Good afternoon, ladies and gentlemen. Thank you for standing by, and welcome to the PTC 2019 third quarter conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. This call is being recorded. If anyone has any objections, you may disconnect at this time. I would now like to turn the call over to Tim Fox, PTC's Senior Vice President of Investor Relations. Please go ahead.
Thank you, Sue. Good afternoon, everyone, thank you for joining PTC's conference call to discuss our fiscal Q3 2019 results. On the call today are Jim Heppelmann, Chief Executive Officer, and Kristian Talvitie, Chief Financial Officer. Before we get started, please note that today's comments include forward-looking statements, including statements regarding future financial guidance, these forward-looking statements are subject to risks and uncertainties and involve factors that could cause actual results to differ materially from those expressed or implied in such statements. Additional information concerning these factors is contained in PTC's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included on this call represent the company's view on July 24th, 2019. PTC disclaims any obligation to update these statements to reflect future events or circumstances.
As a reminder, we'll be referring to operating and non-GAAP financial metrics during today's call. Discussion of our operating metrics and these items excluded from our non-GAAP financial measures, and a full reconciliation of GAAP to comparable non-GAAP financial measures under both ASC 605 and 606 are included in this afternoon's earning release materials and related Form 10-K. I'd also like to remind everyone that starting with fiscal Q1 2019, we adopted ASC 606 on a modified retrospective basis. In our press release and prepared remarks, we've provided results under both 606 and 605, as well as under reconciliations between the two. We've also provided guidance under both standards. Please note that the SEC requires the presentation of 605 results for comparability with prior year results. For such comparability, our discussion on this call will focus on 605 results, unless otherwise stated.
Please note that certain operating metrics, such as bookings and ACV, and non-GAAP financial measures, such as free cash flow, are the same under both 606 and 605. With that, let me turn the call over to Jim.
Thanks, Tim. Good afternoon, everyone, and thank you for joining us. Before we discuss our third quarter results, I'd like to address the bigger picture regarding our performance to date and outlook for the balance of the fiscal year and discuss why, despite having to navigate some near-term challenges, we remain confident about PTC's long-term growth opportunity and our ability to drive significant value for our customers and shareholders. Through the first three quarters of fiscal 2019, we've seen relatively strong performance on revenue and ARR metrics. On the bookings front, we're disappointed with our performance relative to the outlook we provided at the outset of the year. With Kristian coming on board and the benefit of his fresh perspective looking at our first three quarters of performance and full-year outlook, we studied how the year has evolved so far versus our plan.
Through this analysis, it's become clear that the subscription transition has different impacts on different areas of the business. To be clear, there have been many areas of strong performance, especially in our growth business of IoT and AR. What we had not anticipated were some aftereffects of our subscription transition that are causing stress in the system and creating meaningful headwinds to bookings growth this year. You can see these effects in our Q3 booking results and again in our Q4 guidance. Kristian will elaborate on the details, the subscription cutover has created two specific short-term challenges that I'd like to discuss. First, software bookings in geographies such as China and Russia, which are sold primarily through our channel, have declined materially following the end of perpetual license sales there.
Fortunately, we don't have a significant exposure in these countries, but this decline nonetheless cost us a few points of bookings growth versus our plan. The second issue related to subscription is a year-over-year decline in large VPA conversions, VPA being volume purchase agreements. As we cycled through the cohort of our largest support contracts over the past three years, we converted many of these large VPA customers to subscription. For customers that did not convert, in most cases, we increased the support run rate. This support price increase boosted ARR growth, but note that per our convention, we did not count the incremental support ACV as new bookings. As the customers who did not convert come up for support renewal again, we get another chance to try to convert them to subscription.
However, we're seeing a much lower hit rate on this second pass, as these customers are less incented to convert given that they've already accepted the higher support pricing. We'll need to adjust the offering, but in the meantime, this year-over-year slowdown in large VPA conversions cost us a few more points of bookings growth. The final factor, which is not specifically related to the subscription transition, was our execution on the resource shift from our productivity zone into our growth business that we discussed at length last quarter. The shift has benefited our growth business significantly. It continues to have a great year, and bookings were strong again in Q3.
We've closed the sales hiring gap to the point that this is a non-issue in the growth business now, but of course, we need to keep the recruitment engine going to meet our ongoing growth needs. As we've discussed previously, a side effect of the resource shift has been a bookings deceleration in the productivity zone that was steeper than contemplated in our fiscal 2019 plan, and this too cost a few more points of bookings growth. When taken together, these challenges have combined to create a double-digit bookings growth headwind. They represent a one-time step down to what I see as a new normal bookings baseline. The good news is that this new baseline will be a lot easier to grow from going forward.
It's important to note that inside a year where we encountered the strong bookings headwind, there are many other things in our core and growth businesses that worked well. In fact, our core CAD and PLM businesses, together with our IoT and AR growth businesses, are expected to grow a combined 20% this fiscal year in those areas not impacted by the headwinds I just reviewed. The core CAD and PLM, and the IoT and AR growth businesses would be on track to deliver the low double-digit bookings growth we had planned for, if not for the unplanned headwinds that have reduced the forecast to low single-digit bookings growth this year.
I do want to stress here how important it is to remember that we are talking about a bookings growth slowdown, whereas ARR, a better indicator of future growth in a subscription business, has increased double digits in the same period as have margin and cash flow. After what's turning out to be a transitional FY 2019 that's resulting in a push-out of our $850 million free cash flow target to 2024, it's fair to ask what gives us confidence in achieving this plan. Frankly, it's because we are fundamentally in a stronger position now than we were a year ago on almost every metric, and many of these one-time challenges are now behind us. Compared to June of 2018, when we first established this five-year target, we now have significantly more ARR, more margin, and more cash flow, and we have higher bookings and lower churn too.
