PTC (Parametric Technology Corporation) is one of the fifty biggest software companies in the world. Their customers design aircraft, plan buildings, make sneakers, build tools, pioneer new medical diagnostic technology, and much more.
PTC’s earnings have dipped lately. In the second quarter of 2015, PTC recorded $303M in revenue. A little over a year later, that number dropped to $288M. In the same period, earnings swung from $17.4M profit to a loss of $28.5M.
But today their stock is up 85 percent year-over-year, to around $50, from a low of $27 last March. They’ve added almost $2.5B in shareholder value in less than 12 months.
What’s going on here? To answer that question, first let’s take a step back.
The last 18 years has seen a huge change in the $400B software industry. It all started in 1999, when Salesforce.com was founded. As the eleventh hire at Salesforce, I was lucky to be able to help build not just a new kind of CRM, but a whole new approach to enterprise applications that were delivered directly over the Internet, and as easy to use as buying a book on Amazon.
Since then, SaaS has rapidly become the preferred model for distributing and consuming software. Who wants to deal with the headaches of buying the hardware, installing the software, backing it up, dealing with upgrades, and getting calls in the middle of the night when it breaks?
That’s why Gartner predicts that by 2020, more than 80 percent of software providers will have shifted to subscription-based business models. These days it’s all about outcomes, not assets.
But shifting to subscriptions can seem hard, particularly for large traditional software companies like SAP and Oracle. There are so many questions: If I take revenue over time versus up front, doesn’t that hurt my bottom line? Won’t subscriptions lower my margins? How do I get my sales team to sell this stuff? As a result, they find themselves desperately trying to protect an outdated business model.
That’s what makes PTC such an interesting case. They’re in the midst of a near-flawless transition to SaaS. Let’s deconstruct their recent financial performance to see what we can learn.
Just a few years ago, PTC was chugging along, like the rest of the traditional software sector, at low single-digit growth. PTC had to begin every financial year at zero — revenue had to be clawed together one deal at a time, only to vanish again in twelve months. As a result, many wondered if PTC was simply a mature company that should be passing its maintenance revenue to investors in the form of dividends — PTC’s valuation multiples were stuck in the 1x-3x price/sales range.
At the same time, PTC found through its own survey analysis that more than 90 percent of its customers shared a desire for subscription-based pricing. They liked paying for only what they used. They preferred Opex spending to Capex spending — less bureaucracy. And they didn’t want to deal with maintenance.
Those findings weren’t surprising — SaaS had begun to explode into every category. But here’s where it gets interesting. Not only did PTC announce a broad, systemic shift from perpetual licenses to cloud-based subscriptions, they also confidently predicted that this shift would rekindle growth, expand margins, and maximize long-term shareholder value. They wound up going three for three.
In October 2015, at the start of the journey, PTC told investors and analysts that in five years (FY2021) it was aiming for $1.6B in revenue, 10 percent revenue growth, an operating margin in the low thirties and 70 percent of bookings coming from subscriptions.
That resulted in a nice little pop for them — PTC went from $32 per share at the end of September 2015 to about $37 per share at the beginning of November, or 15 percent increase in its valuation.
But just one year later, the news was significantly better.
When PTC gave an update on its transition, it moved its FY21 targets up by a full year. It also raised its target for pure subscription bookings from 70 percent to 85 percent. This was on the heels of FY16 earnings results that consistently demonstrated the transition was tracking ahead of PTC’s initial plan.
Let me just compare those two analyst calls again:
In 2015, PTC predicted $1.6B in revenue with 10 percent sustainable growth in Fiscal 21, a steady-state subscription mix of 70 percent, non-GAAP operating margins in the low 30s (from the mid-20s), and $450M of free cash flow.
In 2016, they revised those estimates to $1.8B in Fiscal 21 revenue growing at a sustainable 10+ percent growth rate,a 85 percent steady state subscription mix resulting in 95 percent of their software revenue being recurring, non-GAAP operating margins in the low 30s, and free cash flow of $525M. Wow!
That kind of successful transformation brings to mind Adobe. In April of 2012, Adobe moved Creative Suite from expensive DVDs to monthly subscriptions, causing its net income to plummet by almost 35 percent the following year. Yet by April 2016, Adobe’s stock price had nearly tripled from its value four years earlier.
Adobe is clearly an inspiration, but today PTC says that they want to be the next “poster child for subscriptions.” And much like Adobe, PTC took a temporary hit to their top line in their transition. After all, they’re spreading revenue over time, not collecting all at once. PTC calls this initial period, which I mentioned at the top of the article as the “subscription trough.”
