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PTC INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements Statements in this Quarterly Report on Form 10-Q about our future financial and growth expectations, our intent to repurchase shares and to return 40% of free cash flow to shareholders, our intent to enter into a new credit facility, our intent to complete the Axeda acquisition, the development of our products and markets and adoption of our solutions and future purchases by customers are forward-looking statements that are subject to the inherent uncertainties in predicting future results and conditions. Risks and uncertainties that could cause actual results to differ materially from projected results include the following: the macroeconomic climate may not improve or may deteriorate; our customers may not purchase our solutions when or in the amounts we expect and that our pipeline deals may not convert as we expect, which could adversely affect our revenue, cash flow and earnings; we may not achieve the license, service or support growth rates or revenue we expect, which could result in a different mix of revenue between license, service and support and could adversely affect our profitability; foreign currency exchange rates may vary from our expectations and thereby affect our reported revenue and expense; our business, including the SLM and the ThingWorx/Internet of Things/Smart, Connected Products businesses, may not expand and/or generate the revenue we expect; we may be unable to achieve planned services margin and operating margin improvements; we may be unable to improve sales productivity as we expect; we may be unable to complete the Axeda acquisition as or when we expect and the acquisition, if completed, may not generate the revenue we expect; the use of cash for share repurchases could reduce our ability to undertake organic and inorganic growth initiatives, uses of cash for purposes other than share repurchases could reduce the amount of shares we repurchase, existing and/or other banks may be unwilling to enter into an expanded credit facility with us, remedial actions related to our investigation in China could have a material impact on our operations in China, substantial fines or penalties may be imposed by government agencies in connection with resolving that matter, and any such resolution may have collateral effects on our business in China, the U.S. or elsewhere; as well as other risks and uncertainties described below throughout or referenced in Part II, Item 1A. Risk Factors of this report. Business Overview PTC Inc. develops and delivers technology solutions, comprised of software and services, that transform the way our customers create, operate and service products for a smart, connected world. Our solutions help our customers in discrete manufacturing organizations optimize the activities within individual business functions, including engineering, supply chain, manufacturing and service, and coordinate these processes across the enterprise to create product and service advantage. Our solutions and software products address the challenges our customers face in the following areas: Computer-Aided Design (CAD) Effective and collaborative product design. Product Lifecycle Management (PLM) Management of product development from concept to retirement. Application Lifecycle Management (ALM) Management of global software development. Supply Chain Management (SCM) Management and optimization of global supply chains. Service Lifecycle Management (SLM) Delivery and capture of product intelligence at the point of service. Internet of Things (IoT) Development of applications for smart, connected products. Our Markets The markets we serve present different growth opportunities for us. We believe the PLM, ALM, SCM, SLM and IoT markets present the greatest opportunities for revenue growth and revenue from these markets will constitute an increasingly greater proportion of our revenue over time. We believe the market for CAD among small- and medium-size businesses also provides an opportunity for growth. Conversely, the market for CAD among large businesses is highly penetrated and presents a lower growth opportunity for us. 22-------------------------------------------------------------------------------- Table of Contents Executive Overview In our third quarter, we continued to deliver on our margin expansion strategy with revenue in line with our expectations and non-GAAP earnings per share just above the high end of our expected range, including a favorable mix of revenue and a lower tax provision than anticipated. Earnings per share was up 11% to $0.32 from $0.29 in the year-ago period, and non-GAAP earnings per share was up 19% to $0.53 from $0.45 in the year-ago period. For the third quarter, our total revenue was $337 million, up 7% year over year. Total license revenue for the quarter was $93 million, up 16% year over year, which reflects an increase in license revenue from large transactions and growth in CAD license revenue. From a geographic perspective, on a constant currency basis, total revenue grew 7% in Europe, 20% in Japan, 1% in the Americas and was flat in the Pacific Rim, compared to the year-ago period. Total revenue in Europe, Japan and the Americas grew 13%, 16% and 1%, respectively, and was flat in the Pacific Rim, compared to the year-ago period. Our operating margin in the third quarter increased to 16% from 14% in the year-ago period (to 24% from 22% on a non-GAAP basis). Our GAAP and non-GAAP operating margins were impacted by a favorable mix of revenue and cost reduction measures, including our restructuring actions in 2013, partially offset by costs of acquired businesses and investments we are making in our Internet of Things business, and annual merit salary increases for employees. We ended the third quarter of 2014 with $304 million of cash, up from $270 million at the end of the second quarter of 2014, reflecting, in part, $106 million in operating cash flow and $60 million used to repurchase shares of our common stock. At the end of the third quarter of 2014, the balance outstanding under our credit facility was $315 million and we had $682 million available to borrow under the revolving loan portion of our credit facility. Non-GAAP measures are reconciled to GAAP results under Results of Operations - Non-GAAP Measures below. Acquisitions On June 30, 2014, we acquired Atego, a European-based developer of model-based systems and software engineering applications for approximately $50 million in cash. This acquisition enhances our portfolio of PLM and ALM solutions and strengthens our commitment to supporting our customers' systems engineering initiatives with powerful modeling capabilities. We expect Atego to contribute approximately $5 million to our fourth quarter 2014 revenue. On July 23, 2014, we signed a definitive agreement to acquire privately-held Axeda Corporation, a pioneer in the development of solutions to securely connect machines and sensors to the cloud, for approximately $170 million in cash. Axeda's technology innovation, extensive customer base, and powerful partnerships directly complement our ThingWorx business, and will accelerate our ability to deliver best-in-class solutions across the entire Internet of Things technology stack. Subject to satisfaction of customary closing conditions and certain regulatory approvals, the transaction is expected to be completed in our fourth quarter of fiscal 2014. Expanded Share Repurchase Authorization and Intent to Expand Credit Facility On August 4, 2014, we announced a capital allocation strategy that over time is expected to return approximately 40% of free cash flow to shareholders while still enabling us to invest in organic and new growth opportunities. As part of this strategy, our Board of Directors has authorized us to repurchase up to $600 million of our common shares through September 30, 2017. We may use cash from operations or may borrow funds under our credit facility to make such repurchases. Under this authorization, we expect to repurchase $125 million of our common stock by the end of fiscal 2014 under an accelerated share repurchase (ASR) agreement. We expect to borrow $125 million under our credit facility for the ASR. We also plan to enter into a new $1.5 billion credit facility in the fourth quarter of 2014 with a syndicate of existing and new banks. Upon closing, the new facility would replace our existing $1.0 billion credit facility, which is scheduled to mature on January 30, 2019. As we have only recently begun to explore this initiative, we cannot be sure if or when we may be able to enter into a new credit facility. Future Expectations, Strategies and Risks 23-------------------------------------------------------------------------------- Table of Contents While we have seen some indications of improvements in global manufacturing economic conditions, there is still a significant level of uncertainty about the pace of recovery in the global manufacturing industry. We continue to expect modest revenue growth and continued operating margin expansion in 2014 driven by: (1) continued vigilance on cost controls and cost savings from restructuring actions; (2) increased sales productivity; and (3) improvement in services non-GAAP gross margin to at least 15%. For 2014, our goal is to achieve year-over-year revenue growth of 3% to 4%. This revenue goal includes license revenue growth of 2% to 7%, support revenue growth of