ITEM 1: Business
Introduction
Parametric Technology Corporation (PTC) was founded in 1985 and is headquartered in Needham, Massachusetts. PTC develops, markets and supports product lifecycle management (PLM) software solutions and related services that help manufacturers improve the competitiveness of their products and product development processes. The PLM market encompasses the mechanical computer-aided design, manufacturing and engineering (CAD, CAM and CAE) markets as well as many previously isolated markets that address various phases of the product lifecycle. These include product data management (PDM), component and supplier management, visualization and digital mockup, enterprise application integration, program and project management, after market service and portfolio management, requirements management, customer needs management, and manufacturing planning. Our software solutions, which include a suite of mechanical computer-aided design tools (our design solutions) and a range of Internet-based collaboration technologies (our collaboration and control solutions), enable manufacturing companies to create virtual computer-based products (digital products), collaborate on designs within the enterprise and throughout the extended supply chain, and control the digital product information throughout the product lifecycle. This results in streamlined engineering processes, improved product quality, optimized product information management and reduced cost and time-to-market cycles. Our PLM software solutions are complemented by our experienced services and technical support organizations, as well as resellers and other strategic partners, who provide training, consulting, ancillary product offerings, implementation and support to customers worldwide.
The PLM market is still relatively new and our entry into this market commenced in 1998 with our acquisition of a PLM technology platform known as Windchill® that is now a cornerstone of our suite of PLM software solutions. Prior to 1998, PTC focused on the CAD/CAM/CAE market. Since 1998, we have invested heavily in expanding our product offerings to offer an integrated portfolio of PLM product offerings. Our traditional CAD/CAM/CAE products remain a key component of our overall PLM offering, but we have introduced new solutions as well based on our Windchill technology.
With our suite of PLM software solutions, we see an opportunity to address several of the key challenges that manufacturing companies face in their product development processes: more frequent change, heterogeneity of systems, and increased communication inside and outside the manufacturing enterprise to support growing offshoring and outsourcing and increasingly transparent supply chains. Accordingly, we have devoted significant resources to our collaboration and control solutions and their integration with our design software. With our PLM software solutions suite, we can provide our customers a product development system that permits individuals-regardless of their roles in the commercialization of a product, the computer-based tools they use, or their location geographically or in the supply chain-to participate in and impact the product development process across the digital product value chain. We believe that as we continue to implement our strategy for our products to become more tightly integrated and easier to deploy, we can create significant added value for our customers. All of our software solutions continue to be distributed primarily through our direct sales force. In tandem with our direct sales force, we utilize an indirect distribution channel. Our indirect distribution channel has been broadened over the last several years through resellers and other strategic partners. Our resellers provide greater geographic and small account coverage, primarily for our design solutions, while our other strategic partners help to expand the breadth of our PLM solutions by providing complementary product and/or service offerings.
Products and Services
Our design solutions and our collaboration and control solutions are aligned under a unified product strategy. The strategy allows us to capitalize on existing product synergies and offer integral product development solutions that enable the creation, collaboration and control of digital product information across the extended design chain. Our efforts have resulted in the creation of our product development system, which is comprised of a suite of integral products and services offerings.
Our product development system delivers a comprehensive footprint that offers the capabilities necessary to improve our customers’ product development processes. These processes involve the entire enterprise and are further extended to include supplier, partner, and customer participants. A leading objective of our product development system approach is to reduce complexity for our customers by ensuring that our solutions, which support core product development processes, work together in a cohesive system. Our product development system provides three essential capabilities to improve product development processes:
• Create product designs (resulting in high fidelity digital products),
• Collaborate cross-functionally in an organization and throughout the digital product value chain, and
• Control and manage product information and product development processes throughout a product’s lifecycle.
Our footprint of capabilities aligns on an optimized system architecture, which is built from the ground up to address the needs of the digital product value chain. Our product development system architecture is:
• Integral-sharing a common database schema and common business objects,
• Internet-based-in that it has an intuitive Internet-based user interface and deploys seamlessly across existing Intranet and Internet infrastructures to accommodate a distributed value chain, and
• Interoperable-integrating easily with other systems using standard protocols and integration approaches.
The following software solutions are part of our overall strategy to provide an integrated portfolio of PLM solutions that address specific business challenges that occur at various points in the product lifecycle. They are designed to enable manufacturers to implement a product development system appropriate for their particular requirements, allowing them to deliver new products to market faster and manage the complexities of product development throughout an evolving supply chain.
DESIGN SOLUTIONS
Our family of engineering design software encompasses a broad spectrum of engineering disciplines essential to the development of virtually all manufactured products, ranging from consumer products to jet aircraft. Manufacturers compete on the basis of cost, time to market and product performance criteria, which are significantly affected by the quality and length of the product development process. Our software solutions offer high-performance product definition capabilities for the creation of digital products that improve product quality and reduce time to market by enabling end-users to evaluate easily multiple design alternatives and to share data with bi-directional associativity.
The cornerstone of our design solutions software is Pro/ENGINEER®, a three-dimensional product design solution based on a robust, parametric, feature-based solid modeler, enabling changes made during the design process to be associatively updated throughout the design. Pro/ENGINEER consists of capabilities for detailed design (CAD), manufacturing/production (CAM), and simulation/analysis (CAE), as well as facilities for exchanging CAD data with a multitude of sources and in varied standard formats, allowing companies to create more innovative, differentiated and functional products quickly and easily.
Offerings within the Pro/ENGINEER family include:
Pro/ENGINEER CAD solutions: Pro/ENGINEER CAD solutions consist of foundational design capabilities for part and assembly modeling, basic surfacing, production drawing creation, welding, sheet metal design and photo rendering. Extended design capabilities include advanced styling and surfacing tools, and solutions for electrical and mechanical systems design involving large assemblies, cable harnesses, and piping.
Pro/ENGINEER CAM solutions: Pro/ENGINEER CAM solutions enable designers to create downstream manufacturing deliverables such as molds and progressive dies, Numerical Control (NC) tool paths, and inspection programs. By directly referencing Pro/ENGINEER designs, production and tooling engineers can handle tooling design and detailing, NC process planning, NC programming, and inspection/verification, automatically responding to changes to the design with no data translation obstacles.
Pro/ENGINEER CAE solutions: Pro/ENGINEER CAE solutions allow engineers to test and optimize designs for structural, dynamic, thermal, and durability performance. These solutions provide benefits by minimizing physical prototyping, increasing engineering creativity, and helping deliver higher quality products in less time.
COLLABORATION AND CONTROL SOLUTIONS
Our collaboration and control solutions have evolved to address expanding customer needs since their introduction in 1998. The cornerstone of our collaboration and control solutions is our suite of Windchill based products, which enables engineering and enterprise-level PLM. Windchill is currently sold in two forms based on the common Windchill infrastructure: (1) Windchill Link solutions and (2) configurable Windchill modules.
Our Windchill Link solutions consist of pre-configured, integral products built on the Internet-based Windchill architecture. These solutions are designed to address specific business-critical manufacturing processes and can be implemented with little configuration in as few as several weeks in accordance with a predefined implementation methodology. These solutions include:
Windchill PDMLink™: a digital product data management solution that helps manufacturers control information by ensuring data accessibility and managing the product development process throughout the life of a product. Windchill PDMLink is fluent with workgroup level CAD data management as well as complete enterprise-wide product data management with capabilities for document management, change management and configuration management.
Windchill ProjectLink™: a project management solution that enables employees, partners, suppliers, and customers to collaborate on projects through Internet-based compartmentalized workspaces, project plan development, milestone and deliverable tracking, activity assignment and management, and discussion forums.
Windchill DynamicDesignLink™: a collaborative application engineering solution that helps manufacturers address the increasing demand for design-to-order products through visually interactive, dynamic, collaborative capabilities including graphical product family modeling, product family catalog publication, product configuration, and automated generation of digital product deliverables.
Windchill PartsLink™: an interactive product catalog solution that enables designers to achieve maximum part reuse through Internet-based access to standard, preferred part suppliers, and allows suppliers of standard parts to provide their customers with rich technical product data.
