Jim Heppelmann
Chief Executive Officer at PTC
Thanks Matt. Good afternoon, everyone, and thank you for joining us. You probably noticed that we have some additional news regarding CEO succession to cover today. So I'll kick off with an overview of Q3, but skip the normal customer commentary to allow time for the succession discussion. I trust that many of you had a good chance to interact directly with customers at a recent LiveWorx event, and I hope that will carry you for a while.
Starting with Q3 results then, I'm pleased to report that in Q3 PTC again delivered solid results. As you know, we feel that ARR and free cash flow are the best metrics to assess the performance of our business. In Q3, we exceeded our guidance on both metrics, and today we are again raising our full-year ARR guidance midpoint as well as our full-year guidance for free cash flow. As usual, I'll focus my discussion on constant currency results when discussing top-line metrics, and Kristian will outline currency effects later in the call.
Starting with the top-line metric of ARR on Slide 4. In Q3, we came in at $1.868 billion, which was above the high-end of our guidance range and up 25% year-over-year. Organic ARR growth accelerated slightly to 14%. ServiceMax contributed the extra 11 points of inorganic growth to bridge us to the overall 25% growth rate. We passed the one year anniversary of acquiring Codebeamer, so we're now counting Codebeamer in our organic ARR results. Though the manufacturing PMIs continue to indicate a sluggish environment globally, our top-line ARR continues to show good resilience. In Q3, we saw broad-based ARR strength across all product groups and geographies, and our churn results remain good. Given strong year-to-date results together with a solid pipeline and outlook for Q4, we're raising our full year ARR guidance midpoint. As I mentioned, Kristian will provide the details later.
Moving to Slide 5 and switching to our bottom line view. We delivered $164 million of free cash flow in Q3, ahead of our guidance and up 46% year-over-year. Remember that ARR is the primary driver of cash flow, so this result was driven by a combination of strong ARR growth and higher operating efficiency. We raised our key -- our free cash flow guidance for the year. Kristian will elaborate on that as well.
Turning to Slide 6. Let's look at ARR growth by geography. ARR growth in the Americas was 29%; in Europe, ARR growth was 24%; and in APAC, ARR growth was 16%. On a global basis, FX was neutral to our year-on-year growth in Q3, but regionally FX continued to be a growth tailwind in Asia, whereas it's a growth headwind in Europe. All three regions benefited from inorganic growth to varying degrees due to the acquisition of ServiceMax. Speaking of ServiceMax, we saw our first cross-sell activity happened in the quarter, and while it's still quite early in the integration process, there is a nice cross-sell pipeline building which bodes well for the future.
Next, let's look at the ARR performance of our product groups on Slide 7. In CAD, which is those products that enable authoring of product data, we delivered 11% ARR growth in Q3 in a market that's been growing an estimated 7%. Within these results, the growth was primarily driven by Creo, but supplemented by strong percentage growth in Onshape. PTC is clearly taking share in different parts of the CAD market with both products.
In PLM, which includes those products that enable data and process management, our ARR growth rate in Q3 was 36%, or 16% organic, with the incremental inorganic growth coming from ServiceMax. In PLM, we continue to significantly outperform the market, which has been growing an estimated 8% in core PLM. ARR growth for PLM in Q3 was primarily driven by Windchill, supplemented by strong organic percentage growth in ALM and SLM. Clearly, we're taking significant share in the PLM market as well.
Turning to Slide 8, I want to double click on our ARR growth strategy, because we've been fielding many investor questions regarding how we've been able to perform so well on the growth front as compared to peers, and whether this differential growth is sustainable. Some investors think we've shifted from one growth strategy to another over the years, but we see it very differently. In our view, we have consistently layered new growth strategies on top of existing growth strategies to create additional tailwinds that fuel faster growth. Let me explain.
Our growth strategy starts at the bottom of the chart, where we participate in CAD and PLM markets that are growing in the upper single-digit range. So that is our baseline. On top of this, our products are very strong competitively, which has allowed us to take some incremental market share and outgrow our peers. Then back in fiscal 2014, we launched our IoT business, which will be more than $200 million of ARR this year, and continuing to grow at a rate that's accretive to company growth.
Perhaps the single biggest driver of growth was unleashed in 2015, when we launched the full on transition from a perpetual and maintenance model to a subscription business model. This was a short-term pain for long-term gain type of strategy. And I'm pleased to say, the pain bottomed out in fiscal '17 and faded in fiscal '19. And we've been enjoying the long term gain and growth rate ever since. Simply put, a recurring model with sticky software creates much more growth than does a perpetual model, even at the same level of new seed sales. That's why companies like PTC cross the Valley of Death to get there. You can refer to our FY '21 investor deck where we took investors through the math model that shows how much easier it is to grow a sticky recurring business model than a perpetual one.