approximately 4%, and a decline in service revenue of approximately 1%. Our 2014 earnings goals are to achieve non-GAAP operating margin expansion of 300 basis points, from 22% in 2013 to approximately 25% in 2014 (expansion of GAAP operating margins from 10% in 2013 to approximately 17% in 2014) and non-GAAP earnings per share of $2.10 to $2.14 (GAAP earnings per share of $1.40 to $1.44). Our 2014 GAAP and non-GAAP goals exclude the impact of our pending acquisition of Axeda and our GAAP operating margin and earnings per share goals exclude the impact of acquisition accounting for the Atego acquisition. In addition, our 2014 GAAP and non-GAAP earnings per share exclude the impact of our intended $125 million accelerated share repurchase described above. If economic conditions do not improve or deteriorate further, or if foreign currency exchange rates relative to the U.S. dollar differ significantly from our current assumptions, our results could differ materially from our targets. Our targets assume rates for the fourth quarter of 2014 of $1.35 USD to one Euro and 101 Yen to one USD. Also, our results have been impacted, and we expect will continue to be impacted, by our ability to close large transactions. The amount of revenue, particularly license revenue, attributable to large transactions, and the number of such transactions, may vary significantly from quarter to quarter based on customer purchasing decisions and macroeconomic conditions. Our growth rates have become increasingly dependent on adoption of our solutions by large direct customers. Such transactions tend to be larger in size and may have long lead times as they often follow a lengthy product selection and evaluation process. This may cause volatility in our results. Impact of an Investigation in China We have been cooperating to provide information to the U.S. Securities and Exchange Commission and the Department of Justice concerning payments and expenses by certain of our business partners in China and/or by employees of our Chinese subsidiary that raise questions concerning compliance with laws, including the U.S. Foreign Corrupt Practices Act. Our internal review is ongoing and now includes periods earlier than those previously examined. We continue to respond to requests for information from these agencies, including a subpoena issued to the company by the SEC. We cannot predict when or how this matter may be resolved. Resolution of this matter could include fines and penalties; however we are unable to estimate an amount that could be associated with any resolution and, accordingly, we have not recorded a liability for this matter. If resolution of this matter includes substantial fines or penalties, this could materially impact our results for the period in which the associated liability is recorded or such amounts are paid. Further, any settlement or other resolution of this matter could have collateral effects on our business in China, the United States and elsewhere. We terminated certain employees and business partners in China in connection with this matter, which may have an adverse impact on our level of sales in China. Revenue from China has historically represented 5% to 7% of our total revenue. Revenue, Operating Margin, Earnings per Share and Cash Flow from Operations The following table shows the financial measures that we consider the most significant indicators of the performance of our business. In addition to operating income, operating margin, and diluted earnings per share as calculated under generally accepted accounting principles ("GAAP"), the table also includes non-GAAP operating income, operating margin, and diluted earnings per share for the reported periods. We discuss the non-GAAP measures in detail, including items excluded from the measures, and provide a reconciliation to the comparable GAAP measures under Results of Operations - Non-GAAP Measures below. 24-------------------------------------------------------------------------------- Table of Contents Percent Change 2013 to Percent Change 2013 Three months ended 2014 Nine months ended to 2014 June 28, June 29, Constant June 28, June 29, Constant 2014 2013 Actual Currency 2014 2013 Actual Currency (dollar amounts in millions, except per share data) License revenue $ 92.7 $ 79.9 16 % 15 % $ 257.1 $ 238.8 8 % 8 % Service revenue 70.2 72.5 (3 )% (5 )% 222.9 222.4 - % - % Support revenue 173.7 162.6 7 % 5 % 510.2 487.5 5 % 5 % Total revenue 336.6 315.0 7 % 5 % 990.3 948.7 4 % 4 % Cost of license 7.8 8.4 (7 )% 23.3 24.7 (6 )% Cost of service 61.9 62.9 (2 )% 191.7 196.1 (2 )% Cost of support 21.3 19.8 8 % 62.8 60.7 3 % Total cost of revenue 91.1 91.2 - % 277.8 281.5 (1 )% Gross margin 245.6 223.8 10 % 712.4 667.2 7 % Operating expenses 191.2 180.6 6 % 552.0 588.9 (6 )% Total costs and expenses (1) 282.3 271.8 4 % 3 % 829.8 870.4 (5 )% (4 )% Operating income (1) $ 54.4 $ 43.2 26 % 19 % $ 160.5 $ 78.3 105 % 102 % Non-GAAP operating income (1) $ 81.4 $ 70.1 16 % 11 % $ 243.8 $ 191.6 27 % 26 % Operating margin (1) 16.2 % 13.7 % 16.2 % 8.3 % Non-GAAP operating margin (1) 24.2 % 22.2 % 24.6 % 20.1 % Diluted earnings per share (2) $ 0.32 $ 0.29 $ 1.01 $ 0.72 Non-GAAP diluted earnings per share (2) $ 0.53 $ 0.45 $ 1.51 $ 1.22 Cash flow from operations $ 106.4 $ 84.6 $ 253.4 $ 181.0 (1) Costs and expenses in the third quarter and first nine months of 2014 included restructuring charges of $0.5 million and $1.6 million, respectively, compared to $3.1 million and $34.3 million in the third quarter and first nine months of 2013, respectively. Additionally, the third quarter and first nine months of 2014 included acquisition-related and pension plan termination costs of $1.5 million and $6.8 million, respectively, compared to $0.9 million and $7.6 million in the third quarter and first nine months of 2013, respectively. These restructuring, acquisition-related and pension plan termination costs have been excluded from non-GAAP operating income. (2) Income taxes for non-GAAP diluted earnings per share reflect the tax effects of non-GAAP adjustments for the third quarters and first nine months of 2014 and 2013, which are calculated by applying the applicable tax rate by jurisdiction to the non-GAAP adjustments described in Non-GAAP Measures, and also include the following tax items. In the fourth quarter of 2012, a valuation allowance was established against our U.S. net deferred tax assets. The non-GAAP tax provision for the first nine months of 2014 and 2013 has been calculated assuming there is no U.S. valuation allowance. The second quarter of 2014 includes a non-cash tax benefit of $8.9 million related to the release of a portion of the valuation allowance as a result of deferred tax liabilities established for the acquisition of ThingWorx. The first nine months of 2013 includes a non-cash tax benefit of $32.6 million related to the release of a portion of the valuation allowance as a result of deferred tax liabilities established in accounting for the acquisition of Servigistics, and a tax benefit totaling $3.2 million related to final resolution of a long standing tax litigation and completion of an international jurisdiction tax audit. These tax benefits have been excluded from non-GAAP diluted earnings per share. Results of Operations Impact of Foreign Currency Exchange on Results of Operations Approximately two-thirds of our revenue and half of our expenses are transacted in currencies other than the U.S. Dollar. Because we report our results of operations in U.S. Dollars, currency translation, particularly changes in the Euro and Yen relative to the U.S. Dollar, affects our reported results. Changes in foreign currency rates did not have a material impact on operating income in the first nine months of 2014. If actual results for the third quarter and first nine months of 2014 had been 25-------------------------------------------------------------------------------- Table of Contents converted into U.S. Dollars based on the foreign currency exchange rates in effect for the third quarter and first nine months of 2013, revenue would have been lower by $4.8 million and $0.4 million, respectively, and costs and expenses would have been lower by $1.7 million in the third quarter and higher by $2.1 million in the first nine months of 2014, and operating income would have been lower by $3.1 million and $2.5 million in the third quarter and first nine months of 2014, respectively. Our constant currency disclosures are calculated by multiplying the actual results for the first nine months of 2014 by the exchange rates in effect for the first nine months of 2013. Revenue from Acquired Businesses Total revenue from the ThingWorx (acquired in the second quarter of 2014), Enigma and NetIDEAS (both acquired in the fourth quarter of 2013) businesses was $2.8 million and $8.8 million in the third quarter and first nine months of 2014, respectively. Revenue We report our revenue by line of business (license, service and support), by solution area (CAD, Extended PLM and SLM) and by geographic region (Americas, Europe, Pacific Rim and Japan). Results include combined revenue from direct sales and our channel. The amounts presented below reflect reclassifications of services revenue between solution areas for historical periods to conform to the current classification. Such reclassifications were less than 2% of each solution area's total revenue for each period. CAD revenue includes PTC Creo® and PTC Mathcad®. Extended PLM revenue includes