We also offer Windchill capabilities in a modular form to support customer-specific configurations that address our customers’ unique needs. The Windchill modules architecture and toolsets enable manufacturers to extend the data models and user interface to support unique business processes, such as legacy system replacement and consolidation, and integration and rationalization of diverse systems following merger or acquisition. Unlike other product information management applications based on proprietary architectures and toolsets that discourage tailored configurations, the Windchill modules architecture and toolsets explicitly enable manufacturers to extend the data models, functionality, and user interface as they see fit. The Windchill modules consist principally of the following: a vault for data management to store and retrieve product information; workflow applications for sequencing the flow of product information and change management processes; visualization software for enabling the customer to see a three-dimensional view of product data; and, when desired, data adaptors for connecting to standard computer aided design (CAD) software or standard enterprise resource planning (ERP) systems via standard application interfaces.
The Windchill modules include:
Windchill Foundation for core PLM infrastructure;
Windchill PDM for product data management;
Windchill ProductView for visualization;
Windchill Information Modeler to accelerate the configuration process;
Windchill Enterprise Systems Integrations to connect Windchill to ERP systems and other enterprise applications; and
Windchill Workgroup Managers to manage CAD data from various source systems.
The Windchill modules have standard features and functions with capabilities that include product and process management, collaboration, and product planning. The pre-defined templates (e.g., document folders and workflows) may be used as is or may be configured to the customer’s business environment. For example, the workflow template may be changed to reflect the customer’s organizational approval preferences.
Additionally, upon our acquisition of OHIO Design Automation, Inc. in the third quarter of 2004, we now offer the InterComm suite of electronic design collaboration solutions to enable enterprise-wide visualization, verification, annotation, and automated comparison of electronic design intent. The InterComm solutions provide easy access to complex CAE and electronic computer aided design data created in leading electronic design automation (EDA) tools. These solutions are targeted toward high tech and electronics manufacturers and other manufacturers of products that contain electronic components. In addition to offering the InterComm products as stand alone solutions, we have begun to integrate this technology into the Windchill product line for future release.
SERVICES
Maintenance Services
We offer maintenance support plans for our software products. Customers who participate in our maintenance support plans receive periodic software updates and new releases. Active maintenance plan customers also have direct access to our global technical support team of certified engineers, an ISO 9001 accredited organization, resulting in timely and accurate issue resolution. In addition, we provide self-service support tools that allow our customers access at all times to an extensive amount of information quickly and dynamically.
Other Services
Our software solutions and maintenance support offerings are complemented by additional service offerings from our services organization, as well as from third-party resellers and other strategic services partners. We designed our portfolio of services offerings to leverage our product and process expertise and create value for customers. We offer a comprehensive portfolio of services to facilitate the adoption of our technology into an optimized product development environment, ensuring alignment of business processes with strategy, conditioning the organization to follow new rules and procedures, deployment of the “right” technology that supports organizational and strategic goals, and driving technology adoption through training programs. Our services organization focuses on:
Implementation Services: We offer a range of technology installation, configuration, and migration services, from pre-packaged “quick start” deployments to full system integration.
Process and Technology Adoption Services: Our consulting services facilitate widespread acceptance and utilization of our solutions, addressing organizational challenges and competing priorities. Our proven methodology helps condition an organization to adopt new processes and enable target users successfully to utilize the applications for measurable productivity gains.
Education Services: We offer an extensive curriculum of instructor-led and Internet-based training courses to accelerate adoption of the product development system and realize value across the entire enterprise. Our education services also assist our customers’ users to overcome resistance to change and reluctance to use new tools.
Product Development
For our products to remain competitive, we must provide our customers with new and innovative software solutions. As a result, we continue to spend on research and development, and we regularly are looking for opportunities to acquire new technologies suited to our customers’ needs. We also must efficiently manage our development resources to ensure that the appropriate balance, based on both product development plans and customer demand, is reached between product lines.
Our ability to rapidly develop new design products is facilitated by the modular structure of our software code. This structure enables functional capabilities of existing products to be utilized by new software applications or modules, thereby reducing the amount of new code required to develop additional products. The major benefit of this approach is more rapid development of new functionality. Our Windchill technology has expanded the breadth of our offerings allowing for a comprehensive suite of PLM solutions. Much of this technology is Internet-centric, Java-based, object-oriented software and our products depend on these evolving technologies. We also license certain technologies from third parties to augment the functionality of our products. We generally pay these third parties either periodic royalties or fixed fees for the use of their technologies and rely on them for development and other support. We continually review the associated costs, development resource savings, support levels, and, if applicable, experience with the third party to determine whether the utilization of such technologies is beneficial.
We are focusing much of our research and development investment on integrating our products into a unified product development system. This strategy is supported by changes we have made to both our product planning and product testing processes. These planning and testing phase changes ensure that the products work together in a cohesive system across specific customer business processes.
We also work closely with our customers to define improvements and enhancements to be integrated into our products. Using this approach, customers become involved in the software design process to help validate feasibility and to provide feedback on functionality early in the development of our products. In addition, we maintain software and hardware partner programs designed to provide partners both with access to our products and with the mechanisms and environment to facilitate the integration of complementary products with our product lines. Through our open software toolkits, program members can build tightly integrated solutions that satisfy the various requirements of our customers.
Information about our research and development expenditures for the three-year period from 2002 through 2004 may be found in the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” beginning on page 8 below.
Sales and Marketing
We derive most of our revenue from products and services distributed directly by our sales force to our end-user customers. In addition, we offer products through third-party distributors. No single customer accounted for more than 10% of our revenue in any of the last three fiscal years. Our direct sales force focuses on large accounts, while our reseller channel provides a cost-effective means of covering the small and medium business market.
Within our direct sales force, there are both strategic accounts and general business accounts units. The strategic accounts unit is further segmented into vertical groups, such as aerospace and defense, automotive, consumer products, electronics and high technology, footwear and apparel, industrial products and life sciences. This vertical orientation is mirrored in our services delivery organization and, increasingly, in the products we deliver to strategic accounts. In addition, we continue to broaden our indirect distribution channel through alliances with third-party resellers and other strategic partners who provide products and/or services that complement our offerings. Our resellers distribute products such as Pro/ENGINEER and provide related services throughout North America, Europe and parts of Asia/Pacific; our other strategic partners help complement our product development system with ancillary offerings. We also have begun to train a select number of resellers to distribute our Windchill Link solutions to the small and medium business market.
Information about our international and domestic operations may be found in Note L of “Notes to Consolidated Financial Statements” and the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” beginning on page 8 below.
Competition
There are a number of companies offering solutions that address specific functional areas covered by our PLM solutions such as: Dassault Systemes and UGS for traditional design solutions, PDM solutions and visualization and digital mock-up solutions; Agile Software Corp. and MatrixOne for PDM solutions; and i2 Technologies Inc. for part sourcing solutions. In addition, larger,
better-known enterprise-solution companies with established customers have entered the PLM market offering solutions integrated with their other enterprise software applications. For example, SAP offers a solution that controls product data within the larger framework of its ERP solution. We believe that our PLM solutions currently offer broader and deeper functionality, more specifically targeted toward the product development processes within discrete manufacturing companies. We, along with our resellers, compete with design products from companies such as Autodesk, Inc. and Solidworks, a subsidiary of Dassault Systemes, for sales to smaller manufacturing customers.
Proprietary Rights
Our software products and our trademarks, including our company names, product names and logos, are proprietary. We protect our intellectual property rights in these items by relying on copyrights, trademarks, patents and common law safeguards, including trade secret protection, as well as restrictions on disclosures and transferability contained in our agreements with other parties. Despite these measures, there can be no assurance that the laws of all relevant jurisdictions will afford adequate protection to our products and other intellectual property.
The software industry is characterized by frequent litigation regarding copyright, patent and other intellectual property rights. While we have not, to date, had any material claims of this type asserted against us, there can be no assurance that someone will not assert such claims against us with respect to existing or future products or other intellectual property or that, if asserted, we would prevail in such claims. In the event a lawsuit of this type is filed, it could result in significant expense to us and divert the efforts of our technical and management personnel, whether or not we ultimately prevail.
We believe that, due to the rapid pace of innovation within our industry, factors such as the technological and creative skills of our personnel are as important to establishing and maintaining a technology leadership position within the industry as are the various legal protections surrounding our technology. We believe that our products, technology and trademarks do not infringe any existing proprietary rights of others, although there can be no assurance that third parties will not assert infringement claims in the future. Certain of our products also contain technology developed and licensed from third parties. We likewise may be susceptible to infringement claims with respect to these third-party technologies.