Heading into fiscal 2020, we'll be growing off a run rate that, as compared to 2018, has significantly less exposure to the one-time headwinds I've been discussing. I trust you all believe that the $850 million of free cash flow remains a very attractive target, even if it happens in 2024, and now the bar to get there is a lot lower than it was a year ago. The bottom line is that the subscription transition effects have a short-term impact, yet we're more confident than ever about our ability to achieve that $850 million free cash flow target. We also remain confident that PTC will emerge as one of the premier public software companies in the next few years, and that we'll create a lot of value for customers and shareholders in the process. With all that as context, let me turn now to our Q3 results.
Our financial performance across revenue, earnings, and ARR was solid once again this quarter. Revenue was in line with guidance. Operating margin was at the high end of guidance. EPS came in at the high end of guidance. Q3 ARR of $1.1 billion grew 13% year-over-year, an improvement of 200 basis points in growth rates over Q3 of 2018, reflecting the strength of our maturing subscription business. Excluding the currency impact related to our guidance, Q3 bookings of $110 million was at the lower end of the guidance range, primarily due to channel performance, mostly attributable to the phase-out of perpetual that I mentioned earlier. On a constant currency basis, Q3 bookings were flat year-over-year against very strong Q3 of 2018 performance when we posted year-over-year bookings growth of 26%.
Let's turn now to our high-growth IoT business, which in terms of reporting includes our AR business. I mentioned that IoT bookings were again solid in Q3. Consistent with recent quarters, IoT bookings came from a mix of new customer acquisitions and from expansions, with the latter accounting for over 60% of Q3 ThingWorx bookings. Q3 was also another strong quarter for large IoT deals, with five seven-figure deals, including four expansions and one new logo deal. The large expansion deals came from a variety of vertical markets for both smart connected processes or factory use cases and smart connected product use cases. Notable wins came from Eaton, a diversified power management supplier, from NCR Corporation, a leading global provider of digital solutions for retail, hospitality, and banking, and from UTC Aerospace, who's further deploying ThingWorx in their factories. Turning now to our Augmented Reality business.
We delivered another strong quarter there as well. The number of six-figure AR deals, which began to accelerate in Q2, continued to increase in Q3, driven in part by the early success of Vuforia Expert Capture, which was just launched in April. Clearly, the recent trends we're seeing in AR are very promising and providing more evidence that industrial AR adoption is broadening and that this business is blossoming into a big hit for PTC. Elsewhere in IoT and AR, we are pleased to see our strategic alliances continue to gain traction. On the Rockwell Automation front, the pace of business accelerated again in Q3 with 34 deals closing in the quarter, including two firsts for the alliance. This quarter marked the first Vuforia Expert Capture deal sold by Rockwell Automation, which was a sizable order in the pharmaceutical space.
We were also pleased to see the first smart connected product deal closed by Rockwell. The SCP use case is an exciting adjacent market opportunity for Rockwell Automation. They can sell the FactoryTalk InnovationSuite into machine builder customers who embed Rockwell controls into the products that they, in turn, sell into the market. With over 1,000 opportunities in the pipeline and a positive outlook for Q4, our confidence around the success of this strategic alliance grows stronger every quarter. Turning now to the Microsoft alliance. Q3 performance was once again strong, with 36 deals closed in the quarter, along with a notable increase in average deal size, fueled by three seven-figure transactions. Bookings doubled sequentially over Q2.
Again, this past quarter, the composition of Microsoft deals extended beyond the smart connected product use case, with a meaningful uptick in hybrid cloud factory deployments and pure cloud deployments hosting PTC's augmented reality solutions. You may have heard this at LiveWorx, but PTC was named Microsoft's partner of the year in manufacturing, and again, separately, in mixed reality. We were also runner-up to our joint partner, Accenture, in IoT. Clearly, Microsoft has tremendous momentum with Azure right now, and we're pleased to be so closely aligned with them in IoT and AR and manufacturing. To summarize on IoT and AR, Q3 provided another strong data point suggesting that adoption of these technologies continues to accelerate across the range of vertical markets, geographies, and use cases. Let me turn now to our core CAD and PLM business.
Q3 combined CAD and PLM bookings declined modestly year-over-year against a tough comparison in Q3 2018, with the biggest drivers being a bookings decline in our CAD channel related to the subscription transition headwinds I mentioned earlier. On a positive note, we continue to see good signs of early traction for Creo Simulation Live, our groundbreaking CAD solution using real-time simulation technology from our strategic alliance with Ansys. We closed 76 transactions in the quarter, with average deal sizes well above Q2 levels. We landed the largest follow-on order to date with a leading defense contractor that intends to deploy Creo Simulation Live to hundreds and potentially even thousands of engineers across multiple business units. While it's still early, we're encouraged to see a growing pipeline and commercial adoption that's beginning to accelerate.
We were pleased to see the continued solid performance of our core PLM business, which delivered above-market bookings growth in the quarter, driven by strong expansion activity. Customers increasingly understand the role of PLM as a backbone for digital transformation, and they're investing accordingly. To wrap up my comments, from a growth perspective, our core PLM business is performing well, and our high-growth IoT and AR businesses continue to gain significant market traction. We remain confident that our CAD business is fundamentally well-positioned and that the subscription-related headwinds are transitory. With that, I'd like to welcome Kristian to our earnings call and turn it over to him.