our PLM solutions (primarily PTC Windchill®), our ALM solutions (primarily PTC Integrity™) and our SCM Solutions (primarily PTC Windchill FlexPLM®). SLM revenue includes PTC Arbortext®, PTC Servigistics® and ThingWorx® products. Revenue by Line of Business % of Total Revenue Three months ended Nine months ended June 28, 2014 June 29, 2013 June 28, 2014 June 29, 2013 License 28 % 25 % 26 % 25 % Service 21 % 23 % 23 % 23 % Support 52 % 52 % 52 % 52 % License Revenue In the third quarter and first nine months of 2014, compared to the year-ago periods, license revenue was up 16% and 8%, respectively, and organic license revenue (excluding revenue from ThingWorx, Enigma and NetIDEAS) grew 15% and 7%, respectively. The amount of license revenue attributable to large transactions, and the number of such transactions, may vary significantly from period to period and by geographic region. We had one transaction with license revenue in excess of $5 million in both the third quarter of 2014 (in the Americas) and the third quarter of 2013 (in Japan) and four in the first nine months of 2014 (three in the Americas and one in Europe) and three in the first nine months of 2013 (two in Japan and one in the Americas). Service Revenue Consulting and training services engagements typically result from sales of new licenses, particularly of our Extended PLM and SLM solutions. Expanding our service partner program under which service engagements are referred to third party service providers, is part of our overall margin expansion strategy. Additionally, over time, we anticipate implementing solutions that fundamentally require less services. As a result, we do not expect that the amount of services we deliver will increase proportionately with license revenue increases. Consulting revenue typically represents approximately 85% of total service revenue and training revenue represents approximately15% of total services revenue. Year over year, service revenue in the third quarter and first nine months of 2014 was down 3% and flat, respectively (down 5% and 2% on an organic basis, respectively). Our consulting service revenue in the third quarter and first nine months of 2014 was down 3% and flat year over year, respectively, (down 4% and 2% on an organic basis, respectively). Year over year, training revenue was down 8% and 1% in the third quarter and first nine months of 2014, respectively. Support Revenue Support revenue is comprised of contracts to maintain new and/or previously purchased software. We have seen steady growth in support revenue in 2012 and in 2013, continuing in 2014. CAD support seats were flat as of the end of the third 26-------------------------------------------------------------------------------- Table of Contents quarter of 2014 compared to the end of the third quarter of 2013 and Extended PLM support seats increased 5% over the same period. Foreign currency exchange rate movements impacted support revenue favorably by $2.8 million in the third quarter of 2014 and unfavorably by $0.6 million in the first nine months of 2014, compared to the third quarter and first nine months of 2013. Revenue by Solution Three months ended Nine months ended Percent Change Percent Change Constant Constant June 28, 2014 June 29, 2013 Actual Currency June 28, 2014 June 29, 2013 Actual Currency (Dollar amounts in millions) CAD License $ 45.4 $ 35.7 27 % 26 % $ 117.5 $ 102.7 14 % 15 % Service 6.0 6.4 (8 )% (10 )% 18.3 18.2 1 % 1 % Support 97.7 93.1 5 % 3 % 287.5 282.6 2 % 2 % Total revenue $ 149.0 $ 135.2 10 % 9 % $ 423.4 $ 403.5 5 % 5 % Extended PLM License $ 39.5 $ 36.3 9 % 7 % $ 112.8 $ 105.5 7 % 7 % Service 47.9 49.5 (3 )% (5 )% 152.3 155.5 (2 )% (3 )% Support 58.5 54.0 8 % 7 % 170.6 161.1 6 % 6 % Total revenue $ 145.9 $ 139.8 4 % 3 % $ 435.7 $ 422.1 3 % 3 % SLM License $ 7.8 $ 7.9 (1 )% - % $ 26.8 $ 30.6 (12 )% (13 )% Service 16.4 16.6 (1 )% (2 )% 52.3 48.7 7 % 7 % Support 17.6 15.5 13 % 12 % 52.1 43.8 19 % 19 % Total revenue $ 41.8 $ 39.9 5 % 4 % $ 131.2 $ 123.1 7 % 7 % CAD Revenue The increase in CAD license revenue in the third quarter and first nine months of 2014 compared with the year-ago periods included double digit percentage license revenue growth in Europe, the Americas and Japan. This growth was driven by large deals, new seats, and sales of modules and upgrades associated with our Creo platform. For the first nine months of 2014 our total CAD revenue has increased 5% year over year. This overall CAD market is expected to grow in the mid-single digits. In the third quarter of 2014, compared with the year-ago period, license revenue in Europe grew 32% ($3.5 million), up 26% on a constant currency basis, the Americas grew 11% ($1.0 million), and Japan grew 89% ($5.1 million), up 94% on a constant currency basis. In the first nine months of 2014, license revenue grew 38% ($12.9 million) in Europe (up 35% on a constant currency basis), 13% ($3.2 million) in the Americas, and 11% ($1.6 million) in Japan (up 19% on a constant currency basis), partially offset by a decline in license revenue in the Pacific Rim of 9% ($2.8 million). CAD channel revenue which represents approximately 40% of total CAD revenue, was up 8% in the third quarter of 2014 compared to the year-ago period (up 6% on a constant currency basis) with license revenue up 16% year over year. CAD channel revenue for the first nine months of 2014 was up 1% year-over-year with license revenue up 3% year over year. Extended PLM Revenue Extended PLM revenue in the third quarter of 2014, compared to the prior year period, reflects double digit percentage license revenue growth in Europe, partially offset by a double digit percentage decline in license revenue in the Americas and the Pacific Rim. Support revenue grew in all regions, with double digit percentage growth in Europe, Japan and the Pacific Rim and mid-single digit percentage growth in the Americas. Extended PLM revenue in the third quarter of 2014 grew 12% ($6.0 million) in Europe, up 6% on a constant currency basis, with license revenue up 66% ($6.0 million), up 56% on a constant currency basis. This growth was partially offset by a 17% decline ($2.6 million) in license revenue in the Americas. Total revenue in Japan increased 1% ($0.1 million), 4% on a constant currency basis, and license revenue increased 5% ($0.3 27-------------------------------------------------------------------------------- Table of Contents million), 7% on a constant currency basis. Total revenue in the Pacific Rim declined 4% ($0.5 million) and license revenue declined 12% ($0.6 million). In the first nine months of 2014, total revenue in the Americas grew 9% ($15.6 million) and license revenue grew 13% ($5.7 million), revenue in Europe grew 1% ($2.3 million), down 2% on a constant currency basis, and license revenue grew 22% ($6.4 million), 17% on a constant currency basis. Japan revenue was flat but increased 12% on a constant currency basis with license revenue down 6% ($0.8 million), up 2% on a constant currency basis. Total revenue in the Pacific Rim declined 9% ($4.2 million) and license revenue declined 20% ($3.9 million). SLM Revenue SLM revenue in the third quarter of 2014, which includes contributions from Enigma (acquired in the fourth quarter of 2013) and ThingWorx (acquired in the second quarter of 2014), reflects double digit growth in support revenue. By region, SLM total revenue grew by double digit percentages in Europe, the Pacific Rim and Japan, partially offset by a mid-single digit percentage decline in the Americas. Compared to the third quarter of 2013, total revenue in Europe grew 18% ($1.5 million), 13% on a constant currency basis, and license revenue grew 104% ($1.1 million), 97% on a constant currency basis; total revenue in the Pacific Rim grew 33% ($0.7 million) and license revenue grew 165% ($1.0 million); and total revenue in Japan grew 31% ($0.7 million), 38% on a constant currency basis and license revenue grew 304% ($1.1 million), 332% on a constant currency basis. Total revenue in the Americas in the third quarter of 2014, compared to the third quarter of 2013, declined 4% ($1.0 million) and license revenue declined 56% ($3.3 million). In the first nine months of 2014, compared to the first nine months of 2013, total revenue in Europe increased 28% ($7.5 million) and license revenue increased 19% ($1.6 million), and total revenue in the Americas grew 3% ($2.4 million) while license revenue declined 28% ($4.1 million). Over the same period, total revenue in Japan declined 26% ($2.2 million) and license revenue declined 55% ($2.0 million) and total revenue in the Pacific Rim increased 5% ($0.4 million) and license revenue increased 22% ($0.8 million). While we have seen variability in the revenue contribution from SLM, we are optimistic about the growth opportunity in the SLM area of our business. Revenue from Individual Customers We enter into customer contracts that may result in revenue being recognized over multiple reporting periods. Accordingly, revenue recognized in a current period may be attributable to contracts entered into during the current period or in prior periods. The table below shows license and/or service revenue of $1 million or more recognized from individual customers in a single quarter during the fiscal year from contracts entered into during that quarter and/or a prior quarter. The amount of revenue, particularly license revenue, attributable to such customers, and the number of such customers, may vary significantly