PTC, the PTC Logo, Parametric Technology Corporation, The Product Development Company, Product First, The way to Product First, Create Collaborate Control, Simple Powerful Connected, Pro/ENGINEER, Wildfire, Pro/DESKTOP, Pro/INTRALINK, MECHANICA, GRANITE, Windchill, Windchill ProjectLink, Windchill PartsLink, Windchill DynamicDesignLink, Windchill PDMLink, and InterComm and all product names in the PTC product family are trademarks or registered trademarks of PTC or our subsidiaries in the United States and/or other countries.
Backlog
We generally ship our products within 30 days after acceptance of a customer order. A high percentage of our license revenue historically has been generated in the third month of each fiscal quarter, and this revenue tends to be concentrated in the later part of that month. Accordingly, orders may exist at the end of a quarter that have not been shipped and not recognized as revenue. We do not believe that our backlog at any particular point in time is indicative of future sales levels.
Employees
As of September 30, 2004, we had 3,042 employees, including 945 in sales and marketing; 812 in customer support, training and consulting; 314 in general and administration; and 971 in product development. Of these employees, 1,362 were located in the United States and 1,680 were located outside the United States.
Website Access to Reports and Code of Business Conduct and Ethics
Our Internet address is www.ptc.com. Through our Internet website, we make available the following reports as soon as reasonably practicable after electronically filing them with, or furnishing them to, the SEC: our annual report on Form 10-K; our
quarterly reports on Form 10-Q; our current reports on Form 8-K; and amendments to those reports filed or furnished pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934. Our Proxy Statements for our Annual Meetings and our Section 16 Officer trading reports on SEC Forms 3, 4 and 5 also are available through our Internet website. The reference to our website is not intended to incorporate information on our website into this document by reference.
Our Code of Business Conduct and Ethics also is available through our Internet website. Additional information about this code and amendments and waivers thereto can be found below in Part III, Item 10 of this Annual Report.
ITEM 1A:
ITEM 1A: Executive Officers of the Registrant
Information about our executive officers is incorporated by reference from Part III, Item 10 of this Annual Report.
ITEM 2:
ITEM 2: Properties
We lease 100 offices in the United States and internationally through our non-U.S. subsidiaries, predominately as sales and/or support offices and for research and development work. Of our total of approximately 1,039,000 square feet of leased facilities used in operations, approximately 492,000 square feet are located in the U.S., including 296,000 square feet of our headquarters facility located in Needham, Massachusetts. The lease for our headquarters began in December 2000 and expires in December 2012, subject to certain renewal rights. We also lease space comprising approximately 580,000 square feet, which is not used for our current operations and is primarily subleased to third parties. This space includes 376,000 square feet of space in Bedford, Massachusetts acquired in our merger with Computervision Corporation in January 1998. As described in Notes B and F of “Notes to the Consolidated Financial Statements,” lease commitments on unused facilities in excess of expected sublease income have been included in our restructuring provisions. We continue to engage in subleasing and early lease termination initiatives to employ alternate uses for these excess facilities. We believe that our facilities are adequate for our present needs.
ITEM 3:
ITEM 3: Legal Proceedings
Certain class action lawsuits were filed by shareholders in the second and third quarters of 2003 against us and certain of our current and former officers and directors in the U.S. District Court for the District of Massachusetts claiming violations of the federal securities laws based on alleged misrepresentations regarding our reported financial results for the fiscal years 1999, 2000 and 2001 and our announced results for 2002. The consolidated amended complaint was filed in the fourth quarter of 2003 and sought unspecified damages. We filed a motion to dismiss the consolidated action with prejudice and the court held a hearing on our motion in the third quarter of 2004. On November 3, 2004, the court granted our motion to dismiss and entered an order dismissing the consolidated action. The plaintiffs did not file a notice of appeal from the court’s order within the applicable period of time for them to do so, which should conclude the litigation.
On May 30, 2003, a lawsuit was filed against us in the U.S. District Court for the District of Massachusetts by Rand A Technology Corporation and Rand Technologies Limited (collectively “Rand”). Rand historically had been our largest distributor. The complaint alleges various breaches of a revised distribution agreement entered into in December 2002, as well as other agreements between Rand and us, and also asserts certain non-contract claims. The complaint, as amended, seeks equitable relief and substantial damages. On November 24, 2003, we filed our substantive response to Rand’s complaint and asserted counterclaims against Rand including, among other things, that Rand’s action in filing the lawsuit constituted a breach of the December 2002 agreement, which established certain dispute resolution procedures and which, we believe, discharged any and all claims arising prior to that date. We believe Rand’s claims are without merit and will continue to contest them vigorously. We also intend diligently to prosecute our counterclaims. We cannot predict the ultimate resolution of this action at this time, and there can be no assurance that this action will not have a material adverse impact on our financial condition or results of operations.
We also are subject to various legal proceedings and claims that arise in the ordinary course of business. We currently believe that resolving these other matters will not have a material adverse impact on our financial condition or results of operations.
ITEM 4:
ITEM 4: Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the last quarter of 2004.
PART II
ITEM 5:
ITEM 5: Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Information with respect to this item may be found in the section captioned “Quarterly Financial Information” on page below.
On September 30, 2004, the close of our fiscal year, our common stock was held by 5,596 shareholders of record. As of November 30, 2004, our common stock was held by 5,577 shareholders of record. We have not paid cash dividends on our common stock and have historically retained earnings for use in our business. We intend to review our policy with respect to the payment of dividends from time to time; however, there can be no assurance that any dividends will be paid in the future.
ITEM 6:
ITEM 6: Selected Financial Data
Information with respect to this item may be found in the section captioned “Five-Year Summary of Selected Financial Data” on page below.
ITEM 7:
ITEM 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
Statements in this Annual Report on Form 10-K about our anticipated financial results and growth, as well as about the development of our products and markets, are forward looking statements that are based on our current plans and assumptions. Important information about the bases for these plans and assumptions and certain factors that may cause our actual results to differ materially from these statements are contained below and in “Important Factors That May Affect Future Results” beginning on page 24.
Unless otherwise indicated, all references to a year reflect our fiscal year that ends on September 30.
Executive Overview
Over the last several years, we have been transforming PTC from a one-product company in a mature CAD/CAM/CAE market to a multi-product company in the emerging PLM market. Our core business focus has been to provide design solutions to customers through our flagship Pro/ENGINEER® design software, and revenue associated with our design solutions continues to comprise a majority of our revenue. During the past few years, however, the discrete market for computer-aided design solutions has declined, and our revenue in this market also has declined. Although much of this decline is a result of market factors, including unwillingness by customers to invest in this market during difficult economic conditions, the decline in our design solutions revenue also is attributable to the relative saturation and increased competitiveness of the North American and European markets for design solutions, and the relative difficulty of displacing incumbent software vendors within this finite market.
Although the discrete market for computer-aided design solutions has declined, we believe that Asia-Pacific continues to present opportunity for growth, as global manufacturing companies have continued to invest in that region, the market in that region for both our design and collaboration and control solutions is relatively unsaturated and economic conditions in that region appear to be improving. Additionally, we believe that there is opportunity for growth in the collaboration and control solutions market and we have seen this market and the computer-aided design solutions market converge into a broader PLM opportunity. To position our company to capitalize on the opportunity presented by the emerging PLM market, we have, among other things, significantly remodeled our product lines, overhauled our distribution infrastructure, and created marketing and sales tools aimed at educating our customers concerning the benefits of our offerings. Much of this investment occurred during the recent economic downturn, which in turn put pressure on our revenue performance and operating profitability. Nevertheless, using cash built up during the 1990s when we experienced sustained growth with our design solutions, as well as using cash generated from our ongoing operations, we were able to proceed with these strategic investments. We believe that our investment in this strategy will
contribute to our success over the long term. We recently have introduced award-winning products that allow our customers to implement a scalable product development system that meets their requirements for both functionality and return on investment, two critical variables in today’s economic environment.
With a good portion of this business transformation investment behind us, beginning in 2003 and continuing during 2004 we embarked on cost cutting initiatives focusing on improving profitability. Although these reductions likely negatively impacted our overall revenue performance in 2003 and 2004, as demonstrated in the following graphs, these cost reductions have improved our overall profitability in 2004 and have provided operating leverage for the future.