But PTC is clearly rocketing out of the other side of the trough, the same way Adobe did. They’ve reached an inflection point. PTC’s subscription ACV (Annual Contract Value) guidance at the beginning of Fiscal 2016 was $43M. They delivered $114M, almost three times that original target.
Let’s take a look at this remarkable shift through three lenses: growth, operating margins, and multiples.
PTC is anticipating a lot of growth. It expects its subscription revenue to grow a significant 50 percent compounded annual growth (CAGR) through FY21.
Before PTC had meaningful subscription revenue (greater than five percent), its CAGR from FY09 to FY14 was 8 percent, with individual fiscal year growth rates ranging from 3-16 percent. Not bad, not great — note that it only hit a double digit growth rate in one year, FY11.
By FY15, PTC had roughly 20 percent of their bookings coming from subscriptions, and they took a look at their books, liked what they saw, and predicted by leaning into subscriptions they could sustainably achieve double-digit growth. So far they’ve consistently seen an acceleration in their growth due to this shift.
Let’s take a look:
You can see the “subscription trough” at around the 11 percent subscription revenue mix, before the overall revenue starts rising dramatically. The net down here is that subscriptions can move large enterprises from single digit annual growth rates to sustained double-digit growth rates.
By definition, there are two ways to expand your operating margins: make more money or lower your expenses. PTC keeps a sharp eye on its expenses. Today it has roughly the same operating expenses, in the mid single digits, as it had before it transitioned to recurring revenue.
But here’s the thing — its operating margins are expected to leap from mid 20s to the low 30s, an almost fifty percent increase. And not only are PTC’s margins much higher, they are vastly more predictable, which creates a virtuous cycle of effective expense management and increased operational efficiency. Recurring revenue isn’t just about growth — it’s about predictable growth.
Let’s take a look at those margins:
The lesson? Subscriptions can create natural margin expansion well beyond what would be possible with a perpetual business model.
In terms of valuation, one dollar of subscription revenue is fundamentally worth more than a perpetual license dollar.
Think about it — would you rather agree to earn a dollar this year, or a dollar every year for the next five, six, seven years. PTC’s products are incredibly sticky — their average customer life is well over ten years.
But subscriptions themselves are sticky (and stable) by definition. In difficult economic conditions, perpetual license sales decline and hurt overall company growth, while a subscription model requires customers keep paying to access the service and thus shields businesses from macroeconomic volatility. That helps explain why PTC is enjoying such a great valuation today.
I want to call out two key points from a recent HBR study on on-premise to SaaS initiatives.
1. You don’t have to go all in, all at once. The study found that investors increase their valuations of the software vendor’s stock by an average of 2.2 percent if the vendor makes clear in its announcement that the SaaS offering is provided in parallel to a perpetual licensing model.
2. You don’t have to do it all yourself. Announcements that implied the SaaS offering would be built in cooperation with cloud infrastructure and platform providers increased company valuations by an average of 2.9 percent.
Take a look at the contrast in the table below, which shows how PTC’s EV/NTM sales multiple has expanded over time as it moved through the transition:
The takeaway? If stock prices are defined by projected future earnings and the risk associated with achieving those earnings, recurring revenue makes a company’s financials substantially more predictable.
We’ve found similarly impressive growth numbers in Zuora’s Subscription Economy Index, which is based on anonymized, aggregated system-generated data of over 350 recurring revenue-based companies that have been on our platform for at least two years. Subscription-based companies are growing nine times faster than S&P sales over the past five years, and four times faster than U.S. retail sales.
So what’s the main lesson here? The story of PTC is a lesson of disrupt or be disrupted. Customers are changing. They don’t want up-front purchases anymore. They want smart, ongoing services that upgrade and adapt according to their needs. And this isn’t just a software story — it’s happening in transportation, retail, media, and manufacturing. It’s happening everywhere.
PTC saw the shift towards subscriptions coming, and reacted with a smart, emphatic transformation. Their management team knew full well that the subscription model creates deferred revenue, so quarterly GAAP metrics can take a short-term hit. While this dynamic has caught other teams flat-footed, PTC embraced it and kept the public investment community informed every step of the way.
As a result, PTC is driving growth, showing substantial margin improvements, and discovering whole new territories of shareholder value.
Continue reading success stories from the Subscription Economy in the latest issue of Subscribed Magazine!