Great. Thanks, Jim. Good afternoon, everyone. Before I review our results, I'd like to note that I'll be discussing non-GAAP results and guidance. All growth rate references will be in constant currency. As Tim mentioned earlier, we adopted the new rev rec standard ASC 606 under the modified retrospective method on October 1st, 2018. For year-over-year comparability purposes, I will be discussing our outlook and results under 605 unless otherwise stated. Please note that certain operating and non-GAAP financial metrics such as bookings, ACV, and free cash flow are the same under 6 05 and 606. We've provided ASC 606 guidance in our press release and our prepared remarks. Starting with the Long-Range Plan. We're resetting our Long-Range targets. To be clear, we remain committed to achieving $850 million in free cash flow.
Given our year-to-date performance and the current outlook for this year, we believe that it's appropriate to plant that stake solidly in fiscal 2024 ground. As Jim stated in his opening remarks, we're not satisfied with our overall performance this year. Transforming a complex global company comes with challenges, but fundamentally, there's a very positive growth story here. The changes made throughout the course of this year have put in place the foundation for PTC to become a premier, high-growth, high-profit, recurring revenue software company, and we remain firmly committed to that objective. We will provide more detail around both our fiscal 2020 and long-range targets under ASC 606 in November on our normal timeline. Now, turning to guidance. Frankly, we're taking a prudent approach.
There are some ongoing effects of the subscription transition within our channel, primarily related to the end of life of perpetual software in certain geographies, and we don't expect this to improve in Q4. Additionally, on the direct side, our support conversion program is expected to remain a bookings headwind in Q4, particularly as it relates to large deal volume, and we're not forecasting any mega deals in the quarter. Clearly, the macro environment is also not helpful at this point, and while we don't feel that it was a major factor in our Q3 performance, we are watching the situation carefully and are mindful of it in our Q4 outlook. For the full year, we now expect bookings in the range of $458 million-$468 million. This represents growth of 1%-3% on a year-over-year basis.
We expect a full year subscription mix of 84% and to exit the year in Q4 with about a 93% mix. We are trimming fiscal 2019 total revenue by $8 million at the midpoint to a range of $1.31 billion-$1.32 billion, which represents growth of 7% year-over-year, driven by software growth of 9%, despite a 1,600 basis point increase in subscription mix. Recurring software revenue is now expected to be approximately $1.2 billion, or growth of 13%, and is expected to be 94% of total software revenue for the year. Our fiscal 2019 operating margin guidance is 22%-23%, representing a year-over-year increase of approximately 400-500 basis points, reflecting PTC's well-demonstrated approach to controlling spending. We now expect operating expenses to increase only 3% year-over-year in constant currency.
Our effective tax rate is expected to be 18%, resulting in non-GAAP EPS of $1.73 - $1.78, which is approximately 21% growth at the midpoint. Based primarily on our expected bookings performance for fiscal 2019, we're reducing our free cash flow guidance by $30 million to a range of $235 million-$245 million, and adjusted free cash flow of $260 million-$270 million, which excludes cash payments for restructuring of approximately $25 million. As with operating margin, we expect free cash flow to accelerate significantly in fiscal 2020 as the subscription model matures. Moving now to our third quarter results. Q3 bookings at guidance FX were at the low end of our guidance range, primarily due to channel performance in certain regions and subscription conversion activity.
Outside that, we saw booking strength in the Americas across all product offerings, and we saw continued strength in our high-growth IoT business and solid growth for our PLM offerings. Our solid Q3 financial performance reflects the strength of our subscription model with revenue, margins, and EPS all within or at the high end of our expectations. Moving on to the income statement. Under the new rev rec standard ASC 606, total revenue in Q3 was $296 million, operating margin was 13%, and EPS was $0.23. Under ASC 605, total revenue in Q3 was $323 million, up 6% year-over-year, and software revenue was $282 million, also an increase of 6%, despite a 1,300 basis point increase in subscription mix. Subscription revenue grew 39%. Please refer to our prepared remarks document on our website, where we reconcile our 606 results to our 605 results.
Importantly, ARR grew 13% year-over-year to $1.088 billion. This is a metric that I'd like to draw more attention to, especially given that we're now primarily a subscription business. As I mentioned at LiveWorx, in fiscal 2020, we'll be doing away with the current reporting framework, which frankly is anchored in a perpetual company view of the world. When we provide more detail on fiscal 2020 and the revised LRP targets in November, we will be using the go-forward 606-based reporting framework and using financial and operating metrics that are important to a subscription company. Suffice it to say that ARR and cash flow will be critical elements of that framework. Continuing through the 605 P&L, Q3 operating margin of 19% at the high end of guidance reflects a 100 basis point improvement year-over-year.
EPS of $0.36, also at the high end of our guidance range, reflecting continued discipline on total spending. Moving to the balance sheet, we remain committed to a balanced capital strategy. We successfully completed the $1 billion ASR that we entered into in Q4 of 2018. In fiscal 2019, we intend to repurchase shares equal to at least 40% of our FY 2019 free cash flow. As a reminder, last month at our investor meeting, we increased that commitment for fiscal 2020, and starting next year, we've committed to return at least 50% of our free cash flow to repurchase shares. In Q3, we used $25 million to repurchase 287,000 shares at an average price of $87. We repaid $40 million on our revolving credit facility.