Looking forward, we are focusing on our long-term goals of growing revenue and increasing our operating margins by leveraging our industry-leading solutions, improved distribution model, and reduced cost structure. Our goal is to increase revenue both by increasing sales of our existing products and by pursuing strategic corporate development opportunities. To achieve these goals, we intend to embark on a course of making measured increases to our direct sales force and reseller channel, to make strategic investments in vertical product solutions as demand for our products dictate, and to continue to make strategic investments in the Asia-Pacific market, while remaining focused on profitability and actively evaluating potential acquisitions. Our overall performance will depend on, among other factors: (i) improved economic conditions and the strengthening of technology spending in the global manufacturing sector; (ii) our ability to elevate PLM expenditures over other technology spending as a budgetary priority among our customers; (iii) our ability to successfully execute our product strategy to provide an integrated, easy to use and rapidly deployable suite of PLM software solutions that customers can deploy to create a product development system that meets their evolving requirements; (iv) our ability to differentiate our products and services from those of our competitors, including larger companies with established enterprise relationships with our customers; and (v) our ability to successfully execute on corporate development initiatives. Our enhanced suite of PLM software solutions provides the foundation for our future growth, as these solutions provide a basis for expanding our relationships with existing customers who have previously purchased our traditional high-end design products. We must accordingly focus on enhancing and marketing our product and service offerings so that our customers are able to understand and realize their advantages.
Our performance also will depend on our ability to undertake our strategic initiatives while at the same time controlling increases in our current operating cost structure. In 2003, we began implementing cost cutting initiatives (discussed further below) designed to reduce our quarterly operating cost structure to approximately $150 million, excluding restructuring charges, by the end of fiscal 2004. By the end of the second quarter of 2004, those cost reductions had reduced our quarterly operating cost structure to under $150 million. In connection with these reductions, we incurred restructuring charges of $42.9 million in 2004 and $30.9 million in 2003. We completed our restructuring program in the fourth quarter of 2004.
Finally, our success also will depend on other factors, including: (i) our ability to optimize our sales and services coverage and productivity through, among other means, effective utilization and management of our resellers and other strategic partners as well as our own sales force; (ii) our ability to further improve customer satisfaction and to build customer references; (iii) our effective management of our development resources; (iv) our success at penetrating strategic emerging markets; and (v) our ability to migrate our customers to a more robust PLM product development system. We believe that we have made progress on these initiatives; however, spending in our sector of the economy has been weak. Although recent economic indicators have suggested that technology spending has begun to increase modestly, technology spending in the manufacturing sector is expected to lag behind overall increases in technology spending.
Additional factors affecting our revenues and operating results are identified under “Important Factors That May Affect Future Results” beginning on page 24.
Results of Operations
Overview
The following is a summary of our results of operations for the last three years. A detailed discussion regarding these results follows the table below:
• Total revenue was $660.0 million in 2004, $671.9 million in 2003 and $742.0 million in 2002.
• License revenue was $198.9 million in 2004, $205.3 million in 2003 and $242.9 million in 2002.
• Service revenue was $461.1 million in 2004, $466.6 million in 2003 and $499.1 million in 2002.
• Collaboration and control solutions revenue was $179.3 million in 2004, $173.5 million in 2003 and $177.1 million in 2002.
• Design solutions revenue was $480.7 million in 2004, $498.4 million in 2003 and $564.9 million in 2002.
• Amortization of goodwill and other intangible assets was $5.2 million in 2004, $5.9 million in 2003 and $35.8 million in 2002.
• Restructuring and other charges were $42.9 million in 2004, $30.9 million in 2003 and $31.2 million in 2002.
• Total costs and expenses, including restructuring and other charges, was $622.6 million in 2004, $751.6 million in 2003 and $820.4 million in 2002.
• In 2004, we recognized a one-time tax benefit of $18.9 million due to a favorable resolution of prior-year tax audits with the Internal Revenue Service.
• Net income (loss) was $34.8 million in 2004, $(98.3) million in 2003 and $(93.6) million in 2002. The improvement in our 2004 results is primarily attributable to reductions in our operating cost structure.
The following table shows certain consolidated financial data as a percentage of our total revenue for the last three years:
Revenue
Total Revenue
Our revenue consists of software license revenue and service revenue, which includes software maintenance as well as consulting, implementation, education and other technical support revenue. We presently report our revenue in two product categories: (1) our collaboration and data management technologies (collaboration and control solutions), including our Windchill® Internet-based software, and (2) our computer-aided design, manufacturing and engineering software (design solutions), including our flagship Pro/ENGINEER® design software. The following table illustrates trends from 2002 to 2004 in our software license revenue and in our service revenue, as well as in our two product categories and by geography.
* On a consistent foreign currency basis from the prior period, total revenue decreased 7% in 2004 compared to 2003 and decreased 14% in 2003 compared to 2002, revenue in Europe decreased 10% in 2004 compared to 2003 and decreased 16% in 2003 compared to 2002, and revenue in Asia Pacific decreased 3% in 2004 compared to 2003 and decreased 4% in 2003 compared to 2002.
Although we experienced modest improvements in our revenue in the second half of 2004 compared to the second half of 2003, our total revenue in 2004, as well as in 2003 and 2002, has declined. We attribute these declines to a number of factors, including the relative saturation and increased competitiveness of the North American and European markets for design solutions, continued reluctance of our customers to consummate large software purchases, reduced delivery capacity in connection with headcount reductions in our services business, ongoing weakness in technology spending in the global manufacturing economy and the relative infancy of the PLM market.
We derived 65%, 63% and 58% of our total revenue from sales to customers outside of North America in 2004, 2003 and 2002, respectively. While we believe ongoing weakness in technology spending continues to affect all of our geographic regions, we believe that Asia-Pacific presents the greatest opportunity for growth as global manufacturing companies have continued to invest in that region, the market in that region for both our design and collaboration and control solutions is relatively unsaturated and economic conditions in that region appear to be improving.
License revenue accounted for 30%, 31% and 33% of total revenue in 2004, 2003 and 2002, respectively. Service revenue, which has a lower gross profit margin than license revenue, accounted for 70%, 69% and 67% of total revenue in 2004, 2003 and 2002, respectively. Although service revenue as a percentage of overall revenue has increased slightly over this three-year period, the composition of our service revenue has changed. Compared to 2003, maintenance revenue for 2004 was up 5% (down 2% on a consistent foreign currency basis), representing 70% of overall services revenue in 2004 compared to 66% in 2003, while other service revenue in 2004 was down 13% over 2003, representing 30% of overall service revenue in 2004 compared to 34% in 2003. Maintenance revenue in 2004 was favorably impacted by customers’ adoption of Pro/ENGINEER Wildfire and growth in Windchill license revenue. However, our other service revenue (consulting, implementation, education and other support revenue) was adversely affected by the removal of a portion of our services delivery headcount in connection with our cost reductions.
In the second quarter of 2003, with the launch of Pro/ENGINEER Wildfire, we began selling a product development system package called “Flex 3C” for Create, Collaborate and Control. This package includes Pro/ENGINEER Wildfire with advanced engineering modules, Windchill ProjectLink, and Windchill PDMLink as a data management option. Because the package includes both design solutions and collaboration and control solutions, for purposes of reporting revenues by product categories, we allocate revenue from sales of the Flex 3C package among our two product categories. Revenue from sales of new Flex 3C licenses is allocated 90% to our design solutions and 10% to our collaboration and control solutions. Revenue from upgrades to the Flex 3C package is allocated 50% to our design solutions and 50% to our collaboration and control solutions. In line with customer demand for a complete product development system, we foresee that we will continue to offer packages that include both design solutions products and collaboration and control solutions products. As such, the delineation between the two product lines may become less meaningful and, accordingly, we may revise our product categories.