from quarter to quarter based on customer purchasing decisions, the completion of large service engagements commenced in previous quarters and macroeconomic conditions. For the third quarters of 2014 and 2013 there were 33 (9 in the Americas, 15 in Europe and 9 in Asia) and 33 (14 in the Americas, 12 in Europe and 7 in Asia) of these customers, respectively, with average revenue per customer of $2.4 million and $2.1 million, respectively. Revenue from large customers in the third quarter and first nine months of 2014 increased 14% and 20%, respectively, compared to the third quarter and first nine months of 2013. License revenue as a proportion of revenue from such customers was 59% and 47% in the third quarters of 2014 and 2013, respectively, and 52% and 45% in the first nine months of 2014 and 2013, respectively. We attribute the increase in revenue from large customers to an improving overall economy. Three months ended Nine months ended June 28, 2014 June 29, 2013 June 28, 2014 June 29, 2013 (Dollar amounts in millions) License and/or service revenue greater than $1 million from individual customers in a quarter $ 77.6 $ 68.3 $ 226.5 $ 188.0 % of total license and service revenue 48 % 45 % 47 % 41 % Revenue by Geographic Region 28-------------------------------------------------------------------------------- Table of Contents Three months ended Percent Change Nine months ended Percent Change Constant Constant June 28, 2014 June 29, 2013 Actual Currency June 28, 2014 June 29, 2013 Actual Currency (Dollar amounts in millions) Revenue by region: Americas $ 130.4 $ 129.5 1 % 1 % $ 403.6 $ 380.3 6 % 7 % Europe $ 130.7 $ 115.4 13 % 7 % $ 385.7 $ 353.9 9 % 5 % Pacific Rim $ 36.4 $ 36.3 - % - % $ 107.0 $ 114.2 (6 )% (6 )% Japan $ 39.2 $ 33.8 16 % 20 % $ 93.9 $ 100.3 (6 )% 5 % Three months ended Nine months ended June 28, 2014 June 29, 2013 June 28, 2014 June 29, 2013 Revenue by region as a % of total revenue: Americas 39 % 41 % 41 % 40 % Europe 39 % 37 % 39 % 37 % Pacific Rim 11 % 12 % 11 % 12 % Japan 12 % 11 % 9 % 11 % Americas The increase in revenue in the Americas in the third quarter of 2014 compared to the third quarter of 2013 consisted of an increase of 6% ($3.9 million) in support revenue, and an increase of 6% ($1.9 million) in service revenue, partially offset by a a decrease of 17% ($4.9 million) in license revenue. The increase in the first nine months of 2014 compared to the first nine months of 2013 consisted of an increase of 6% ($4.7 million) in license revenue, an increase of 6% ($12.5 million) in support revenue and an increase of 6% ($6.1 million) in service revenue. The third quarter of 2014 included one transaction with license revenue in excess of $5 million in the Americas and the first nine months of 2014 included three such transactions. The third quarter of 2013 did not include any transactions with license revenue in excess of $5 million and the first nine months of 2013 included one such transaction. Europe Revenue in Europe in the third quarter of 2014 compared to the third quarter of 2013 consisted of an increase in license revenue of 50% ($10.6 million), 43% on a constant currency basis, and an increase in support revenue of 10% ($6.3 million), 4% on a constant currency basis, partially offset by a decrease in service revenue of 6% ($1.7 million), 11% on a constant currency basis. Revenue in Europe in the first nine months of 2014 compared to the the first nine months of 2013 reflects an increase in license revenue of 29% ($20.8 million), 25% on a constant currency basis, an increase in support revenue of 8% ($15.2 million), 4% on a constant currency basis, partially offset by a decrease in service revenue of 5% ($4.2 million), 8% on a constant currency basis. The third quarter of 2014 did not include any transactions with license revenue in excess of $5 million in Europe and the first nine months of 2014 included one such transaction. No such transactions were recorded in the third quarter and first nine months of 2013. Changes in foreign currency exchange rates, particularly the Euro, favorably impacted revenue in Europe by $6.6 million and $13.6 million in the third quarter and first nine months of 2014, respectively, as compared to the third quarter and first nine months of 2013. Pacific Rim Revenue in the Pacific Rim in the third quarter of 2014 compared to the third quarter of 2013 included an increase of 4% ($0.6 million) in license revenue and an increase in support revenue of 6% ($0.8 million), offset by a decrease of 17% ($1.2 million) in service revenue. The decrease in revenue in the Pacific Rim in the first nine months of 2014 compared to the first nine months of 2013 consisted primarily of a decrease of 11% ($5.9 million) in license revenue and a decrease of 10% ($2.4 million) in service revenue, partially offset by an increase of 3% ($1.2 million) in support revenue. Revenue from China, which has historically represented 5% to 7% of our total revenue, increased 3% in the third quarter of 2014 as compared to the third quarter of 2013 and decreased 6% in the first nine months of 2014 as compared to the first nine months of 2013. Revenue in China has been lower than anticipated and future revenue growth in China remains uncertain. Japan 29-------------------------------------------------------------------------------- Table of Contents Following a weak first half of 2014, license revenue in Japan in the third quarter of 2014 compared to the third quarter of 2013 increased 49% ($6.5 million), which increase was partially offset by a decrease of 31% ($1.3 million) in service revenue. The decrease in revenue in Japan in the first nine months of 2014 compared to the first nine months of 2013 included a decrease of 4% ($1.2 million) in license revenue, an increase of 4% on a constant currency basis, and a decrease of 11% ($6.2 million) in support revenue, an increase of 2% on a constant currency basis, partially offset by an increase in service revenue of 9% ($1.1 million), an increase of 23% on a constant currency basis. The third quarter of 2013 included one transaction with license revenue in excess of $5 million in Japan and two such transactions in the first nine months of 2013. No such transactions were recorded in the third quarter and first nine months of 2014. Changes in the Yen to U.S. Dollar exchange rate unfavorably impacted revenue in Japan by $1.3 million and $11.7 million in the third quarter and first nine months of 2014, respectively, as compared to the third quarter and first nine months of 2013. Gross Margin Three months ended Nine months ended Percent Percent June 28, 2014 June 29, 2013 Change June 28, 2014 June 29, 2013 Change (Dollar amounts in millions) Gross margin $ 245.6 $ 223.8 10 % $ 712.4 $ 667.2 7 % Non-GAAP gross margin 252.5 231.1 9 % 733.1 690.6 6 % Gross margin as a % of revenue: License 91.6 % 89.4 % 90.9 % 89.6 % Service 11.8 % 13.2 % 14.0 % 11.8 % Support 87.7 % 87.8 % 87.7 % 87.6 % Gross margin as a % of total revenue 72.9 % 71.1 % 71.9 % 70.3 % Non-GAAP gross margin as a % of total revenue 75.0 % 73.2 % 74.0 % 72.6 % Gross margin as a percentage of total revenue in the third quarter of 2014 compared to the year-ago period reflects higher license margins. The increase in our GAAP service gross margin in the first nine months of 2014 was due in part to improved consulting margin. Service margins have been improving due to cost reductions, improved efficiencies and in part to reducing the amount of direct services that we perform through expansion of our service partner program. We are targeting GAAP services margins of at least 13% for fiscal 2014 (at least 15% on a non-GAAP basis). Service revenue comprised 21% and 23% of our total revenue in the third quarter and first nine months of 2014, respectively, compared to 23% in the third quarter and first nine months of 2013. Three months ended Nine months ended Percent Percent June 28, 2014 June 29, 2013 Change June 28, 2014 June 29, 2013 Change (Dollar amounts in millions) Costs and expenses: Cost of license revenue $ 7.8 $ 8.4 (7 )% $ 23.3 $ 24.7 (6 )% Cost of service revenue 61.9 62.9 (2 )% 191.7 196.1 (2 )% Cost of support revenue 21.3 19.8 8 % 62.8 60.7 3 % Sales and marketing 91.4 88.3 4 % 261.6 269.9 (3 )% Research and development 57.4 53.8 7 % 166.1 166.8 - % General and administrative 33.8 28.8 17 % 98.9 98.0 1 % Amortization of acquired intangible assets 8.0 6.5 22 % 23.8 19.8 20 % Restructuring charges 0.5 3.1 (84 )% 1.6 34.3 (95 )% Total costs and expenses (1) $ 282.3 $ 271.8 4 % $ 829.8 $ 870.4 (5 )% Total headcount at end of period 6,126 5,987 (1) On a constant currency basis, compared to the year-ago period, total costs and expenses for the third quarter and first nine months of 2014 increased 3% and decreased 4%, respectively. 