Wrapping up, just to be explicit about our Q4 guidance under ASC 605, we expect bookings in the range of $135 million-$145 million. Total revenue is expected to be in the range of $330 million-$338 million. Q4 operating expenses are expected to be $189 million-$191 million, resulting in operating margin in a range of 21%-22%, and EPS of $0.42-$0.47. With that, I'll turn the call over to the operator, and we can begin the Q&A.
Thank you. We will now begin the question and answer session. In order to provide everyone the opportunity to ask questions, we ask that you limit your questions to one question only. If you have further questions, simply reinsert yourself back into the queue and your additional questions will be answered as time permits. To ask a question, please press star followed by one. Please ensure your phone is unmuted and record your name clearly when prompted. Again, that is star followed by one to ask a question. If you need to withdraw your request, press star two. One moment please for the first question. The first question comes from Ken Talanian with Evercore ISI. You may go ahead.
Hi, Ken.
Hi. Thanks for taking the question. Could you give us a sense for the percent of L&S bookings relative to guidance that you've already closed in the quarter compared to what you typically close in July?
I don't actually think we have that data in front of us. I think it so far feels like a pretty normal quarter for Q4.
Okay.
If you're really going to, do we see some macro thing unfolding? I think the answer is no.
Okay. I guess you noted in the prepared remarks you don't anticipate closing any mega deals in 4Q. Just to clarify, were there any deals in your guidance that are no longer there? If they're in the pipeline, what are the main issues to getting them closed?
First, just to remind everybody, if a deal is more than $1 million in PEB booking, we call it a large deal, and a mega deal we refer to as more than $5 million in PEB bookings. Keep in mind that a lot of times these big deals might be associated with a conversion. Because we don't see the conversions happening at the rate that we had been enjoying, let's say, a year ago, we're a little reticent to assume that a deal that might be a large deal could be grossed up to a mega deal. There's no deals we're losing. There certainly are deals that could come in smaller and meaningfully smaller than we might have expected a quarter or two ago when we were more confident about the impact that conversions would have. I think we're just being conservative.
We'd love to surprise you and show up with a mega deal, but I think, at this point, given the trend that we see in the data, we don't feel like it would be prudent to guide that way.
Great. Thank you.
Thank you. The next question comes from Ken Wong with Guggenheim Securities. You may go ahead.
Hey, Ken.
Great. Thanks for taking my question, guys. You guys mentioned VPAs or you guys had a tough time converting those. Of the VPAs you guys have remaining, I guess one, what percent of VPAs are still left to convert? As we think about when you convert them, what's the potential uplift that we could potentially expect here? Are you going to have to take that down from the kind of the 20%-25% you guys have been seeing in the past?
You want to take that one?
Yeah, sure. I think that we can break the conversions out into two or three different cohorts. There's the large VPAs, of which we have converted approximately half of them over the past two to three years.
Let's say half in the first pass.
In the first pass. There's still more than about a couple hundred left that have a significant support run rate. I think if we look over the past three years where we were doing the conversions on the first pass for the large ones, we were seeing uplifts in the 40%-50% range off that run rate. We think there's still a significant opportunity for customers to get value out of this program as we modify it. There's a couple other tiers. There's still a tail of a mid-tier, where there's a significant number of customers there as well. There's obviously the channel customers, and frankly, we've actually seen conversions in the channel space increasing this year significantly over the run rate from last year.
Yeah, maybe just to clarify some data here associated with what Kristian said. The number of conversions is up. However, it's up most in the channel space, where the conversions are smallest. It's flat to up a little bit in the direct, but not Volume Purchase Agreement cohort. In the Volume Purchase Agreement, the biggest accounts, it's down materially. While the number is up, the dollar value is down materially in aggregate.
Got it. Great. Thanks for the clarification, guys.
Maybe to clarify one other comment I said. Kristian mentioned we got about half of these customers to convert in the first pass. Ultimately, we plan to convert all of them. It's just, we need to go back and look at the offering. Andy Miller always used to talk about the proverbial carrot and stick, we need to go back to that conversation and think about how to make the carrot sweeter and how to create another stick if need be. We're going to do it. Over time, it's inconceivable that they won't all convert because everything we sell them from this point forward will be on a subscription contract. Over time, even if they prefer perpetual and support, it's going to get watered down with more and more subscription. We'll get them all.
It's just we're not getting them as fast here in fiscal 2019 as we sort of had assumed we would. We need to go do some more work to rethink the offering and go back and try to get them in a second pass.
Got it. Very helpful, guys.
Thank you.
Thank you.
The next question comes from Saket Kalia with Barclays. You may go ahead.
Hello, Saket.
Hey, guys. Hey, Jim. Hey, Kristian. Thanks for taking my question here. I'll stick to the one-question rule. Maybe the few drivers that we've talked about here for the lower outlook for Q4, Jim, if we put some of the pricing things aside, can you just talk about just fundamentally the health of underlying demand in CAD and PLM that you've seen as you've talked to customers? I know you talked about you're not really seeing anything kind of unfolding in the macro front here in July, but I'd love if you could expand on it. Also, just given what one of your competitors said this morning, just about the competitive dynamics, I was wondering if you could talk about market share dynamics in those core CAD and PLM businesses as well.
Yeah. Saket, I think if you set aside the situations that have external influences like VPA renewals or conversions, and this discussion about certain geographies that don't really like perpetual. If you say, aside from that, how does demand look? How's the business doing? The business is doing very well. The combined IoT, AR, CAD, and PLM business were not affected by those external forces, is up 20% year-over-year. Bookings up 20%. I think we feel like the fundamental demand where companies are buying for the first time, where they're expanding, I think is very good and our competitive dynamic is very strong, and we're seeing good success with the Ansys stuff and so forth. Again, these other effects, though, are material, and so they've taken a lot of the wind out of the sail.