We have been building and diversifying our reseller channel to become less dependent on a small number of distributors and to provide the resources necessary for more effective distribution of our products. Although we typically receive lower revenue per seat for an indirect sale versus a direct sale, we believe that utilizing diverse and geographically dispersed distributors that focus on smaller businesses will provide an efficient and cost effective means to reach these customers, while allowing our direct sales force to focus on larger sales opportunities. License sales from our reseller channel, which are primarily for design solutions, were $56.2 million, $45.9 million and $44.0 million in 2004, 2003 and 2002, respectively. This growth is due in part to our efforts to expand our reseller channel as mentioned above. We also attribute the increase in reseller channel revenue to the growing success of Pro/ENGINEER Wildfire in small and medium businesses both relative to our historic offerings as well as to competitive offerings in this market segment. Increases in revenue from our reseller channel have occurred in tandem with the expiration of our arrangement with Rand A Technology Corporation, which historically had been our largest distributor. Rand A Technology Corporation’s distribution rights for certain territories expired on December 31, 2003 and, for the remaining territories, expired at the end of March 2004. The expiration of Rand’s distribution rights has not had a material effect on our operating results, as the customers formerly serviced by Rand may now be serviced by PTC directly or by other PTC resellers. We are also currently involved in a lawsuit with Rand, as described in Part I, Item 3, “Legal Proceedings”.
Collaboration and Control Solutions Revenue
The following table illustrates trends from 2002 to 2004 in our collaboration and control solutions software license revenue and service revenue:
Total revenue from our collaboration and control solutions software and related services was 27%, 26% and 24% of our total revenue in 2004, 2003 and 2002, respectively.
Collaboration and control solutions license revenue grew 3% in 2004 compared to 2003 after having decreased 7% in 2003 compared to 2002. Although we are encouraged by this recent performance, particularly in the second part of 2004, the PLM market is still in its early stages and we continue to observe reluctance on the part of our customers to consummate large software purchases, particularly in this evolving market. Further, we have seen an ongoing trend of customers purchasing PLM solutions in incremental fashion and have continued to see sales shift from enterprise-level Windchill modules to our Windchill Link solutions. We feel that we have addressed this evolving customer demand with our Windchill Link solutions (described below), as well as with our product development system adoption roadmap, which provides customers with a suggested approach for purchasing and implementing our solutions in stages.
The increase in collaboration and control solutions maintenance revenue for all periods presented is attributable to a growing user base of our Windchill solutions and the introduction of our Flex 3C package in 2003, which includes Windchill software. Other service revenues have been adversely affected by the removal of a portion of our delivery capacity in connection with our cost reductions.
To improve our ability to provide PLM solutions to a broader range of customers, to complement our enterprise offerings and to meet evolving customer demand, we have introduced Windchill-based solutions targeted at specific business-critical PLM processes (our Windchill Link solutions). In 2004, 2003 and 2002, Windchill Link solutions license revenue was $29.7 million, $29.9 million and $11.4 million, respectively, which represented 50%, 52% and 18%, respectively, of our collaboration and control license revenue. We expect that our Windchill Link solutions will continue to gain acceptance with existing and new customers, and that they will comprise a large portion of our overall Windchill license revenue. We believe these solutions address a growing customer demand for better return on investment as they can be implemented in incremental fashion. As the requirements of our customers and the general market change, we plan periodically to evaluate the need for additional solutions.
In addition to these product changes, we also have begun to expand our distribution of our PLM solutions by recently offering a limited number of qualified resellers the ability to sell our Windchill Link solutions as well as related services. In 2004, we also completed the acquisition of OHIO Design Automation, Inc., a developer of collaboration solutions for electronics design. This acquisition will allow us to better serve the high technology and electronics industries by providing the technology necessary to offer an integrated solution, enabling the dynamic management of both mechanical and electrical design information. We have begun to integrate OHIO Design Automation’s technology into the Windchill product line for future release, while continuing to offer the technology on a stand-alone basis. OHIO Design Automation’s revenues on a historic stand-alone basis were not significant.
Design Solutions Revenue
The following table illustrates trends from 2002 to 2004 in our design solutions software license revenue and service revenue:
Total revenue from our design solutions and related services was 73%, 74% and 76% of our total revenue in 2004, 2003 and 2002, respectively. Compared to the prior year, design solutions license revenue reflects an increase in software unit sales of 12% in 2004 and a decline in software unit sales of 9% in 2003, and reflects decreases in the average selling price per seat of 16% in 2004 and 10% in 2003. The 2004 increase in unit sales, or seats, and decrease in the average selling price per seat are attributable, in part, to a higher mix of lower-end software packages being sold due to growing acceptance of Pro/ENGINEER Wildfire in the low-end of the mechanical computer-aided design market, as well as to an increased mix of sales completed by resellers, for which we receive lower revenue per seat. The decrease in design solutions total service revenue is due in large part to the lag effect of license revenue declines in prior periods and also has been adversely affected by the removal of a portion of our services delivery capacity in connection with our cost reductions.
While we have experienced fluctuations in our design solutions revenue quarter to quarter, overall we are cautiously optimistic that, with the introduction of Pro/ENGINEER Wildfire (discussed further below), our design solutions revenue has begun to stabilize. However, in light of the unfavorable market conditions described below, future revenue trends for our design solutions and related services remain uncertain.
Design solutions revenue continues to be adversely affected by: (i) the relative maturity and saturation of the North American and European markets; (ii) the difficulty associated with displacing incumbent product design systems in the discrete market for computer-aided design solutions; (iii) increased competition and price pressure from products offering more limited functionality at lower cost; and (iv) weakness in technology spending in the global manufacturing economy, which has led to a decline in large-dollar license transactions. The decrease in our design solutions revenue during 2003, compared to 2002, also reflects the sale of our ICEM surfacing business in the fourth quarter of 2002. The ICEM business had contributed revenue of $11.2 million in 2002.
To address the decline in our design solutions revenue, we have introduced design solutions packages that have price points, functionality and ease-of-use features that appeal to a broader spectrum of design solution users. Pro/ENGINEER Wildfire, released in February 2003 and updated with Pro/ENGINEER Wildfire 2.0 in May 2004, supports Internet interfaces and Windchill-based interfaces and provides customers with the opportunity to integrate more readily traditional design solutions with collaboration and control solutions. The product’s user interface makes it more competitive with lower-end modeling tools on the market that are known for ease-of-use, while maintaining the powerful functionality of Pro/ENGINEER. The new Internet interface, which is unique to Pro/ENGINEER, offers a differentiated design solution to manufacturing companies looking for a complete product development system. All Pro/ENGINEER customers on an active maintenance plan received Pro/ENGINEER Wildfire as a maintenance release consistent with their current configurations, and we attribute our recent growth in design solutions maintenance revenue, in part, to the success of Pro/ENGINEER Wildfire among existing customers. We also offer various technology and service upgrade packages, allowing customers to purchase upgrades from their existing product configuration to the full suite of Pro/ENGINEER Wildfire functionality.
Costs and Expenses
Over the past several years, we have made significant investments needed to transform our business from providing a single line of technical software with a direct distribution model to providing a family of enterprise solutions with an expanded channel
and partner-involved distribution model. We undertook to reduce our cost structure after completing a significant portion of this transformation and we believe we will be able to maintain product quality and customer satisfaction, even with our reduced cost structure. All cost and expense categories in 2004, 2003 and 2002 were impacted by restructuring actions taken in those periods. The following table illustrates trends from 2002 to 2004 in our costs and expenses:
* On a consistent foreign currency basis from the prior period, total costs and expenses decreased 20% in 2004 compared to 2003 and decreased 11% in 2003 compared to 2002.
Compared to the prior year, total costs and expenses decreased $129.0 million and $68.9 million in 2004 and 2003, respectively, primarily as a result of our restructuring plan initiated in 2003 and completed in the fourth quarter of 2004. To achieve our objective of restoring profitability, we implemented cost cutting measures that reduced our headcount, resulting in lower aggregate salaries, benefits and related costs. As a result, our headcount has decreased over the last three years to 3,042, 3,500 and 3,803 at the end of 2004, 2003 and 2002, respectively. In addition, our cost reduction initiatives resulted in reduced facility charges, including rent and related overhead costs. Primarily as a result of headcount reductions and lease costs related to excess facilities, we recorded restructuring and other charges of $42.9 million, $30.9 million and $31.2 million in 2004, 2003 and 2002, respectively. See “Restructuring and Other Charges” below and Note B of “Notes to Consolidated Financial Statements” for further discussion.
The decrease in costs and expenses in 2003 from 2002 was also due to lower amortization of goodwill and certain intangible assets as a result of the adoption of Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, and lower variable expenses resulting from lower revenues.