30-------------------------------------------------------------------------------- Table of Contents Costs and expenses in the third quarter and first nine months of 2014, compared to the third quarter and first nine months of 2013, decreased primarily as a result of: • restructuring charges, which were $32.8 million lower in the first nine months of 2014; and • cost savings resulting from restructuring actions in 2013. These cost decreases were offset by costs from acquired businesses (approximately 90 employees), investments we are making in the Internet of Things solutions area of our business, and company-wide merit pay increases totaling approximately $12 million on an annualized basis, which were effective February 1, 2014. Cost of License Revenue Three months ended Nine months ended Percent Percent June 28, 2014 June 29, 2013 Change June 28, 2014 June 29, 2013 Change (Dollar amounts in millions) Cost of license revenue $ 7.8 $ 8.4 (7 )% $ 23.3 $ 24.7 (6 )% % of total revenue 2 % 3 % 2 % 3 % % of total license revenue 8 % 11 % 9 % 10 % Our cost of license revenue consists of fixed and variable costs associated with reproducing and distributing software and documentation, as well as royalties paid to third parties for technology embedded in or licensed with our software products and amortization of intangible assets associated with acquired products. Cost of license revenue as a percent of license revenue can vary depending on product mix sold and the effect of fixed and variable royalties and the level of amortization of acquired software intangible assets. Amortization of acquired purchased software totaled $4.3 million and $4.6 million in the third quarters of 2014 and 2013, respectively, and $13.0 million and $13.9 million in the first nine months of 2014 and 2013, respectively. Cost of Service Revenue Three months ended Nine months ended Percent Percent June 28, 2014 June 29, 2013 Change June 28, 2014 June 29, 2013 Change (Dollar amounts in millions) Cost of service revenue $ 61.9 $ 62.9 (2 )% $ 191.7 $ 196.1 (2 )% % of total revenue 18 % 20 % 19 % 21 % % of total service revenue 88 % 87 % 86 % 88 % Service headcount at end of period 1,386 1,364 2 % Our cost of service revenue includes costs such as salaries, benefits, and computer equipment and facilities for our training and consulting personnel, and third-party subcontractor fees. In the third quarter and first nine months of 2014 compared to the third quarter and first nine months of 2013, total compensation, benefit costs and travel expenses were higher by 3% ($1.3 million) and 2% ($2.5 million), respectively. The cost of third-party consulting services was $2.6 million and $7.0 million lower in the third quarter and first nine months of 2014, respectively, compared to the third quarter and first nine months of 2013. The decrease in the use of subcontracted third-party consultants is a result of improved utilization and the implementation of our strategy to have our strategic services partners perform services for customers directly, all of which have contributed to improving services margins. Cost of Support Revenue Three months ended Nine months ended Percent Percent June 28, 2014 June 29, 2013 Change June 28, 2014 June 29, 2013 Change (Dollar amounts in millions) Cost of support revenue $ 21.3 $ 19.8 8 % $ 62.8 $ 60.7 3 % % of total revenue 6 % 6 % 6 % 6 % % of total support revenue 12 % 12 % 12 % 12 % Support headcount at end of period 638 614 4 % Our cost of support revenue includes costs such as salaries, benefits, and computer equipment and facilities associated with customer support and the release of support updates (including related royalty costs). In the third quarter and first nine months of 2014 compared to the third quarter and first nine months of 2013, total compensation, benefit costs and travel expenses were higher by 8% ($1.2 million) and 4% ($1.7 million), respectively. 31-------------------------------------------------------------------------------- Table of Contents Sales and Marketing Three months ended Nine months ended Percent Percent June 28, 2014 June 29, 2013 Change June 28, 2014 June 29, 2013 Change (Dollar amounts in millions) Sales and marketing $ 91.4 $ 88.3 4 % $ 261.6 $ 269.9 (3 )% % of total revenue 27 % 28 % 26 % 28 % Sales and marketing headcount at end of period 1,387 1,419 (2 )% Our sales and marketing expenses primarily include salaries and benefits, sales commissions, advertising and marketing programs, travel and facility costs. Compared to the third quarter and first nine months of 2013, our compensation, benefit costs and travel expenses were higher by 6% ($4.1 million) in the third quarter of 2014 primarily due to higher commission and salary expense, and lower by 2% ($4.3 million) in the first nine months of 2014 primarily due to lower headcount. In the third quarter and first nine months of 2014 compared to the third quarter and first nine months of 2013, total depreciation and telecommunication costs decreased by $0.7 million and $2.2 million, respectively. Research and Development Three months ended Nine months ended Percent Percent June 28, 2014 June 29, 2013 Change June 28, 2014 June 29, 2013 Change (Dollar amounts in millions) Research and development $ 57.4 $ 53.8 7 % $ 166.1 $ 166.8 - % % of total revenue 17 % 17 % 17 % 18 % Research and development headcount at end of period 2,068 1,970 5 % Our research and development expenses consist principally of salaries and benefits, costs of computer equipment and facility expenses. Major research and development activities include developing new releases and updates of our software that enhance functionality and developing new products or features. Total compensation, benefit costs and travel expenses were higher by 7% ($3.1 million) and 1% ($1.3 million) in the third quarter and first nine months of 2014, respectively, compared to the third quarter and first nine months of 2013. Headcount in 2014 includes a higher mix of research and development headcount in lower cost geographic regions as compared to 2013. Additionally, research and development headcount at the end of the third quarter of 2014 included approximately 40 employees added from companies acquired since the third quarter of 2013. Total depreciation and telecommunication costs in the third quarter and first nine months of 2014 decreased by $0.5 million and $1.7 million, respectively, compared to the third quarter and first nine months of 2013. General and Administrative Three months ended Nine months ended Percent Percent June 28, 2014 June 29, 2013 Change June 28, 2014 June 29, 2013 Change (Dollar amounts in millions) General and administrative $ 33.8 $ 28.8 17 % $ 98.9 $ 98.0 1 % % of total revenue 10 % 9 % 10 % 10 % General and administrative headcount at end of period 637 610 4 % Our general and administrative expenses include the costs of our corporate, finance, information technology, human resources, legal and administrative functions, as well as acquisition-related charges, bad debt expense and outside professional services, including accounting and legal fees. The increase in overall general and administrative costs in the third quarter of 2014, compared to the third quarter of 2013, was due primarily to total compensation, benefit costs and travel costs which were 10% ($2.1 million) higher and acquisition-related costs, which were $0.4 million higher. The increase in overall general and administrative costs in the first nine months of 2014, compared to the first nine months of 2013, was due in part to total compensation, benefit costs and travel costs which were 4% ($2.7 million) higher, partially offset by acquisition-related costs, which were $0.6 million lower. Additionally, in the third quarter and first nine months of 2014, compared to the third quarter and first nine months of 2013 costs for outside professional services were higher by $2.1 million and $1.1 million, respectively. Cost increases in the first nine months of 2014 were partially offset by certain business taxes in a foreign jurisdiction which were lower by $1.2 million in the first nine months of 2014, compared to the first nine months of 2013. 32-------------------------------------------------------------------------------- Table of Contents Amortization of Acquired Intangible Assets Three months ended Nine months ended Percent Percent June 28, 2014 June 29, 2013 Change June 28, 2014 June 29, 2013 Change (Dollar amounts in millions) Amortization of acquired intangible assets $ 8.0 $ 6.5 22 % $ 23.8 $ 19.8 20 % % of total revenue 2 % 2 % 2 % 2 % Amortization of acquired intangible assets reflects the amortization of acquired non-product related intangible assets, primarily customer and trademark-related intangible assets, recorded in connection with completed acquisitions. The increase in amortization of acquired intangible assets in the third quarter and first nine months of 2014 includes our acquisition of ThingWorx in the second quarter of 2014 and our acquisitions of Enigma and NetIDEAS in the fourth quarter of 2013. Restructuring Charges Three months ended Nine months ended Percent Percent June 28, 2014 June 29, 2013 Change June 28, 2014 June 29, 2013 Change (Dollar amounts in millions) Restructuring charges $ 0.5 $ 3.1 (84 )% $ 1.6 $ 34.3 (95 )% In the first nine months of 2014, we recorded restructuring charges of $1.6 million, primarily associated with the completion of the restructuring actions initiated in the fourth quarter of 2013. In the third quarter and first nine months of 2013, as part of our continued strategy to reduce costs and to realign our business, we implemented restructuring actions and recorded restructuring charges of $3.1 million and $34.3 million, respectively, primarily for severance and related costs associated with 63 and 351 employees notified of termination during the third quarter and first nine months of 2013, respectively. The restructuring charges also included $1.4 million related to facility consolidations in the second quarter of 2013. The 2013 restructuring actions resulted in quarterly cost savings of approximately $16 million (which is largely reflected in our results for the first nine months of 2014 and contemplated in our 2014 