What should be a double-digit bookings growth year overall gets watered down to what's going to be a single-digit bookings growth year. That's unfortunate, but we feel like because the underlying fundamentals are so strong and because these headwinds have now become a diminished size, the base that the headwinds apply to is actually becoming quite small. We feel pretty confident going forward. We feel like this year we didn't make the progress we hoped to this year, but when we look going forward, we feel just as confident as we ever did.
Anything on market share that you could talk about in CAD and PLM, Jim? Of course, I'm referring to a little bit about what Dassault talked about on their call earlier. Any sort of share shift that you're seeing in CAD and PLM?
I think if anything, PTC is holding its own. Now, you can say in the quarter our CAD business didn't grow, but I think the SolidWorks business grew 4%, so I don't think really Dassault is crushing it either right now. I think there's not a significant share shift going on. I think, again, if we don't talk about geographies where we have this perpetual to subscription thing happening, which actually has nothing to do with fundamental demand, it's more a business model change. If we look then generally at the SMB and sort of medium-sized account, it's very strong. I don't know. We certainly don't think we're losing any share. I think from quarter to quarter, there can be little ups and downs brought on by external influences like we're seeing right now.
I think fundamentally, we feel like the CAD business, the PLM business, and the IoT and AR businesses are fundamentally very competitive, very strong, and we expect that we're going to be in a position to have a strong growth year next year.
Very helpful. Thanks.
Thank you. The next question comes from Matt Hedberg with RBC Capital Markets. You may go ahead.
Go ahead.
Thanks. This is actually Matt Swanson for Matt. Jim, I know at the beginning of the year when we talked about restructuring towards growth areas, the focus was not to do this in a bunch of small steps, but to line the company up with kind of a long-term strategic outlook. After the large shift, do you feel that at this point, maybe you've over-rotated and maybe need to invest resources back towards CAD and PLM? Or is the disruption just kind of a natural risk that comes with a change of that magnitude?
Matt, let me be clear. We did not shift resources out of CAD and PLM into IoT and AR. We shifted resources out of places like ALM, SLM, and what we call our classic product groups, small brands that rarely even get mentioned on an earnings call. We shifted resources out of low-growth, high-margin businesses to make them potentially lower growth and higher yet margin, and moved those particularly go-to-market resources into our high-growth business, where we felt like to fuel the growth, we needed a lot more resources. Yeah, the consequence of that was successful on the high-growth business. We're getting good growth. We had actually thought we'd give up some bookings growth ground, and we gave up more than we expected. Now, it's not worth putting resources back there. Those businesses are small to begin with, and they're even smaller now.
They're very highly profitable to us. They're kind of our small cash cows that don't get talked about that much, but help generate profit for us. The size of those businesses is small enough that what happens next year is not really going to be that impactful. They were pretty small already from a booking standpoint, and having given up some ground this year, they're actually pretty small going forward. We would not put resources back there. We hope to see them stabilize and be flat next year, and that would be just fine. They cannot go down as much next year in terms of bookings as they did this year because there isn't room to do that, just to put it in perspective.
Separate from this discussion about bookings, I want you to understand the revenue and profit is going up in these businesses because, in fact, the churn rates are very low and the bookings still exceed the churn. The size of these small, profitable businesses is growing, and the profit, of course, is growing even faster because we've taken quite a bit of resources out. I don't want anybody to think these businesses are in decline. The growth rate of bookings is in decline. The businesses themselves continue to grow in both revenue and profit.
That's helpful color. Thanks.
Thank you. The next question comes from Tyler Radke with Citi. You may go ahead.
Hello, Tyler.
Hey, thank you . Hi. Good to talk to you guys. You talked about a macro backdrop that's not super helpful right now. I was wondering if you could expand on that, and then how do you think about the uptake of IoT in a weaker macro backdrop, especially if some of these projects are more greenfield and a little bit more in the pilot phase. How have you factored that into your assumptions relative to IoT with the macro backdrop? Thanks.
Tyler, I think that the IoT business, frankly, is new enough that we haven't really been through a cycle. Certainly, we have no reason to believe it would be a cyclical business. Frankly, we have evidence to the contrary that suggests it's a secular business. The level of interest in digital transformation is very, very high. The level of demand and the level of bookings growth and revenue growth in our IoT and AR businesses is very high, even in this situation where the PMIs, for example, have kind of broken through 50 on the way down. We think, and the data to date would suggest, that IoT and AR are secular businesses. CAD and PLM, historical, have shown some correlation to PMI. They are a little bit more cyclical. CAD, for example, is largely tied to headcount.
If you hire more engineers, you need more CAD seats. If you're not hiring engineers, you don't. I don't see anybody cutting heads. I just really don't. I couldn't name a single customer that's reducing engineering headcount right now, even though the PMIs are low. I think we're in a funny situation where the job market is so strong. I think also the fears people have about the economy are so sort of short-term, like let's see what happens with China next week, and maybe this isn't a problem after all. I don't think this is a fundamental economic decline. It's just a period of uncertainty related in large part to trade and politics and nonsense like that's got people nervous. They're not acting on that nervousness, it appears, in ways that hurt us.
