Great. Hello, everyone. My name is Alexei Gogolev, and today I'm delighted to have CFO of PTC with us, Kristian Talvitie. Thank you very much for joining.
Thanks for having us.
Of course. First of all, Kristian, maybe we could start with some of the comments that [Neil] mentioned during the most recent earnings call and investor conversations. Obviously, there has been a strategic decision to be a bit more focused on what the customers are saying, and you have lowered some of your ARR expectations. Can you talk about what preempted that decision, and maybe tell us anything that is relevant with regards to deal sizes that you think these customers may be looking at in the current environment, perhaps how they're feeling about certain parts of the economy and the sectors that they're exposed to?
Yeah, sure. Happy to jump into that. Before, I guess, we get started, my lawyer would be extremely upset with me if I did not remind everybody about our safe harbor language and forward-looking statement language, which is available on our website, on our press releases, SEC filings, etc. Please refer you to those cautionary statements. In terms of the ARR guidance, as you will remember, we started the year with guidance in the range of 9-10% ARR growth. After our second quarter, which ended here at the end of March, some fairly remarkable developments in the world. In early April, there was a bunch of news about Liberation Day and associated tariffs and potential impact to businesses around the world. As we contemplated guidance for the rest of the year, the pipeline actually is still solid.
I think we feel good about the pipeline. We feel good about fundamental underlying demand. It's just that we have had some customer conversations where they've said they're not sure, but they may have to think about either downsizing the initiative that we're working on them with right now or delaying it. We won't really know for sure, really, till the end of the quarter and the end of the year, what kind of impact that will ultimately have. We felt it was prudent, given some of that cautionary language that was starting to creep into some of these customer conversations, to adjust the high-end down to 9%. We also adjusted the low-end down to 7%. We went from 10-9 to 9-7.
That 7% range, we tried to think about what if things actually got materially worse and kind of more broad-based, if you will, than some larger transactions, we'll call it at the top end of the forecast, being either downsized or delayed. We came at it a few different ways. There was an effort to look at it from a bottoms-up perspective, what would happen if close rates across the board got meaningfully worse, etc.
You could also look at it, we also looked at it from a top-down perspective and tried to think about what happened to the business performance during a couple of the other more significant global crises that the business has weathered, whether that was COVID, which lasted a couple of quarters, the severe uncertainty in 2020, or 2009, the GFC, as I think it's now referred to, which was, of course, four quarters of uncertainty and a pretty severe demand environment or execution environment, I guess I should say. I think that 7% scenario tries to contemplate something that might approximate that kind of global atmosphere in the potential results.
Those conversations that you're referring to with some of your clients, were they, do you think the feedback was more broad-based, or was it more customer-specific or maybe certain segment-specific?
I mean, they're all definitely customer-specific. I mean, I think that there are certain verticals and certain companies within certain geos that are perhaps facing more challenges right now and uncertainty with what's going on in the world, which include, for example, automotive, automotive industrials, particularly in the U.S. On the flip side, I think that there are also positive signs coming from other verticals like FA&D, for example, that have a pretty robust demand environment right now.
Just to finish off with the guidance, you've already provided quite a bit of color on the estimates that you put in and assumptions that were made with that 7-9% range. Can you give us maybe a little bit more color? In that extreme scenario, that is hopefully unlikely, the 7% growth of ARR, what sort of assumptions are you making in terms of external factors, macro environment, or maybe some headwinds that you're assuming?
Yeah. I mean, again, in the downside scenario, I think we would, the assumption would be that things would have gotten meaningfully worse or meaningfully more uncertain than it already is.
Okay. Great. Obviously, the important takeaway, I feel, is that the underlying demand for your core business, based on those conversations that you had with clients, still remains strong. Maybe you could provide some more indicators of the pipeline quality and velocity today versus perhaps the start of the year, calendar year that you're seeing.
Yeah. Thank you for that. I agree. The fundamental underlying demand, we think, remains very robust. Ultimately, in hindsight, this may prove as yet another bolstering point for companies around the world on why digital transformation is important to be able to adapt more quickly in uncertain environments, to be able to adapt their businesses. Of course, digital transformation is at the heart of what we do. Hopefully, that works out in the end. In terms of the, again, the fundamental demand, as I said, the pipeline remains very solid.