Cost of License Revenue
Our cost of license revenue consists of fixed and variable costs associated with reproducing and distributing software and documentation as well as royalties owed to third parties for technology embedded in or licensed with our software products. Cost of license revenue as a percentage of license revenue was 4% for 2004, 5% for 2003 and 7% for 2002. Cost of license revenue as a percent of license revenue can vary depending on product mix sold and the effect of fixed and variable royalties in relation to the level of license revenue. The decrease in cost of license revenue in 2004 and 2003 compared to the prior periods was primarily due to lower royalty costs of approximately $2.2 million and $4.4 million, respectively, resulting primarily from lower revenue.
Cost of Service Revenue
Our cost of service revenue includes costs associated with training, customer support and consulting personnel, such as: salaries, benefits and travel; third-party subcontractor fees; costs associated with the release of maintenance updates (including related royalty costs); and facility costs. Cost of service revenue as a percentage of service revenue was 38% in 2004, 44% in 2003 and 40% in 2002. The decreased cost of service revenue in 2004 compared to prior periods is due primarily to our removal of a portion of our services delivery headcount. Service revenue margins improved in 2004 from 2003, primarily due to this reduction in service-related employee headcount, reducing headcount in our services organization by 17% at the end of 2004 as compared to the end of 2003 and resulting in a $16.9 million reduction in compensation, benefit and travel costs. In addition, royalty costs were
$11.5 million lower in 2004 than in 2003, primarily as a result of a contract renegotiation finalized in the second quarter of 2004, resulting in a one-time benefit of $5.0 million from the reversal of an accrual established in the fourth quarter of 2003. Compared to 2002, service revenue margins in 2003 declined due to lower revenue and higher cost of service expense, including the fourth quarter 2003 accrual referred to above, partially offset by a 6% decrease in service-related employee headcount at the end of 2003 compared to the end of 2002.
Sales and Marketing
Our sales and marketing expenses primarily include salaries and benefits, sales commissions, advertising and marketing programs, travel and facility costs. Sales and marketing expenses as a percentage of total revenue were 34%, 44% and 45% for 2004, 2003 and 2002, respectively. Total sales and marketing employee headcount decreased 15% at the end of 2004 and 18% at the end of 2003 compared to the prior year. At the end of 2004, 2003 and 2002, sales and marketing headcount was 945, 1,114, and 1,358, respectively. Compared to the prior year, total sales and marketing expenses decreased 24% in 2004 and 10% in 2003 primarily as a result of the headcount reductions, as well as to reductions in marketing program costs, which, compared to the prior period, were $8.4 million and $6.2 million lower in 2004 and 2003, respectively. In addition, sales commissions were lower by approximately $10.1 million in 2003 compared to 2002 due to lower license and service revenue.
Research and Development
Our research and development expenses consist principally of salaries and benefits, costs of computer equipment and facility expenses. Major activities of this organization include developing new releases of our software that work together in a more integral fashion and that include functionality enhancements desired by our customers. Research and development expenses as a percentage of total revenue were 16%, 19% and 19% in 2004, 2003 and 2002, respectively. Compared to the prior year, research and development expenses decreased 16% in 2004 and decreased 6% in 2003. The decrease in 2004 and 2003 from the prior periods is due primarily to shifting certain development activities to our existing facilities in India where overall research and development costs are lower, to lower depreciation and telecommunication costs and, in 2004, to cost reductions from our restructuring plan completed in that year, which resulted in a 10% lower headcount at the end of 2004 compared to the end of 2003.
General and Administrative
Our general and administrative expenses include the costs of our corporate, finance, information technology, human resources and administrative functions as well as bad debt expense. General and administrative expenses as a percentage of total revenue were 9%, 10% and 9% for 2004, 2003 and 2002, respectively. Compared to the prior year, these costs decreased 16% in 2004 and increased 3% in 2003. The decrease in 2004 is primarily due to a 7% reduction in headcount as well as lower depreciation, bad debt expense and insurance costs. The decreases were partially offset by an increase in compensation expense associated with incentive plan bonuses for which targets were met in 2004. The increase in 2003 is primarily related to increased insurance costs and investments in information technology systems, as well as an increase in bad debt expense. Bad debt expense in 2004, 2003 and 2002 was $3.1 million, $5.1 million and $4.3 million, respectively.
Amortization of Goodwill and Other Intangible Assets
Amortization of goodwill and other intangible assets totaled $5.2 million, $5.9 million and $35.8 million in 2004, 2003 and 2002, respectively. These costs represent the amortization of acquired intangible assets, including developed technology and customer lists and, for intangible assets acquired prior to October 1, 2002, these costs also include the amortization of goodwill, trademarks and assembled workforce. In July 2001, the Financial Accounting Standards Board issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires that, effective October 1, 2002, ratable amortization of goodwill and intangible assets with indefinite useful lives be replaced with periodic impairment tests of those assets and that certain intangible assets other than goodwill be amortized over their useful lives. In accordance with SFAS No. 142, beginning October 1, 2002, we no longer amortize goodwill and certain intangible assets with an indefinite useful life, including acquired trademarks. As a result, amortization of goodwill and other intangible assets decreased $29.9 million in 2003 compared to 2002. For a further discussion, see Critical Accounting Policies-Valuation of Goodwill and Other Intangible Assets below and Note D of “Notes to Consolidated Financial Statements.”
In the third quarter of 2004, we completed the acquisition of OHIO Design Automation, Inc. for $9.8 million in cash. Ohio Design Automation develops collaboration solutions for electronics design. The purchase price was allocated to assets acquired and liabilities assumed based on our estimates of fair value. The values assigned included intangible assets of $1.8 million for customer lists and $1.6 million for purchased software, which are being amortized over estimated useful lives of 5 years and 3 years, respectively. The excess purchase price over the amounts allocated to assets acquired and liabilities assumed of $7.0 million was recorded as goodwill. Upon the fulfillment of certain specified conditions, an additional $2 million related to the acquisition will be paid through April 2007. Any such contingent payments will be recorded as operating expenses as incurred.
Restructuring and Other Charges
In 2004, 2003 and 2002, we recorded restructuring and other charges of $42.9 million, $30.9 million and $31.2 million, respectively, primarily associated with reductions in workforce and excess facility obligations to reduce our cost structure and to improve profitability. During those same periods, we made cash payments related to restructuring and other charges of $40.6 million, $24.4 million and $42.5 million, respectively. Amounts not yet paid at September 30, 2004 related to restructuring and other charges taken during the current and all prior periods were $43.3 million and primarily relate to excess facility obligations to be paid out through 2014. Of the total amount accrued at September 30, 2004, we expect to pay approximately $12 million within the next twelve months.
In 2004, we recorded restructuring and other charges of $21.0 million for severance and termination benefits related to 459 employees terminated during 2004 and $21.9 million related primarily to excess facilities. The charges for excess facilities are primarily related to gross lease commitments in excess of estimated sublease income for excess facilities. Of the total restructuring and other charges recorded in 2004, $1.9 million was non-cash for the write-off of leasehold improvements related to the excess facilities. This restructuring program was completed in the fourth quarter of 2004.
In 2003, we recorded restructuring charges of $17.9 million for severance and termination benefits related to 361 employees terminated during 2003. We also recorded charges of $11.6 million related to excess facilities and $1.4 million of other costs, primarily related to the write-off of acquired technology. The increases in the liability for excess facilities in 2003 related primarily to revised estimates of gross lease commitments in excess of expected sublease income for leases assumed in our 1998 acquisition of Computervision Corporation as well as to consolidating existing leased facilities.
In 2002, we recorded restructuring and other charges of $17.3 million for severance and termination benefits related to approximately 310 employees who were notified or terminated during 2002 and $13.9 million related to excess facilities. The excess facilities charge was primarily comprised of an increase to Computervision lease liabilities for existing excess facilities, necessitated by changing real estate market conditions and related actions taken by several subtenants.
Interest Income
Interest income relates to earnings on the investment of our excess cash balances in various financial instruments and totaled $3.5 million, $3.3 million and $4.1 million in 2004, 2003 and 2002, respectively. The modest increase in interest income in 2004 compared to 2003 was due to earnings on higher average cash balances at lower interest rates in 2004 than in 2003. The 20% decrease in interest income in 2003 compared to 2002 resulted primarily from lower investment returns and declines in average investment balances.