We don't think, at this point, that the macro situation is any kind of a significant factor. It might be a small factor in tiny pockets. I'll give you one example. A lot of our Kepware software is sold with capital equipment. Somebody buys a machine, they buy a copy of Kepware to go with it. Maybe the sales of capital assets are down in our Kepware business, which is part of our IoT business. That small pocket was a little bit weak, it's not a big business. It's not a big part of IoT, frankly, it wasn't that weak. I think it could be a secondary factor in pockets. It's not, thus far, so far as we can tell, a primary factor in what our issues are here in 2019.
Great. If I could ask a follow-up on the conversion to subscription. You mentioned some customers that kind of proceeded with the maintenance price increase, which caused weaker subscription conversions. What's the plan of attack there in terms of converting those over going forward? Are you having to change your strategy there? Could you just help us walk through what the strategy is? Thank you.
Sure. I think, again, you need to go back and think in terms of these three cohorts. The large direct customers who had Volume Purchase Agreements, all the rest of the direct customers being the second cohort, and the third cohort being all the channel customers. These really are three different situations, and situation one has been challenged, but situation two is okay, and situation three, cohort three, is doing well. I think in the first cohort, we need to go back and sweeten up the value proposition, this proverbial carrot and stick I was talking about. We need to give them more incentives to convert because, in fact, they've already paid part of the tax in the first pass by paying more support costs. We need to sweeten it up, and we'll do that. We'll take a look at it.
I think, like I said, in the end, they will all convert. It's just a question of at what pace. Thus far in 2019, the pace has been slower than we would've expected. We need to go back and think about what can we do to sweeten it up and get them to convert faster. In the end, when you check back in a couple of years, they'll all be subscription customers. I'm pretty sure of that.
Yeah. I might just even say it's not necessarily just sweetening it's making sure that we understand what the real value driver for them is. That there was a current value proposition...
Right
-that resonated very well with a segment of customers.
Yep. With the first half.
Now we just need to go back and make sure we understand what the real value driver is going to be for the second half and adjust accordingly.
Yeah. I might add, there are well-known techniques here. For example, Autodesk raised the support pricing materially, and that created another incentive. We haven't done that yet. Not at all to the extreme level they did, but at some point, we might do that or do some variation of that to incent people really to move on to the subscription business model.
Thank you. The next question comes from Jay Vleeschhouwer with Griffin Securities. You may go ahead.
Yeah. Thank you. Good evening.
Go, Jay.
Hi, and welcome back, Kristian.
Thank you.
Jim, you mentioned a number of short-term and external influences to explain the bookings outlook and bookings performance. You also spoke about some positives in the business, such as momentum in IoT, the momentum behind CAD and PLM and so forth. There remains, of course, that disconnect to the bookings outlook and ultimately the cash flow outlook. I'd like to ask both of you about what may be a missing ingredient here in your commentary thus far, and that is your product roadmaps. There were some detailed questions about that last month at LiveWorx, but to the extent that customers think in multi-year terms about the roadmaps of their vendors, when we think about what you're doing with CAD and PLM, particularly PLM, is there perhaps an issue here? There are positives.
I can see that in the roadmaps, but might there be some issues nevertheless, that are cumulatively adding up to some detriment to your future business outlook? Might there be some solutions that you need to offer in terms of not just pricing and sweetening that you mentioned, but perhaps new configurations, new packaging, something else, or something more fundamentally architectural that is deep down, perhaps what's going on here in terms of the long-term bookings CAGR?
Jay, I'm going to tell you, no, I don't believe that's the case, and I want to say that pretty firmly, because if we go through our products one by one, let's pick the easy ones. There's nothing like our AR product out there. It's phenomenal. People love it. There's nothing like our IoT product out there. We've won every Magic Quadrant-like analysis that's been published in the last four or five years. If we drop down to PLM, in fact PLM had a pretty decent quarter. Sometimes people like to say, "Oh, Aras is disrupting PTC," and I'm telling you, that's hogwash. Our business is doing well. By the way, there was just a third Magic Quadrant-like report published just in the past week here, and PTC is the winner once again.
I'm just saying every piece of external data suggests PTC is best in class in PLM, and our bookings are pretty strong. I feel like the story actually about PLM as a backbone for digital transformation, which, for example, I told in my keynote at LiveWorx, our customers are super excited about that. I don't think there's a product issue in PLM. Let's come over to CAD. If you look at what we're doing with generative design and what we're doing with real-time simulation, there's nothing like that in the market. Customers are so excited about this stuff because the value that you can create in terms of high-quality products coming to market much faster, it's unbelievable. I don't want to say we couldn't do creative packaging and so forth. Yeah, there's always room for that.
If we go to the fundamental competitiveness of our products, I feel like they're incredibly strong in each and every one of these four major businesses of CAD, PLM, IoT, and AR. I don't think that's the problem. Just telling you very frankly and very firmly, I don't think that's the problem. I think the problem is, for example, in China, we used to sell perpetual software to people who would then drop maintenance. We don't want to do that. We either want to sell them subscription software that they pay for year after year, or we don't want to do business in China. There's no point in chasing empty bookings of perpetual software where maintenance doesn't attach at a high rate. China, Russia, places like that. That's one factor, meaning we could take perpetual orders if we want to. We don't want to.
It's not really interesting to the bottom line, to the cash flow strategy and so forth. This issue about these VPAs, that's really just a year-over-year factor. It helped us more last year than it's helping us this year. That means that this year's bookings, year-over-year comparison, are down. Nonetheless, the CAD business, I think, we're not influenced by that stuff. Like I said, it's doing very well. I don't know. I mean, you and I can discuss this sometime when we're together again, but I'm going to say very definitively, I don't think there's a product issue. I feel very confident about our products, and you know I'm a product guy who knows these products inside and out. I talk to customers all the time. I'm very confident that our products are very strong.