In any of these conversations, we haven't seen customers saying, "Hey, we're just never going to do this project, cancel the project." In fact, again, we won't know until we actually put paperwork in front of them and they have a decision to make as to what they're actually going to do, whether they're going to downsize or not, or ramp more of it than they originally thought about doing. That remains to be seen here as Q3 and Q4 ultimately play out. I guess the other thing worth talking about, since you're asking about pipeline, pipeline quality, as I think most of you know, earlier this year, we announced a transformation of our go-to-market organization. It was really an evolution of the direct sales organization and sales marketing customer success organization that had primarily been focused more on geographies.
What we're doing is moving more towards verticals, so focusing on the core verticals that we're already strong in: industrials, federal aerospace and defense, automotive, electronics, high-tech, and med tech. Really trying to align all three pillars of that go-to-market organization around those verticals with specific industry expertise to be able to make sure that we're better understanding our customers' challenges, better able to actually help them solve those challenges, and ultimately, hopefully, drive incremental growth for PTC as well. In that transformation, we actually had a kind of a one-time expense of about $20 million associated with this, which involved both some severance as well as one-time consulting fees that was actually recorded in our first quarter as we let certain positions go. Again, this was never intended to be a cost-cutting exercise.
In fact, we intend to hire that run rate back, just different positions, different capabilities in the organization. That can create some turmoil. The planning for that was done really in Q4, Q1. The execution of that change was really kind of tail end of Q1 and into the beginning of Q2. I promise I'm getting to your question about pipeline. There was the possibility, potential for disruption. I guess I would say here, as we sit now, partway through Q3 and can look back on Q2 and even Q1 and reflect on that, we haven't seen any, I'd say, quantifiable signs of disruption as a result of that. Pipeline creation was actually up in Q2, higher than it was in Q1, higher than it was Q2 a year ago. I think the pipeline is good.
As part of this transformation, we also brought in a new leader, sales leader, Chief Revenue Officer named Rob Dahdah, who has a great reputation. I have had the pleasure of getting to know him here now for the past few months. It has been great working with him and watching him work. He brings his own brand of discipline as well around, we will call it, sales process, pipeline hygiene, etc. Those changes, his cultural change, the changes to the vertical, I think we are beginning. We are in the early stages of finding our stride with that. I think that is going to be a multi-quarter journey, but ultimately should yield results for PTC.
If I could double-click on this verticalization of Salesforce, how can you think we track some of the progress that you've shown here? Any metrics that you would suggest we focus on to monitor beyond the $20 million that you mentioned and the changes in some hiring efforts? Anything you think we can track to see the progress here?
Yeah. I mean, I think ultimately, the intended impact is that we see incremental net new ARR growth. In the meantime, I think it's a good question. We can take that back and see if there's other kinds of metrics that we could provide to provide some more transparency, I guess, to those who are interested in watching and seeing how we think that progress is happening. I think it's a great question. Thank you.
It is very impressive because obviously, one of the names we look at is Procore. It's not really a competitor per se, but they are going through a transformation right now and have seen some disruption. It is quite impressive that you're not seeing that.
So far.
Yeah. Switching gears slightly, in terms of kind of demand for your software, obviously, software is increasingly more embedded in hardware these days. What sort of opportunity does this create for PTC, and which product lines would benefit most?
Yeah. Another great question. Totally agreed. Software is becoming more and more pervasive in almost every product. That, of course, creates opportunities as well as challenges for companies that are building products. A lot of these companies have relied on PTC for CAD to help them design the mechanical product, for PLM to help them with configuration management, platform opportunities, etc., as well as ALM or application lifecycle management. A couple of years ago, we bought a business called Codebeamer that does exactly that and augments some of our already existing ALM capabilities. Codebeamer is particularly good in test and requirements management. For our customers, this has been a pretty big focus, especially for companies that are in highly regulated industries where they need to be able to have traceability for changes and traceability for changes made to the product or the software code.
We have actually seen a lot of interest and growth in Codebeamer since the acquisition. Obviously, the ALM piece is where we would see the main thrust of that opportunity. That said, because it is hardware software going into hardware, it is really managing that full product configuration. Therefore, I think that the combination of ALM and PLM is a pretty powerful one, pretty powerful one for our customers.
Great. Thank you. Kristian, how about the growth algorithm for PTC? How should we think about new logos contribution versus cross-sell and upsell? What role does the price increases play in that?
Yeah. It's another good question. I think if I were to stack rank the elements of growth, I think the largest component is really upsell and cross-sell or sorry, upsell and expansion. The difference being expansion is I have whatever, 10 seats of Creo and I want to add 5 more. Upsell being I have 10 seats of this particular package of Creo, I need incremental functionality. So I still want 10 seats, but I want incremental functionality, which would be the upsell. That's probably the largest component of the growth, followed by cross-sell. I think it would drop down a fair bit from there, and you would see the impact of pricing. I think the fourth element, which comes after that, would be new logos.
