South America, but just to tease it out, because it's more than that, it will say it's the Amazon of South America. All right, that's going to do it for this episode. Thank you all for listening. Remember, we are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients

may hold securities discussed in this podcast. Thank you all for listening. We'll see you next time. don't you wish you could just hit skip on the worst parts of your life you know the same way you can skip an ad i get it i'm siaya and i live in ice cove i've made some questionable decisions that didn't end up the way i planned and today i'm still figuring it out somehow things usually get worse before they get better apparently that's how i roll so bundle up and come along for the bumpy ride. Stream a new episode

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