Thanks very much.
Yeah. Thank you, Jay.
Thank you. The next question comes from Adam Borg with Stifel. You may go ahead.
Great. Thanks for taking the question.
Go ahead.
At analyst day, you guys talked about the various stages of the IoT journey with pilots, production, and expansion, and I know you called out a few larger IoT expansions this quarter, but I guess when you look at the broader cohort of IoT more broadly, maybe you could just dissect a little bit more how pilots, production, expansion did? Thanks.
Yeah. We said that 60% of the bookings, again, came from expansion. I think that's a pretty healthy number. We have a lot of sales guys out there selling new deals. The new deals tend to be small, and then we come back, and we want to expand them and grow them all into significant ARR run rates. We've seen this pattern of roughly 60% of our bookings coming from expansion for as many quarters as I can remember in IoT. Maybe, I don't know, if 60% is the perfect number or not, but it feels like a good number where a lot of business comes from people buying more, even though far more energy is spent winning new accounts. I think that's probably a decent ratio, and it shows that we're having success upselling and turning small accounts into big ones.
Great. Thanks again.
Yep.
Thank you. The next question comes from Steve Koenig with Wedbush Securities. You may go ahead.
Hello, Steve.
Thank you.
Hey, Steve.
Hey, Jim. Hey, Kristian. I appreciate the granular detail on the headwinds that impacted you this quarter, kind of the discrete nature of a bunch of those things. If we step back and just think about fiscal 2019 versus fiscal 2018, it's kind of a very different year. You've had a bunch of headwinds. If you think about the execution levers you have to pull to make fiscal 2020 a better year than fiscal 2019, how would you kind of rank those things? What are your priorities in terms of what you want to do to maybe execute more consistently?
Well, I think we want to certainly stabilize this productivity zone, ALM, SLM, and what we call classic product scope. Again, I want to be clear, though, we could not have as big a falloff because there isn't room for it. Even in the very worst case where bookings went to zero, it would be less of a headwind. That's not going to happen, and I'd like to see them be flat to up, because I feel like our execution left some business hanging out there that we could go get. That's the main thing. With respect to for example, the problem of geographies that don't want to buy subscription, prefer to buy perpetual, I think we need to keep pushing on that. It may just be a transitory thing, but nonetheless, it's also not a big thing.
We're really talking about a small percentage of our bookings, but that small percentage declined quite a bit in the last couple of quarters. Again, from this run rate, it can't decline a lot more because it's pretty small at this point. I think to me, the big headwinds, there is no room for the headwinds to be that big this coming year of fiscal 2020. Meanwhile, the execution on everything else has been very good. I think if we can just contain the headwinds, then the beauty of how well we're doing in general is going to shine through in fiscal 2020. That's really the way we're looking at it. We'll give you the data in roughly 90 days, but I think you're going to see us come out with a growth plan that we're pretty confident in next year.
It's because we're going to be growing off a baseline that's very solid with a lot of wind in our sails in terms of product momentum, new sales capacity, all that type of stuff that should put us in a position to do well.
Got it. Thanks, Jim.
Thank you.
You're welcome.
The next question comes from Matthew Broome with Mizuho Securities. You may go ahead.
Go Matthew.
Hi, thanks very much. Hi. How is net retention for subscription revenue during the quarter?
Yeah. Hey, it's Kristian. Net retention has been really stable, I think, on a sequential basis for the subscription space. I think we've seen a slight improvement from last year, and we have programs in place to try and continue to improve these over the coming years. No meaningful change.
Okay, thanks very much.
Thank you.
I'm sorry. If I could add, if you look at some of the metrics Kristian talked about, where the recurring software revenue's up 13% and the margins for the year should be up 400 to 500 basis points and so forth. We don't have a problem with the business we have in-house. It's really more a headwind of bringing in the new bookings and then comparing it to last year when we didn't have some of those headwinds.
Thank you. The next question comes from Sterling Auty with JP Morgan. You may go ahead.
Great, thanks.
Hey, Sterling.
Hi, guys. This is Jackson. It's Jackson Ader for Sterling tonight. Just a couple of quick questions on the IoT growth. If subscription is growing approaching 40%, but the overall business growing mid-20s on a constant currency basis, is that suggesting maybe that we've reached a point in the industry where machines are coming with some pre-configured software to integrate to the IoT and maybe don't need the Kepware layer, like maybe we did a couple of years ago?
No, I don't think so. Keep in mind, when you go into a factory, there's no new factory that has only new equipment in it. If a factory has 100 pieces of automation equipment in it and somebody buys a new one that doesn't need Kepware, well, great, the other 99 still do. I've actually said before publicly several times that maybe at some point in time the world won't need Kepware because all the machines will be brand new and upgraded to the latest protocols. I can't actually imagine that scenario happening in the timeframe that I'm still employed in the business. Because there's 20, 30, 40, 50, 60-year-old machines in these factories, and they're not going anywhere because they're fully amortized and they work well and so forth. I don't want you to think Kepware had a bad quarter.
It didn't do quite as well as we expected, but it did grow year-over-year. Just we had more ambitious growth plans, but nonetheless, it grew from a bookings and a revenue standpoint. It's been a good, strong performer for us. It never was the fastest-growing part of our IoT suite, but it's a very important part because it brings together the ability for a brand-new machine to coexist with the machines that are five years, 10 years, 15, 20, 40, 50 years old, all together in one automated information system. One other thing, just to clarify so that we don't have the wrong impression here. I talked about how the combination of CAD and PLM and IoT and AR were not influenced by these external factors, was growing 20%.