financial goals). In the first nine months of 2014, we made cash payments related to restructuring charges of $19 million, compared to $31 million in the first nine months of 2013. At June 28, 2014, accrued expenses for unpaid restructuring charges totaled $2 million, which we expect to pay within the next twelve months. Interest and Other Income (Expense), net Three months ended Nine months ended June 28, 2014 June 29, 2013 June 28, 2014 June 29, 2013 (in millions) Interest income $ 0.7 $ 0.7 $ 2.3 $ 2.2 Interest expense (2.0 ) (1.7 ) (5.4 ) (5.5 ) Other income (expense), net (1.0 ) 4.2 (3.6 ) 2.8 Total interest and other income (expense), net $ (2.3 ) $ 3.2 $ (6.7 ) $ (0.5 ) Interest and other income (expense), net includes interest income, interest expense, costs of hedging contracts and certain realized and unrealized foreign currency transaction gains or losses. A large portion of our revenue and expenses is transacted in foreign currencies. To reduce our exposure to fluctuations in foreign exchange rates, we engage in hedging transactions involving the use of foreign currency forward contracts, primarily in the Euro and Canadian Dollar. The change in other income (expense), net in the third quarter and first nine months of 2014, compared to the prior year periods, was due primarily to a legal settlement gain of $5.1 million recorded in the third quarter of 2013 and foreign currency net losses which were $1.0 million higher in the first nine months of 2014. 33-------------------------------------------------------------------------------- Table of Contents Income Taxes Three months ended Nine months ended June 28, 2014 June 29, 2013 June 28, 2014 June 29, 2013 (Dollar amounts in millions) Pre-tax income $ 52.1 $ 46.4 $ 153.7 $ 77.8 Tax provision (benefit) 14.1 11.9 32.3 (9.5 ) Effective income tax rate 27 % 26 % 21 % (12 )% In the third quarter and first nine months of 2014, our effective tax rate was lower than the 35% statutory federal income tax rate due to our corporate structure in which our foreign taxes are at a net effective tax rate lower than the U.S. rate and the reversal of a portion of our valuation allowance against net deferred tax assets described below. In the first nine months of 2013, our effective tax rate was lower than the 35% statutory federal income tax rate due primarily to the reversal of a portion of our valuation allowance against net deferred tax assets described below. Our tax provision in the third quarter and tax benefit in the first nine months of 2013 did not include a tax benefit on our forecast 2013 U.S. loss as it was offset by a valuation allowance established in the fourth quarter of 2012 as described below. A discrete benefit of $1.6 million was recorded in the third quarter of 2013 as a result of the conclusion of tax audits in several jurisdictions. In the first nine months of 2013, we recorded a $2.0 million tax benefit related to research and development (R&D) tax credits in the U.S triggered by a retroactive extension of the R&D credit and a $3.2 million tax benefit related to final resolution of a long standing tax litigation and completion of a tax audit. In the fourth quarter of 2012, we recorded a $124.5 million non-cash charge to the income tax provision to establish a valuation allowance against all of our U.S. deferred tax assets. In the second quarter of 2014 and first quarter of 2013, our acquisitions of ThingWorx and Servigistics, Inc. were accounted for as business combinations. Assets acquired, including the fair values of acquired tangible assets, intangible assets (including finite-lived acquired intangible assets totaling $32.1 million for ThingWorx and $118.3 million for Servigistics) and assumed liabilities were recorded, and we recorded net deferred tax liabilities of $8.9 million and $35.6 million, respectively, primarily related to the tax effect of the acquired intangible assets that are not deductible for income tax purposes. These net deferred tax liabilities reduced our net deferred tax asset balance and resulted in a tax benefit of $8.9 million related to ThingWorx recorded in the second quarter of 2014 and $32.6 million related to Servigistics recorded in the first quarter of 2013 to decrease our valuation allowance in jurisdictions where we have recorded a valuation allowance (primarily the U.S.). As these decreases in the valuation allowance were not part of the accounting for the business combinations (the fair value of the assets acquired and liabilities assumed), they were recorded as income tax benefits. In the fourth quarter of 2014, in conjunction with our acquisitions of Atego and Axeda (if completed), we expect to record a non-cash tax benefit due to the recording of deferred tax liabilities related to the tax effect of acquired intangible assets that are not deductible for income tax purposes and the resulting reduction in the U.S. and U.K. valuation allowance on net deferred tax assets. We have concluded, based on the weight of available evidence, that a full valuation allowance continues to be required against our U.S. net deferred tax assets as they are not more likely than not to be realized in the future. We have taken and will continue to take measures to improve core earnings in the U.S. If our U.S. results continue to improve, the valuation allowance against the U.S. net deferred tax assets may no longer be required. We will continue to reassess our valuation allowance requirements each financial reporting period. In the normal course of business, PTC and its subsidiaries are examined by various taxing authorities, including the Internal Revenue Service (IRS) in the United States. We regularly assess the likelihood of additional assessments by tax authorities and provide for these matters as appropriate. We are currently under audit by tax authorities in several jurisdictions. Audits by tax authorities typically involve examination of the deductibility of certain permanent items, limitations on net operating losses and tax credits. Although we believe our tax estimates are appropriate, the final determination of tax audits and any related litigation could result in material changes in our estimates. Our future effective income tax rate may be materially impacted by the amount of income taxes associated with our foreign earnings, which are taxed at rates different from the U.S. federal statutory income tax rate, as well as the timing and extent of the realization of deferred tax assets and changes in the tax law. Further, our tax rate may fluctuate within a fiscal year, including from quarter to quarter, due to items arising from discrete events, including settlements of tax audits and assessments, the resolution or identification of tax position uncertainties, and acquisitions of other companies. Non-GAAP Measures 34-------------------------------------------------------------------------------- Table of Contents The non-GAAP measures presented in the discussion of our results of operations and the respective most directly comparable GAAP measures are: • non-GAAP revenue-GAAP revenue • non-GAAP gross margin-GAAP gross margin • non-GAAP operating income-GAAP operating income • non-GAAP operating margin-GAAP operating margin • non-GAAP net income-GAAP net income • non-GAAP diluted earnings per share-GAAP diluted earnings per share The non-GAAP measures exclude fair value adjustments related to acquired deferred support revenue, stock-based compensation expense, amortization of acquired intangible assets expense, acquisition-related charges, restructuring charges, pension plan termination costs, identified discrete charges included in non-operating other income (expense), net and the related tax effects of the preceding items, and any other identified tax items. These items are normally included in the comparable measures calculated and presented in accordance with GAAP. Our management excludes these items when evaluating our ongoing performance and/or predicting our earnings trends, and therefore excludes them when presenting non-GAAP financial measures. Management uses, and investors should consider, non-GAAP measures in conjunction with our GAAP results. Fair value of acquired deferred support revenue is a purchase accounting adjustment recorded to reduce acquired deferred support revenue to the fair value of the remaining obligation. Stock-based compensation expense is a non-cash expense relating to stock-based awards issued to executive officers, employees and outside directors, primarily consisting of restricted stock units. Amortization of acquired intangible assets expense is a non-cash expense that is impacted by the timing and magnitude of our acquisitions. Charges included in general and administrative expenses include acquisition-related charges and pension plan termination costs. Acquisition-related charges include direct costs of potential and completed acquisitions and expenses related to acquisition integration activities, including transaction fees, due diligence costs, severance and professional fees. In addition, subsequent adjustments to our initial estimated amount of contingent consideration associated with specific acquisitions are included within acquisition-related charges. These costs are not considered part of our normal operations as the occurrence and amount will vary depending on the timing and size of acquisitions. In the second quarter of 2014, we began the process of terminating a U.S. pension plan. Costs associated with the termination are not