Other Expense, Net
Other expense, net includes costs of hedging contracts, certain realized and unrealized foreign currency transaction gains or losses, charges incurred in connection with financing customer contracts, write-downs of investments and foreign exchange gains or losses resulting from the required period-end currency remeasurement of the financial statements of our subsidiaries that use the U.S. dollar as their functional currency. A large portion of our revenue and expenses is transacted in foreign currencies. To reduce our exposure to fluctuations in foreign exchange rates, we engage in hedging transactions involving the use of foreign currency forward contracts and, from time to time, foreign currency option contracts, primarily in the Euro and in Asian currencies. Other expense, net totaled $3.9 million, $6.1 million and $8.6 million in 2004, 2003 and 2002, respectively. The 36% decrease in other expense, net, in 2004 compared to 2003 was due primarily to lower charges in connection with financing customer contracts, which
were $2.1 million in 2004 compared to $3.9 million in 2003. The 30% decrease in other expense, net in 2003 compared to 2002 was due primarily to lower costs of foreign currency hedging. See Item 7A
ITEM 7A: Quantitative and Qualitative Disclosures about Market Risk
We face exposure to financial market risks, including adverse movements in foreign currency exchange rates and changes in interest rates. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial results.
Foreign currency exchange risk
Our earnings and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. Our most significant foreign currency exposures relate to Western European countries that use the Euro as a common currency and to Japan. We enter into various hedging transactions to manage this risk. We do not enter into or hold foreign currency derivative financial instruments for trading or speculative purposes.
Our international revenues generally are transacted through our non-U.S. subsidiaries and typically are denominated in their local currency. In addition, our international expenses that are incurred by our international subsidiaries typically are denominated in their local currency. Approximately 65%, 63% and 58% of our total revenue was from sales to customers outside of North America in 2004, 2003 and 2002, respectively. Approximately 45%, 43% and 42% of our total expenses were incurred by our subsidiaries domiciled outside of North America in 2004, 2003 and 2002, respectively.
Our exposure to foreign currency exchange rate fluctuations arises in part from intercompany transactions, with most intercompany transactions occurring between a U.S. dollar functional currency entity and a foreign currency denominated entity. Intercompany transactions typically are denominated in the local currency of the international subsidiary in order to centralize foreign currency risk. Also, both PTC (the parent company) and our international subsidiaries may transact business with our customers and vendors in a currency other than their functional currency (“transaction risk”). In addition, we are exposed to foreign exchange rate fluctuations as the financial results and balances of our international subsidiaries are translated into U.S. dollars (“translation risk”). If sales to customers outside of the United States continue to comprise a growing percentage of total revenues, our exposure to fluctuations in currency exchange rates could increase.
Our foreign currency risk management strategy is principally designed to mitigate the future potential financial impact of changes in the value of transactions and balances denominated in foreign currency, resulting from changes in foreign currency exchange rates. Our foreign currency hedging program utilizes forward contracts to manage the foreign currency exposures that exist as part of our ongoing business operations. The contracts primarily are denominated in European currencies and Japanese Yen, and have maturities of less than three months.
Generally, we do not designate foreign currency forward contracts as hedges for accounting purposes, and changes in the fair value of these instruments are recognized immediately in earnings. Because we enter into forward contracts only as an economic hedge, any gain or loss on the underlying foreign-denominated balance would be offset by the loss or gain on the forward contract. Gains and losses on forward contracts and foreign denominated receivables and payables are included in other income (expense), net. As of September 30, 2004 and 2003, we had outstanding forward contracts with notional amounts equivalent to approximately $83.3 million ($58.9 million in Euros, $12.1 million in British Pounds, $6.4 million in Japanese Yen and $5.9 million in other currencies) and $75.7 million ($56.8 million in Euros, $8.1 million in British Pounds, $4.1 million in Japanese Yen and $6.7 million in other currencies), respectively.
We periodically use foreign currency option contracts to hedge specific forecasted net cash flow transactions that are derived from anticipated international revenue. Foreign currency option contracts are designated as cash flow hedges for accounting purposes and changes in the fair value of the option contract are deferred in accumulated other comprehensive income and reclassified into earnings when the underlying forecasted transaction impacts earnings. As of September 30, 2004 and 2003, there were no foreign currency option contracts outstanding.
Cash and cash equivalents
As of September 30, 2004, cash equivalents are invested in highly liquid investments with maturities of three months or less when purchased. We invest our cash with highly rated financial institutions in North America, Europe and Asia/Pacific and in diversified domestic and international money market mutual funds. At September 30, 2004, we had $128.9 million, $92.4 million, $64.2 million and $9.4 million of cash and cash equivalents in the United States, Europe, Japan and other international countries, principally in Asia/Pacific, respectively. Given the short maturities and investment grade quality of the portfolio holdings at September 30, 2004, a hypothetical 10% change in interest rates would not materially affect the fair value of our cash and cash equivalents.
Our invested cash is subject to interest rate and, for international operations, foreign currency risk. In a declining interest rate environment, we would experience a decrease in interest income. The opposite holds true in a rising interest rate environment. Over the past several years, the U.S. Federal Reserve Board, European Central Bank and Bank of England have significantly decreased certain benchmark interest rates, which has led to a general decline in market interest rates. This decline in market interest rates has resulted in lower interest income earned on our cash and cash equivalents. In the second half of 2004, the U.S. Federal Reserve Board increased benchmark interest rates slightly. Interest income will continue to fluctuate based on changes in market interest rates and levels of cash available for investment. During 2004 and 2003, our consolidated cash balances were impacted favorably by strengthening of foreign currencies relative to the U.S. dollar, particularly with respect to the Euro and the Japanese Yen.
ITEM 8:
ITEM 8: Financial Statements and Supplementary Data
The consolidated financial statements and notes to the consolidated financial statements are attached as APPENDIX A below.
ITEM 9:
ITEM 9: Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
ITEM 9A:
ITEM 9A: Controls and Procedures
(a) Evaluation of disclosure controls and procedures. Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this annual report. Based on this evaluation, our principal executive officer and principal financial officer concluded that these disclosure controls and procedures are effective and designed to ensure that the information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the requisite time periods.
(b) Changes in Internal Control Over Financial Reporting. There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) identified in connection with the evaluation of our internal control that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B:
ITEM 9B: Other Information
None.
PART III
ITEM 10:
ITEM 10: Directors and Executive Officers of the Registrant
Information with respect to our directors and executive officers, including the qualifications of certain members of the Audit Committee of our Board of Directors, may be found in the sections captioned “Proposal 1: Elect Three Directors,” “Who Are Our Directors,” “The Committees of the Board,” “Certain Relationships and Transactions” and “Section 16(a) Beneficial Ownership & Reporting Compliance” appearing in our 2005 Proxy Statement. Such information is incorporated herein by reference.
Our executive officers are:
Name
Age
Position
C. Richard Harrison
Chief Executive Officer and President
Barry F. Cohen
Executive Vice President, Strategic Services and Partners
Paul J. Cunningham
Executive Vice President, Worldwide Sales
Anthony DiBona
Executive Vice President, Global Maintenance Support
James E. Heppelmann
Executive Vice President and Chief Product Officer
Cornelius F. Moses
Executive Vice President and Chief Financial Officer
Aaron C. von Staats
Senior Vice President, General Counsel and Clerk
Mr. Harrison has been Chief Executive Officer and President of PTC since March 2000. Prior to that, Mr. Harrison served as President and Chief Operating Officer since August 1994.
Mr. Cohen has been Executive Vice President, Strategic Services and Partners since August 2002. Prior to that, Mr. Cohen served as Executive Vice President, Marketing and Human Resources from December 2000 to July 2002 and Executive Vice President, Marketing from January 1998 to November 2000.
Mr. Cunningham has been Executive Vice President, Worldwide Sales since October 2002. Prior to that, Mr. Cunningham served as Executive Vice President, Americas Sales from July 2000 to September 2002, and from October 1998 to June 2000 he was Executive Vice President, Primary Sales.
Mr. DiBona has been Executive Vice President, Global Maintenance Support since April 2003. Prior to that, Mr. DiBona led the PTC Global Business Partner Group from April 2000 to April 2003. Mr. DiBona joined PTC in August 1998 as Executive Vice President, PTC Major Account Sales.