That's a combination of AR and IoT growing much faster than 20, and of course, CAD and PLM are not growing at the 20% level. That was sort of an average of some moderate growers and some fast and some super fast growers coming together.
Okay. Actually one quick follow-up on, rather than Tekla, that was really helpful explanation. The follow-up would be, is there any mention, maybe we missed it, of the fiscal 2021 targets? Are they still in place or are you doing any shifting to those targets today?
Yeah, I think it's safe to say that when we come out in November and provide fiscal 2020 targets and then revised 2024 targets, that there will be a change in 2021 as well.
Let me say, though, from a guidance standpoint, I know how Kristian feels about this. First of all, we feel that PTC, on the scale of things, is quite disclosive. What we'd like to do is guide for the current year, guide for the next quarter, give you a five-year guide. Every time the five-year guide becomes a four-year guide or a three-year guide because a year has passed, I don't think we want to keep updating all these numbers. At some point, we'd be giving you a number for every one of the next five years, that's just a little too precise, I think, for what we're capable of doing. We're not trying to take anything off the table, we're also not trying to keep updating everything we ever said, even though it no longer fits into the scheme.
Hopefully, you understand that. We'd like to give you a one-year guide, a one-quarter guide, and a five-year guide and leave it at that and let that all roll forward.
Sure. Okay. Thanks, guys.
Thank you. The next question comes from Alex Tout with Deutsche Bank. You may go ahead.
Hi guys. Thanks for taking the question. Just kind of a follow-up to the last question. I know you don't want to give a precise number on FY 2021 right now, but if I look at $850 million in FY 2024, and your new guidance for free cash flow this year, it's implying 29% free cash flow CAGR from FY 2019 to FY 2024. You're on track to do about 15% constant currency this year. Would you expect a sort of linear acceleration up to that 29% level, post FY 2019? If you can give us any kind of idea of what to expect there, and also, given everything that you've said about the headwinds going away after FY 2019 from a bookings perspective, is the low teens bookings growth still something that you can adhere to post FY 2019? Thanks.
Yeah. It's Kristian. Hey, thanks for the question. Listen, understand and appreciate the desire for more information. I think we're just going to stick to we're going to provide a detailed plan, and outlook in November when we get there. I think that's just the easiest way to do it. We're just going to stick to that.
Could I just ask as a follow-up? The support revenues were a little bit light in the quarter. We talked about the churn rates in subscription, have you seen an increase in the churn rates on the support side of things? To what would you attribute that?
No, we actually haven't seen a deterioration in support retention. As we said earlier, actually, the conversion program effective in the channel actually is working quite well, and we've seen that tick up quite a bit from last year.
Kristian, there was another factor here that might explain a little bit of this, that is that the quarter actually ended on June 29th for us this quarter, I'm wondering if that maybe would also play a little bit into this. During the course of the year, we close our quarters on the Saturday rather than the last day of the month. Keep in mind that any revenue that would've been recognized on the last day of the quarter, meaning June 30th, actually for us ends up in the next quarter. Sometimes just the quarter ends affect this stuff by a little bit, I'm guessing that's probably what you're seeing. Operator, we have time for one more question, please. Thanks.
Okay. Thank you. The next question comes from Jason Celino with KeyBanc Capital Markets. You may go ahead.
Hey guys. Thanks for taking my question. When I think about kind of your channel commentary, and I appreciate what you're saying around China and Russia, but your channel's been performing better above market growth in CAD and PLM outside of the areas in China and Russia, how did those do in the quarter?
In general, the channel had a respectable quarter.
Was it still above?
With a significant drop off in certain geos where we just did not succeed in selling subscription software to people who are used to buying perpetual software from us.
Outside of those areas, your CAD and PLM growth was still above industry CAD/ PLM growth.
I don't know if it was above, but it was respectable.
Okay.
Not significantly above, not significantly below. Was not a great quarter for the channel. I think we were clear on that. That means that most geos did well or decent, respectable, and then a few really took a hit. It's really that hit from a few geos that affects the overall growth rate.
Okay. I appreciate the commentary. Thank you.
Yeah. Okay.
Thank you.
All right. I think we're out of time, but let me just thank everyone for joining us. I want to reflect actually on a few things that Kristian said as he was talking here. We're talking about a disappointing year, but nonetheless, recurring software revenue is going to be up 13%. Operating margin is going to be up 400-500 basis points. EPS is going to be up 21% at the midpoint, and free cash flow will be around $260 million-$270 million. Actually, though we're disappointed in bookings for the reasons that we elaborated on, the business moved forward quite a bit. Because of the booking situation, we pushed this very attractive target back a year. I think it's as attractive as it ever was, and I think it's very, very credible that from this point forward, we can accomplish that target.
You heard Kristian, his confidence behind it. He's got models behind it. We feel like it's doable. We've got to do it, for sure, but it's certainly an achievable target. We feel that this has essentially become a transition year, and the fundamentals of the business are very strong, and we're going to continue to grow the ARR and cash flow to very attractive levels. We look forward to talking to you in about 90 days if we don't cross paths sooner. At that point, we'll be prepared to share a lot more specific financial details with you about what we think fiscal 2020 will look like. Thank you very much, and goodbye.
Thank you. That does conclude today's conference. All participants may disconnect. Thank you for your participation.