considered part of our ongoing operations. Restructuring charges are costs incurred in a period related to strategies to reduce costs and to realign our business, including costs related to employee terminations and costs of excess facilities. We use these non-GAAP measures, and we believe that they assist our investors, to make period-to-period comparisons of our operational performance because they provide a view of our operating results without items that are not, in our view, indicative of our core operating results. We believe that these non-GAAP measures help illustrate underlying trends in our business, and we use the measures to establish budgets and operational goals (communicated internally and externally) for managing our business and evaluating our performance. We believe that providing non-GAAP measures affords investors a view of our operating results that may be more easily compared to the results of peer companies. In addition, compensation of our executives is based in part on the performance of our business based on these non-GAAP measures. The items excluded from the non-GAAP measures often have a material impact on our financial results and such items often recur. Accordingly, the non-GAAP measures included in this Quarterly Report should be considered in addition to, and not as a substitute for or superior to, the comparable measures prepared in accordance with GAAP. The following tables reconcile each of these non-GAAP measures to its most closely comparable GAAP measure on our financial statements. 35-------------------------------------------------------------------------------- Table of Contents Three months ended Nine months ended June 28, 2014 June 29, 2013 June 28, 2014 June 29, 2013 (in millions, except per share amounts) GAAP revenue $ 336.6 $ 315.0 $ 990.3 $ 948.7 Fair value of acquired deferred support revenue - 0.5 - 2.7 Non-GAAP revenue $ 336.6 $ 315.5 $ 990.3 $ 951.4 GAAP gross margin $ 245.6 $ 223.8 $ 712.4 $ 667.2 Fair value of acquired deferred support revenue - 0.5 - 2.7 Stock-based compensation 2.5 2.1 7.4 6.8 Amortization of acquired intangible assets included in cost of revenue 4.4 4.6 13.3 13.9 Non-GAAP gross margin $ 252.5 $ 231.1 $ 733.1 $ 690.6 GAAP operating income $ 54.4 $ 43.2 $ 160.5 $ 78.3 Fair value of acquired deferred support revenue - 0.5 - 2.7 Stock-based compensation 12.5 11.2 37.9 34.9 Amortization of acquired intangible assets included in cost of revenue 4.4 4.6 13.3 13.9 Amortization of acquired intangible assets 8.0 6.5 23.8 19.8 Charges included in general and administrative expenses (1) 1.5 0.9 6.8 7.6 Restructuring charges 0.5 3.1 1.6 34.3 Non-GAAP operating income $ 81.4 $ 70.1 $ 243.8 $ 191.6 GAAP net income $ 38.0 $ 34.5 $ 121.4 $ 87.3 Fair value of acquired deferred support revenue - 0.5 - 2.7 Stock-based compensation 12.5 11.2 37.9 34.9 Amortization of acquired intangible assets included in cost of revenue 4.4 4.6 13.3 13.9 Amortization of acquired intangible assets 8.0 6.5 23.8 19.8 Charges included in general and administrative expenses (1) 1.5 0.9 6.8 7.6 Restructuring charges 0.5 3.1 1.6 34.3 Non-operating one-time gain (2) - (5.1 ) - (5.1 ) Income tax adjustments (3) (1.3 ) (2.3 ) (23.1 ) (47.8 ) Non-GAAP net income $ 63.7 $ 53.9 $ 181.7 $ 147.6 GAAP diluted earnings per share $ 0.32 $ 0.29 $ 1.01 $ 0.72 Fair value of acquired deferred support revenue - - - 0.02 Stock-based compensation 0.10 0.09 0.31 0.29 Amortization of acquired intangible assets 0.10 0.09 0.31 0.28 Charges included in general and administrative expenses (1) 0.01 0.01 0.06 0.06 Restructuring charges - 0.03 0.01 0.28 Non-operating one-time gain (2) - (0.04 ) - (0.04 ) Income tax adjustments (3) (0.01 ) (0.02 ) (0.19 ) (0.39 ) Non-GAAP diluted earnings per share $ 0.53 $ 0.45 $ 1.51 $ 1.22 36-------------------------------------------------------------------------------- Table of Contents Operating margin impact of non-GAAP adjustments: Three months ended Nine months ended June 28, 2014 June 29, 2013 June 28, 2014 June 29, 2013 GAAP operating margin 16.2 % 13.7 % 16.2 % 8.3 % Fair value of acquired deferred support revenue - % 0.2 % - % 0.3 % Stock-based compensation 3.7 % 3.5 % 3.8 % 3.7 % Amortization of acquired intangible assets 3.7 % 3.5 % 3.7 % 3.5 % Charges included in general and administrative 0.5 % 0.3 % 0.7 % 0.8 % Restructuring charges 0.2 % 1.0 % 0.2 % 3.6 % Non-GAAP operating margin 24.2 % 22.2 % 24.6 % 20.1 % (1) Represents acquisition-related charges and costs related to terminating a U.S. pension plan of $0.2 million in the third quarter of 2014 and $0.1 million in the second quarter of 2014. (2) Other income (expense) net in the third quarter of 2013 included a legal settlement gain of $5.1 million which was excluded from non-GAAP income. (3) Income tax adjustments for the three and nine months ended June 28, 2014 and June 29, 2013 reflect the tax effects of non-GAAP adjustments which are calculated by applying the applicable tax rate by jurisdiction to the non-GAAP adjustments listed above, and also include any identified tax items. In the fourth quarter of 2012, a valuation allowance was established against our U.S. net deferred tax assets. As the U.S. is profitable on a non-GAAP basis, the 2014 and 2013 non-GAAP tax provision is being calculated assuming there is no U.S. valuation allowance. Additionally, the following identified tax items have been excluded from the non-GAAP tax results. The second quarter of 2014 includes a non-cash tax benefit of $8.9 million related to the release of a portion of the valuation allowance as a result of deferred tax liabilities established for the acquisition of ThingWorx. The second quarter of 2013 includes tax benefits of $3.2 million relating to final resolution of long-standing tax litigation and completion of an international jurisdiction tax audit. The first quarter of 2013 includes a non-cash tax benefit of $32.6 million related to the release of a portion of the valuation allowance as a result of deferred tax liabilities established for the acquisition of Servigistics. Liquidity and Capital Resources June 28, 2014 June 29, 2013 (in thousands) Cash and cash equivalents $ 304,173 $ 257,031 Amounts below are for the nine months ended: Cash provided by operating activities $ 253,387 $ 181,022 Cash used by investing activities (128,240 ) (239,945 ) Cash used by financing activities (63,532 ) (168,178 ) Cash and cash equivalents We invest our cash with highly rated financial institutions and in diversified domestic and international money market mutual funds. Cash and cash equivalents include highly liquid investments with original maturities of three months or less. At June 28, 2014, cash and cash equivalents totaled $304.2 million, up from $241.9 million at September 30, 2013, reflecting $253 million in operating cash flow, $57 million of net amounts borrowed under our credit facility ($110 million borrowed in the first quarter of 2014 for our acquisition of ThingWorx, net of amounts repaid in the second and third quarters of 2014), partially offset by $112 million used for our acquisition of ThingWorx and $100 million used to repurchase common shares outstanding. Cash provided by operating activities Cash provided by operating activities was $253.4 million in the first nine months of 2014, compared to $181.0 million in the first nine months of 2013. The increase is primarily due to improved profitability. Operating income for the first nine months of 2014 and 2013 was $160 million and $78 million, respectively. The first nine months of 2013 included restructuring charges of $34 million and restructuring payments of $31 million compared to the first nine months of 2014 which included restructuring charges of $2 million and restructuring payments of $19 million. Accounts receivable days sales outstanding was 37-------------------------------------------------------------------------------- Table of Contents 62 days at the end of the third quarter of 2014 compared to 60 days as of September 30, 2013 and 58 days at the end of the third quarter of 2013. We periodically provide financing with payment terms up to 24 months to credit-worthy customers for software purchases. As of June 28, 2014 and September 30, 2013 amounts due from customers for contracts with original payment terms greater than twelve months (financing receivables) totaled $61.3 million and $53.1 million, respectively, compared to $65.8 million at June 29, 2013. Cash used by investing activities Nine months ended June 28, 2014 June 29, 2013 (in thousands)Cash used by investing activities included the following: Acquisitions of businesses, net of cash acquired $ (111,519 ) $ (220,817 ) Additions to property and equipment (16,721 ) (19,128 ) $ (128,240 ) $ (239,945 ) In the first nine months of 2014, we used cash of $111.5 million (net of cash acquired) to acquire ThingWorx, Inc. and in the first nine months of 2013, we used cash of $220.8 million (net of cash acquired) to acquire Servigistics, Inc as described in Note 6. Acquisitions in the Notes to Consolidated Financial Statements in this Form 10-Q. Our expenditures for property and equipment consist primarily of computer equipment, software, office equipment and facility improvements. Cash provided (used) by financing activities Nine months ended June 28, 2014 June 29, 2013 (in thousands) Cash provided (used) by financing activities included the following: Net borrowings (repayments) under our credit facility $ 56,875 $ (101,875 ) Repurchases of common stock (99,915 ) (54,912 ) Payments of withholding taxes in connection with vesting of stock-based awards (26,749 ) (14,974 ) Proceeds from issuance of common stock 801 3,412 Excess tax benefits from stock-based awards 9,576 171 Credit facility origination costs (4,120 ) - $ (63,532 ) $ (168,178 ) In the first quarter of 2014, we borrowed $110 million under our credit facility to finance the acquisition of ThingWorx, which closed early in the second quarter on December 30, 2013. We repaid $53 million of the amount outstanding under our credit facility in the second and third quarters of 2014. In the second quarter of 2014, we incurred costs of approximately $4 million in connection with entering into the new credit facility described below. Payments of withholding taxes in connection with vesting of stock-based awards were higher in the first nine months of 2014, compared to the first nine months of 2013, primarily because the market value of our stock (upon which the withholding taxes are based) at the time shares vested was higher. Credit Facility On January 30, 2014, we entered into a multi-currency credit facility with a syndicate of 13 banks for which JPMorgan Chase Bank, N.A. acts as Administrative Agent. Amounts outstanding under the prior facility were repaid with amounts borrowed under the new facility. As of June 28, 2014, the balance outstanding under the credit facility was $315.0 million, our leverage ratio was 0.93 to 1.00, our fixed charge coverage ratio was 22.05 to 1.00 and we were in compliance with all financial and operating covenants of the credit facility. The credit facility consists of a $250 million term loan and a $750 million revolving loan commitment, and may be increased by an additional $250 million (in the form of revolving loans or term loans, or a combination thereof) if the existing 38-------------------------------------------------------------------------------- Table of Contents or additional lenders are willing to make such increased commitments. The revolving loan commitment does not require amortization of principal. The term loan requires repayment of principal at the end of each calendar quarter. The revolving loan and term loan may be repaid in whole or in part prior to the scheduled maturity dates at PTC's option without penalty or premium. The credit facility matures on January 30, 2019, when all amounts outstanding will be due and payable in full. We are required to make principal payments under the term loan of $9.375 million, $21.875 million, $25.0 million, $34.375 million, $37.5 million and $121.875 million in 2014, 2015, 2016, 2017, 2018 and 2019, respectively. For a description of additional terms and conditions of the credit facility, including limitations on our ability to undertake certain actions, see Note 12. Debt in the Notes to Consolidated Financial Statements in this Form 10-Q. We expect to use the credit facility for general corporate purposes, including acquisitions of businesses and working capital requirements as well as repurchases of our common shares. On August 4, 2014, we announced our intention to replace our existing credit facility with a new $1.5 billion credit facility in the fourth quarter of 2014 with a syndicate of existing and new banks. As we have only recently begun to explore this initiative, we cannot be sure if or when we will be able to enter into a new credit facility. Also, as described below in Share Repurchases, on August 4, 2014 we announced that we intend to draw $125 million from our credit facility and to fund the accelerated share repurchase agreement. Share Repurchases Our Board of Directors has periodically authorized us to repurchase shares of our common stock. We were authorized to repurchase up to $100 million worth of shares with cash from operations in the period October 1, 2013 through September 30, 2014, which amount we fully repurchased in the first nine months of 2014 (a total of 2.8 million shares of our common stock). In the first nine months of 2013, we repurchased 2.3 million shares of our common stock at a cost of $54.9 million under our repurchase program. All shares of our common stock repurchased are automatically restored to the status of authorized and unissued. On August 4, 2014, our Board of Directors authorized a share repurchase program for up to $600 million of our common stock through September 30, 2017. We intend to use cash from operations and borrowings under our credit facility to make such repurchases. As part of the repurchase program, we intend to enter into a $125 million accelerated share repurchase agreement in the fourth quarter of fiscal 2014 (and to borrow $125 million under the credit facility for such accelerated share repurchase). Future Expectations We believe that existing cash and cash equivalents, together with cash generated from operations, will be sufficient to meet our working capital and capital expenditure requirements through at least the next twelve months and to meet our known long-term capital requirements. We expect to borrow approximately $300 million under our credit facility in the fourth quarter of fiscal 2014 to complete the acquisition of Axeda for approximately $170 million, which we expect to close in the quarter, and to enter into the intended $125 million accelerated share repurchase agreement. Further, we evaluate possible strategic transactions on an ongoing basis and at any given time may be engaged in discussions or negotiations with respect to possible strategic transactions. Our expected uses of cash could change, our cash position could be reduced and we may incur additional debt obligations to the extent we complete additional acquisitions. As described in Note 14. Pension Plans in the Notes to Consolidated Financial Statements in this Form 10-Q, we have begun the process of terminating our U.S. pension plan. In April 2014, we contributed $7.5 million to the plan and we expect to contribute an additional $22 million to the plan over the next 12 to 24 months to complete the termination. At June 28, 2014, we had cash and cash equivalents of $33.4 million in the United States, $141.8 million in Europe, $84.4 million in the Pacific Rim (including India), $16.4 million in Japan and $28.1 million in other non-U.S. countries. As of June 28, 2014, we had an outstanding intercompany loan receivable of $44.6 million, primarily resulting from our business reorganizations described in Note G Income Taxes in the Notes to Consolidated Financial Statements of our 2013 Annual Report on Form 10-K, owed to the U.S. from our top tier foreign subsidiary. This amount can be repaid with cash generated by our foreign subsidiaries and repatriated to the U.S. without future tax cost. Critical Accounting Policies and Estimates The financial information included in Item 1 reflects no material changes in our critical accounting policies and estimates as set forth under the heading Critical Accounting Policies and Estimates in Part II, Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations of our 2013 Annual Report on Form 10-K. We did not make any changes to these policies or to these estimates during the quarter ended June 28, 2014. We completed our annual goodwill impairment review as of June 28, 2014 based on a valuation of our reporting units and concluded that no impairment charge was required as of that date. To conduct these tests of goodwill, we compared the fair 39-------------------------------------------------------------------------------- Table of Contents value of each reporting unit to its carrying value. We estimate the fair value of our reporting units using discounted cash flow valuation models. Those models require estimates of future revenues, profits, capital expenditures, working capital, terminal values based on revenue multiples, and discount rates for each reporting unit. We estimate these amounts by evaluating historical trends, current budgets, operating plans and industry data. The estimated fair value of each reporting unit was more than double its carrying value as of June 28, 2014. Recent Accounting Pronouncements In accordance with recently issued accounting pronouncements, we will be required to comply with certain changes in accounting rules and regulations. Revenue Recognition In May 2014, the Financial Accounting Standards Board (the FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers: Topic 606 (ASU 2014-09), to supersede nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing U.S. GAAP including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. ASU 2014-09 is effective for us in our first quarter of fiscal 2018 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-09; or (ii) retrospective with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application and providing certain additional disclosures as defined per ASU 2014-09. We are currently evaluating the impact of our pending adoption of ASU 2014-09 on our consolidated financial statements. Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists In July 2013, the FASB issued ASU No. 2013-11, Income Taxes (Topic 740)-Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. ASU 2013-11 generally requires that an unrecognized tax benefit, or a portion of an unrecognized tax benefit, shall be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. ASU 2013-11 is effective for us in our first quarter of fiscal 2015. We are currently evaluating the impact of our pending adoption of ASU 2013-11 on our consolidated financial statements. |