Understood. Obviously, you've been in this space for a very long time, leading positions. Can you update us what you're seeing in terms of competition in the U.S. and in Europe and other international markets? Are you seeing any incremental changes, anyone getting more aggressive in certain parts of the business?
As you all know, it's at the same time a very dynamic industry that we operate in, but also a very mature industry, right? There's kind of three to four primary market participants in CAD and PLM as the core products. And we've all been around for PTC is actually celebrating its 40th year as a company this year. We've been around for a long time, as well as the competition. I mean, to be honest, you just don't see a ton of massive share shift between these industry players. It happens every once in a while, but it's not that common.
I feel like on the most recent call, your team alluded to some competitive displacements among sizable accounts. What drove these displacements, and how much of an opportunity is green shoots versus in-house systems or competitive displacements that you can follow through with?
Yeah. I mean, again, I think the one place maybe where we see more competitive displacements is particularly with Onshape, as an example, which is really the industry's only SaaS-native CAD platform. That is definitely seeing some interest out there still relative to overall PTC, small numbers, but interesting prospects for sure. In terms of expansion or competitive displacement within the other products, it really varies by product category, whether it is CAD or PLM or SLM. In SLM, you are often replacing homegrown systems or no system at all. In PLM, you may just be expanding into another division or another product line. Same thing with CAD, really. Many customers, companies, especially big ones, actually have multi-CAD environments. They might have multiple PLM systems operating for a variety of reasons. They have acquired companies, they are divested companies, etc. It is a pretty interesting landscape.
Interesting. Switching gears to AI, PTC has begun to roll out AI SKUs across all of its products, ServiceMax AI and a few others. Should we expect to see embedded AI agents across these products?
Yeah. This is certainly an area of high interest and we believe opportunity for PTC as well. To be clear, the only AI agents that are actually or SKUs that are actually GA at this point are the ServiceMax ones. That's where we started, but are also hard at work with AI in, I think, Codebeamer would be next, and then Windchill. I think maybe the right way to think about it is the first version will be AI agents for ServiceMax within ServiceMax and Codebeamer within Codebeamer and Windchill within Windchill. I think that'll ultimately be followed with agents that help connect across those platforms and then ultimately connect to other enterprise platforms that our customers use, whether it's an ERP system or an MES system, to help bring this information all together. Again, ServiceMax recently GA'd.
I think the Codebeamer and Windchill parts should be available. I don't want to say a specific date, but I would say I would look toward the end of this calendar year.
Okay. End of this calendar year. Very interesting. Also, in terms of your M&A strategy, you recently completed a small tuck-in with IncQuery Group. Can you provide a bit more color on that deal? Generally, how do you think about M&A in terms of capital allocation going forward?
Yeah. I think that the IncQuery Labs was actually a great fit for PTC. They did or still do a lot of work in ALM, deep expertise in ALM, and a lot of the work they did was actually specifically with Codebeamer as well. Excuse me. In a way, I think you could think about this acquisition for us as an acqui-hire, as a way to get 50 or so really talented ALM experts in-house with us to help further accelerate development with Codebeamer in particular.
Interesting. In terms of the guidance that you provided beyond ARR, can you give us a bit more color and thought process? What gives you the confidence that you'll be able to hit some of those new revenue metrics and specifically the free cash flow metric? How does that guidance increase reconcile with an update of your ARR outlook?
Yeah. It's a great question. Just to clarify, we started the year with free cash flow estimates for the year of between $835 million and $850 million. Here with our most recent results, we updated that to $840 million-$850 million, which takes into account both the performance that we had in the first half as well as our outlook for the second half. We had pretty strong performance in the first half. We slightly beat our guidance for Q1 and Q2. That was helpful. As we think about the back half, remember from a cash flow perspective, most of what we're going to collect this year will have already invoiced by the end of Q3, right?
You'll probably get some of the July invoicing of month one of our Q4 will still collect, but the majority of what we're going to collect this year will have already been invoiced. We have pretty good line of sight into what we think our collections are going to be this year and as well as what our kind of cash outflows are going to be. I think we felt pretty comfortable with raising the low end of the ARR or the cash flow guidance range.
Makes sense. Obviously, it's still very early to talk about 2026. I realize that you haven't done the budgeting yet, but do you feel comfortable suggesting that your free cash flow next year is likely to be higher than free cash flow this year? Is that fair?
