Software maker PTC PTC -1.30 % Inc. is suffering from declining revenue and earnings. It has cut staff and taken restructuring charges five years in a row. Yet PTC’s shares are up 70% since February, and analysts are almost all bullish on the stock.
PTC managed to put a shine on its gloomy situation when it changed the way its customers pay for its software, which is used by manufacturers for computer-aided design and product management. That has made it hard to compare old and new and led investors to focus on nonstandard measures of growth.
Those measures have driven PTC’s stock rally. When the Needham, Mass.-based company said Oct. 3 that this quarter’s revenue and earnings would be below its prior guidance, the software maker’s shares climbed nearly 2%. The reason: Investors focused on bookings, which came in better than expected.
The business doesn’t look as good under standard accounting measures. Profits and revenues are expected to decline when the company reports earnings Wednesday. Sales fell by 7.5% to $1.26 billion in fiscal 2015 as operating income declined 20.8%. For 2016, sales and operating income are expected to drop 8.4% and 36.8%, respectively.
The new business model has risks that investors don’t appear to be appreciating. In the past, customers bought the software and paid an annual maintenance fee. Starting two years ago, PTC began effectively renting its software to subscribers who pay less up front and more in annual fees. It is a common shift among mature software companies, including PTC competitors such as Autodesk Inc. ADSK -1.19 % and Adobe Systems Inc. ADBE -1.61 %
PTC argues that customers will pay 40% more over time than they did under the old model. The biggest concern is that revenue collected under a subscription contract won’t match revenue collected under a traditional license until the fourth year. Yet PTC’s subscription contracts are one to three years in length, meaning it is counting on customers to renew at least once just to match what they were paying before.
PTC says the renewal rate for maintenance contracts connected to traditional licenses is over 90%. It is unclear whether subscription customers who haven’t paid big up front costs will be as loyal.
Another concern is how PTC can convince customers to give them more money for essentially the same products. For existing license customers, PTC says it requires a minimum 25% increase in annual contract value to change that to a subscription. It is giving customers incentives to switch by letting them rearrange what they buy from among various software offerings. It is difficult to see how that flexibility would be enough to convince customers to pay 40% more over time.
Software companies that switch to a subscription model typically see a decline in revenue because they no longer get big upfront payments from customers. That decline should be at least partially offset by an uptick in deferred revenue from subscriptions. This has been the case at Autodesk.
But PTC’s deferred revenue declined sequentially in two of the past four quarters and grew by only 1% in another, even though subscriptions have been expanding as a percentage of bookings. This discrepancy may be at least partially explained by the fact that the annual maintenance revenue PTC still collects under its traditional model, which has been hurt by currency effects, is also recorded as deferred revenue.
Bullish analysts say deferred revenue should begin to grow consistently in fiscal 2017 when subscriptions represent a greater portion of bookings.
PTC’s performance is also obscured by a series of restructurings. A year ago, the company said it would eliminate 8% of positions world-wide, resulting in a charge of $40 million to $50 million. That charge was increased twice since then and is now up to between $75 million to $80 million. Analysts expect PTC’s earnings before interest, taxes, depreciation and amortization to be $250 million in fiscal 2016, adjusted for the restructuring charges.
This is PTC’s fifth consecutive year of recording restructuring charges. The company says each one has been a distinct program aimed at cutting costs and focusing investment in higher growth areas. PTC says operating margins would be rising if not for the business-model shift.
With all of the trouble comparing the old and new business models, PTC has focused on bookings as a measure of its success. The problem is that bookings under a subscription model are different from those under the old model. To deal with that, PTC takes the annualized contract value from a subscription sale and then multiplies the number by two.
Why two? PTC says it arrived at this “conversion factor” by considering variables including pricing, support, length of term and renewal rates. Bullish analysts say two is conservative. Still, there is no way for investors to gauge that. Simply shortening the customer lifetime by a year or two, or assuming a lower renewal rate, would imply a lower conversion factor.
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PTC acknowledges subscription bookings don’t represent the revenue it will eventually recognize from subscription sales. What matters, it says, is that investors use a consistent multiplier to compare bookings from quarter to quarter.
PTC, whose market cap is $5.4 billion, trades at 40 times forward earnings estimates, up from 16 times a year ago. Even by fiscal 2018, net income isn’t expected to regain fiscal 2015 levels. Investors should question whether PTC’s subscription transition really makes it that much more valuable.
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