Following that, we put a strong focus on commercial improvements such as improved churn, improved discounting, and price optimization, and then redoubled our efforts in these areas when we entered the COVID and inflationary periods. Collectively, these improvements have created incremental tailwinds to company growth rates, and we think there's more to be done here, going forward. We could have been satisfied to stop there, but we didn't. We saw the CAD and PLM markets beginning to pivot towards SaaS, which led us to acquire the pure-SaaS Onshape and Arena businesses. These businesses continue to be growth tailwinds, as the growth is accretive to PTC's overall growth rate.
Then in fiscal '22, we decided to bring the SaaS phenomenon that was driving strong Onshape and Arena growth to our core CAD and PLM business, which we did using the Atlas platform that leveraged Onshape technology. This strategy allows us to land larger ARR run rates because we're selling both the software and the service to deliver it. And of course, now we can expand the existing on-premise customer-based ARR run rates by shifting customers to SaaS and upselling to include the value of the delivery service that customer now gets from PTC.
Frankly, this growth driver is in its early stages and its impact is minor right now, compared to what it promises to contribute in the coming years. Because we already enjoy strong growth independent of this SaaS driver, you should consider that SaaS is not our growth strategy per se, it's just another tailwind that helps in our quest to drive our growth rates higher.
Finally, during fiscal '22 and '23, we made smart acquisitions like Codebeamer for the ALM part of our PLM strategy; and ServiceMax for the SLM part of our PLM strategy. On a standalone basis, these businesses are growing faster than PTC. And of course, these growth tailwinds will increase as we further develop the cross-sell synergies we're pursuing. Cross-sell is already becoming meaningful for Codebeamer now, and looks very promising for ServiceMax where we're still quite early in the process. So when an investor asks, what is driving the 14% organic growth that PTC is reporting this quarter? The answer really is, all of it, except of course, ServiceMax, which is not yet factored into the organic calculation, but will be in a few quarters.
For those who questioned whether this level of ARR growth is sustainable, I'd first like to point out that fiscal '23 will be the seventh consecutive year of double-digit ARR growth across good macro setups and bad. And indeed, ARR growth has generally been accelerating over that time as more of these growth drivers came into play. I'd also point out that several of these drivers should be more impactful going forward, whereas none of them show signs of fading away. The sluggish macro no doubt has cost us a small amount of growth here in fiscal '23, but past history suggests we'll get it back when macro conditions improve. Bottom line is, we feel very confident that PTC is positioned to deliver sustained double-digit ARR growth at or near the top of our peer group. Most importantly, please keep in mind that it is ARR, not revenue, that drives free cash flow at PTC.
On the subject of free cash flow then, let's turn to Slide 9 where I'd like to double click on the dramatic increase in margins that we've been driving, which raises similar investor questions of, how and for how long. Our strong margin expansion, best measured using our operating efficiency metric, starts with the bottom four strategies we've been driving for many years. The first and biggest expansion driver has been the mix shift from professional services to software. Before this transformation, our revenue had a roughly 25% mix of low margin professional services, whereas currently we're at about 7% professional services mix on our way to a 5% mix, thanks to the recent arrangement to sell a portion of our professional services business to ITCI in the form of DxP services.
In turn, the large system integrator partner ecosystem we built has become a critical part of our growth strategy as SIs help create software demand in order to drive demand for their own services. We've been backfilling the low-margin services mix with high-margin software all along, and by the time we get to our 5% services mix target, the cumulative effect of this mix shift will be about 10 points of margin expansion. We feel the negative impact to revenue growth from declining services revenue over the years has been more than justified by the positive impact of the higher profit software mix to our margins and free cash flow. Said differently, the quality of PTC's revenue has increased dramatically.
At the next level, a second big driver of margin expansion has been our Go To Market improvements, which had dramatically increased the productivity of our sales force over the years. In particular, our development of a strong cross-sell muscle has been very helpful to sales productivity, and naturally we leverage this key strategy whenever we bring acquired products into the mix like Codebeamer and ServiceMax.
The third big driver in this group is our R&D offshoring program, which allows us to maintain relatively rich resourcing against more moderate spending levels. We tend to have a higher degree of offshoring than peers, and we have consistently proliferated this strategy across our portfolio and into acquisitions that we make. On a non-GAAP basis, year-to-date R&D spending is around 16% of revenue. But R&D accounts for 37% of our employee base. Our largest offshore site is the PTC R&D Center in India that will celebrate its 30th anniversary next year. So, you can see we have an incredibly deep pool of talent and expertise there.