Yeah. I think that is fair. Maybe I try to characterize it like this. Again, as a reminder, almost all of our business is subscription contracts we bill annually in advance. We're pretty religious about that. As we think about this year in that $840 million-$850 million range, going into next year, I think that actually is a pretty good baseline place to start. Let's just assume somewhere in that range. I would remind everybody that this year, as I mentioned earlier, we had about $20 million of kind of one-time cash outflows related to the severance and the consulting fees for the go-to-market transformation. I think you could add that $20 million back on top of that.
In addition, we have been paying down debt as well as we restarted the share repurchase initiative that we have as well, but started paying down, been paying down pretty religiously our debt. I would think that we'll have less cash interest payments next year as well, which would also take free cash flow up from there. There's an offset, which of course is our cash taxes are going to go up by a fair amount next year, pending the impacts of any legislation that may or may not get passed, particularly as it relates to Section 174 of the Revenue Code, which has to do with the capitalization of R&D expense or the treatment of R&D expense. That's way too early to make any judgment calls on A, whether they're going to do anything, and B, what that might actually look like.
In the meantime, I would expect our cash taxes to go up, which would be an offset to the growth that we just talked about. You have to get into the kind of three or four other main variables, one of them being we actually have to see where we end this year. Number two, we need to complete the budgeting and the planning process, which would include how much incremental we expect to grow next year still, and then even based on that, how much incrementally we would expect to invest into the business. Those are two variables that we have not sorted through the details on yet. My last and most favorite variable is, of course, foreign exchange rates, which have been highly volatile and can have a meaningful impact one way or the other.
Really, it's the FX rates on September 30 as we finish this year and start thinking about the plan for next year that matter most. A lot has happened with FX rates over the last six months, and who knows what will happen over the next six months.
Great. Maybe this is a good time to poll for questions. Anyone in the room?
All right. Thank you. Just maybe structurally wanted to get your views on if you look at the installed base of CAD and PLM seats within the DM auto OEMs and you compare that to where the installed base of CAD and PLM seats is within some of the Chinese automotive manufacturers, which is sort of, I guess, a 10th almost in terms of the numbers of seats. And maybe those are a little bit too low because the supply chain isn't particularly well penetrated with PLM. How do you see that rebalancing over the long term? Do you see Chinese OEMs in the automotive space scaling up their design capabilities as they expand variants, or do you see the, I guess, the developer or the more legacy OEMs coming down?
What are your thoughts around that sort of over the next five, 10 y ears, how that plays out?
You might want to talk to Alexei's counterpart, who's the automotive analyst, to get a better feel on that. For us, our business in China is really well under 5% of our total business. Not trying to dodge the question, but I think you probably want an expert to answer.
Any more questions? If not, I have one more, Kristian. Obviously, you spoke about deleveraging. You've done extremely well last year in the last 12 months, ratio now to 1.5 times. What is the near-term target that you feel is reasonable, and how would that go versus your strategy to do more buybacks? You announced a pretty significant program last year.
Yeah. I think that's a great question as well. For anybody that's been kind of following PTC for a number of years, we said that we had a plan to return, historically, what we said is 50% of free cash flow to shareholders, assuming that our leverage ratio was kind of under three times. We had done a number of acquisitions over the past few years that we really focused on deleveraging. This year, in particular, we had a $500 million bond that was coming up, so we were planning on paying that off. Even coming into this year with a range of $835 million-$850 million, we said we were going to pay off the bond, which came due in February, and then we were going to buy back about $300 million worth of stock this year.
We did $75 million in Q1, $75 million in Q2. We said we'll do another $75 million in Q3. We have been doing what we've communicated we were going to do on that front. We have also, I think for those who have been following, somewhat modified the language around the 50% of free cash flow being used towards buybacks. Really, I think the way that I would think about it is we do not really have any intention of running this business at a 0.0 leverage. What we have also said is that we really, because of the stability of the cash flows coming in, the subscription nature of it, we really actually are trying to get to as low a cash balance as we can operate with.
Beyond that, assuming that we do not want to use any for M&A, I think the implication there is that we would return anything that was not otherwise used to shareholders in the form of buybacks. I think that is a decent framework to think about where we are. The good news is we have a $2 billion repurchase authorization, which is good through 2027. We will have done in and around $300 million this year. I think that gives us ample flexibility as to how much and how and when we think about executing against the rest of that authorization.
Thank you very much, Kristian. Great to see you at our conference. Thank you for coming.
Thanks very much for having us.