The fourth item to point out is the portfolio rebalancing we do part -- as part of our planning every year to ensure that our resources are best-positioned to drive growth while maximizing profitability. This strategy essentially boiled down to driving low growth businesses at very high margins, while driving moderate growth businesses at good margins, thus reserving sufficient dry powder to invest more aggressively to develop new high growth businesses like Onshape, all while retaining an attractive and expanding company margin profile.
The next layer of the margin strategy is to leverage the benefits of scale that a recurring subscription business offers. Because growth in ARR requires relatively little growth in terms of variable costs, we've been doing a good job following our rule of thumb that on average, our costs will rise at half the rate of ARR growth, helping to drive expanding margins year-after-year. The improving commercial discipline around churn discounting and price optimization that I previously mentioned as a growth driver, is obviously a margin driver too, since our input costs are essentially the same, independent of churn discount and price levels. The incremental growth we get here comes at nearly 100% margin.
Finally, the changes we made in fiscal '21 to align our field organization to SaaS organizational principles, together with the operational rebalancing we did in fiscal '22 to better align spending with a growth outlook in IoT and AR have been big margin drivers, because they've allowed us to meet incremental resourcing needs without incremental hiring.
Our IoT business, for example, now has mid-teens operating efficiency margins, while being accretive to company growth. Similar then to what I said about ARR growth, the significant margin expansion we're delivering here in fiscal '23 is really due to all of the above factors. In my view, these gains are fully sustainable, with more to come in the future. As Kristian and I have said previously, we expect our operating efficiency margin to expand to 40% by fiscal '25, and expect we can get to mid-40s longer-term, so we continue to have a lot of runway here.
Moving on to Slide 10, then I'd like to discuss our plans for CEO succession. I feel the company is in great shape in terms of top-line and bottom line growth with multiple layers of initiatives that can sustain this performance well into the future. I trust you see we're continuing to demonstrate the resilience of our business as our growth powers on while PMI trends in the wrong direction. So for me, with more than 25 years under my belt now at PTC, half that time as CEO, I think, it's a perfect time to think about putting a new generation of leadership in place that can sustain this high-level of success well into the future.
I love this company, and I'm very proud of all that's been accomplished during my time here, but life is calling me to a new chapter. In following the succession, I plan to retire from traditional management roles. PTC's Board has given careful consideration to who should be PTC's next leader, and how we could best transition this person into the role to preserve our strategy and momentum. Our Board engaged Korn Ferry's CEO succession practice to determine what characteristics were most important in our next CEO, to vet our internal candidates and to consider external candidates. That careful process led us to an ideal successor in Neil Barua, the former CEO of ServiceMax.
Neil is smart in articulate, and he knows our industry. He's been a CEO twice already, yet still has a lot of career runway. He has a finance background, but really leans in with customers and product strategies. He has developed great followership within PTC already, and by the time Neil becomes CEO, he will have spent more than a year coming up to speed as a PTC insider. We are set up to have a seamless transition that offers complete continuity in the company's strategy and performance. So effective now, we've made a series of changes that initiate the transition process.
I have been named Chairman and CEO and with plans for the CEO role to transfer to Neil on February 14th, 2024, which is the date of our next Annual Shareholders Meeting. Neil has been appointed to the Board and has been given the title of CEO-elect. Neil and I will work together over the coming six months to ensure Neil has ample opportunity to get to know our important customer, employee and shareholder constituencies, and to transition my knowledge, relationships and responsibilities to him.
Given that I'm a Non-Independent Chairman by definition, the Board has appointed experienced Director Janice Chaffin to be Lead Independent Director. Neil will inherit and be surrounded by an excellent team that fully supports him. Mike DiTullio will continue to head our operations as President and COO. Kristian Talvitie will continue to head our financial strategy as CFO. Likewise, other PTC executives, such as our Chief Product Officer, Chief Technology Officer, Chief Strategy Officer, Chief Legal Counsel and Chief Human Resources Officer will remain in place throughout the transition and beyond. This transition should be very smooth.
The bottom line is that the Board chose a great successor whom I fully endorse and who has the support of the entire team. I'm very happy for Neil and for myself, I might add, that we could find such an elegant way to transition PTC leadership into what promises to be an exciting and successful next phase for the company.
With that, I'd like to turn to Slide 11 and ask Neil to spend a few minutes introducing himself before we move back to Kristian for additional commentary regarding results and guidance. Neil?