Mr. Heppelmann has been Executive Vice President, Chief Product Officer beginning February 2003 after being our Executive Vice President, Software Solutions and Chief Technology Officer since June 2001. Prior to that, Mr. Heppelmann was Executive Vice President, General Manager Windchill Solutions from November 2000 to June 2001. He had served as Executive Vice President and General Manager of Windchill Netmarkets from July 2000 to November 2000 and Senior Vice President of Windchill from January 1998 to July 2000.
Mr. Moses joined PTC in June 2003 as our Executive Vice President, Chief Financial Officer and Treasurer and since March 2004 has been our Executive Vice President and Chief Financial Officer. Prior to joining PTC, Mr. Moses was Executive Vice President and Chief Financial Officer of Axcelis Technologies, Inc., a semiconductor equipment manufacturer, from October 2000 to June 2003. Prior to that, Mr. Moses was Senior Vice President, Chief Financial Officer of Bradlees, Inc., a discount retail chain, from 1996.
Mr. von Staats has been Senior Vice President, General Counsel and Clerk since February 2003. Previously, he served as Vice President, North American Counsel from December 2001 through January 2002 and prior to that served as Regional Corporate Counsel, North America from June 1998 through November 2001.
We have adopted the PTC Code of Business Conduct and Ethics, a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, and Controller, as well as others. A copy of the PTC Code of Business Conduct and Ethics is publicly available on our website at www.ptc.com. If we make any substantive amendments to the PTC Code of Business Conduct and Ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer or Controller, we will disclose the nature of such amendment or waiver in a report on Form 8-K.
ITEM 11:
ITEM 11: Executive Compensation
Information with respect to executive compensation may be found under the headings captioned “How We Compensate Our Directors” and “Information About Executive Compensation” appearing in our 2005 Proxy Statement. Such information is incorporated herein by reference.
ITEM 12:
ITEM 12: Security Ownership of Certain Beneficial Owners and Management
Information with respect to security ownership may be found under the heading captioned “Information About PTC Common Stock Ownership” appearing in our 2005 Proxy Statement. Such information is incorporated herein by reference.
EQUITY COMPENSATION PLANS
The following table sets forth information regarding our equity compensation plans as of September 30, 2004:
(1) Comprises (a) 8,223,007 shares of our common stock available for future issuance under our 2000 Employee Stock Purchase Plan and (b) 2,195,666 shares of our common stock available for awards under our 2000 Equity Incentive Plan (the “2000 EIP”). In addition to stock option awards, the 2000 EIP provides for the issuance of stock appreciation rights (“SARs”). SARs are rights to receive any excess in value of shares of common stock over the exercise price; the Compensation Committee (the “Committee”) of our Board of Directors determines whether they are settled in cash, common stock or other of our securities, awards or other property and may define the manner of determining the excess in value of the shares of common stock. Under our 2000 EIP, the Committee also may make awards of common stock subject to certain restrictions during a specified period, such as the participant’s continued service with PTC or the company achieving certain financial goals. The participant generally will forfeit the shares if the specified conditions are not met and the participant cannot transfer the shares before termination of that period. The participant is, however, entitled to vote the shares and receive any dividends during the restriction period. The Committee also may award common stock without restrictions to recognize outstanding achievements or as a supplement to restricted stock awards when PTC’s performance exceeds established financial goals. The Committee determines what, if anything, the participant must pay to receive such a stock award, but the number of shares that may be granted under the 2000 EIP for less than fair market value is limited to 10% of the shares authorized under the plan.
(2) Excludes 249,534 shares of our common stock issuable upon exercise of outstanding options assumed in connection with our mergers or other acquisition transactions; these options have a weighted-average exercise price of $19.06.
Non-Stockholder Approved Plan
PTC maintains the 1997 Non-Statutory Stock Option (the “Plan”). The purpose of the Plan is to attract and retain key employees and consultants of the company and our majority-owned subsidiaries, to provide an incentive for them to achieve long-range performance goals and to enable them to participate in our long-term growth. Our employees and consultants, and those of any of our majority-owned subsidiaries, capable of contributing significantly to the successful performance of the company are eligible for option awards under the Plan. Our officers and directors are not eligible to participate in the Plan. Options granted under the Plan may only be stock options that are not intended to be “incentive stock options” within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended.
The Plan is administered by the Committee. Subject to the provisions of the Plan, the Committee has the authority to select the employees and consultants to whom options are granted and determine the terms of each option, including the amount, exercise price, vesting schedule (generally in four equal annual installments on each of the first four anniversaries of the date of grant) and term, which may not exceed ten years. The per share exercise price of an option must be at least 100% of the fair market value of our common stock on the date of grant.
Options generally are exercisable only during an optionee’s term of employment or engagement as a consultant and for a period of between ten and ninety days after that term ends. In the case of termination as a result of death or permanent disability, options generally are exercisable thereafter for twelve months; in the case of termination as a result of retirement, options generally are exercisable thereafter for three months. During the lifetime of the optionee, his or her option is exercisable only by him or her and is not transferable except by will or by the laws of descent and distribution.
The Committee may act to preserve an optionee’s rights under an option in the event of a change in control of PTC by (i) accelerating any time period relating to the exercise of the option, (ii) providing for compensating payments to the optionee, (iii)
adjusting the terms of the option to reflect the change in control, (iv) causing the option to be assumed by another entity, or (v) making any other provision that the committee may consider equitable to optionees and in the best interests of PTC. Unless otherwise determined by the Board, stock options held by Senior Vice President and Vice President level employees become exercisable in full if, within one year following a change in control of PTC, such employee’s employment is terminated without cause, by the employee due to a Change in Status, or due to his or her death or partial or total disability.
The Board of Directors may amend, suspend or terminate the Plan or any portion thereof at any time. The Committee may amend, modify or terminate any outstanding award with the respective optionee’s consent unless the amendment would not materially and adversely affect the optionee in which case, consent is not required. However, the Committee may not, without stockholder approval, amend any outstanding option to reduce the exercise price at any time during the term of such option.
Plans Assumed in Connection with a Merger or Other Acquisition Transaction
PTC has also assumed stock options under certain equity plans in the course of its merger and acquisition activities. These plans are all inactive and no future options may be granted under them. The plans are all substantially similar to the Plan, discussed above, except that certain of the options outstanding are “incentive stock options” within the meaning of Section 422 of the Code.
ITEM 13:
ITEM 13: Certain Relationships and Related Transactions
Information with respect to this item may be found under the heading “Information About Certain Insider Relationships” appearing in our 2005 Proxy Statement. Such information is incorporated herein by reference.
ITEM 14:
ITEM 14: Principal Accounting Fees and Services
Information with respect to this item may be found under the heading “Information About Our Independent Registered Public Accounting Firm” appearing in our 2005 Proxy Statement. Such information is incorporated herein by reference.
PART IV
ITEM 15:
ITEM 15: Exhibits, Financial Statement Schedules
(a) Documents Filed as Part of Form 10-K
(b) Exhibits
As part of this Annual Report on Form 10-K, we hereby file the Exhibits listed in the attached Exhibit Index.
(c) Financial Statement Schedules
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 14th day of December, 2004.
PARAMETRIC TECHNOLOGY CORPORATION
By
/s/ C. RICHARD HARRISON
C. Richard Harrison
Chief Executive Officer and President
POWER OF ATTORNEY
We, the undersigned officers and directors of Parametric Technology Corporation, hereby severally constitute Cornelius F. Moses, III and Aaron C. von Staats, Esq., and each of them singly, our true and lawful attorneys with full power to them, and each of them singly, to sign for us and in our names in the capacities indicated below any and all subsequent amendments to this report, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated below, on the 14th day of December, 2004.
E XHIBIT INDEX
* Identifies a management contract or compensatory plan or arrangement in which an executive officer or director of PTC participates.
** Indicates that the exhibit is being furnished with this report and is not filed as a part of it.
APPENDIX A
PARAMETRIC TECHNOLOGY CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements.
PARAMETRIC TECHNOLOGY CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements.
PARAMETRIC TECHNOLOGY CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
PARAMETRIC TECHNOLOGY CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
PARAMETRIC TECHNOLOGY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. Description of Business and Summary of Significant Accounting Policies
Business
Parametric Technology Corporation (PTC), founded in 1985 and headquartered in Needham, MA, develops, markets and supports product lifecycle management (PLM) software solutions that help manufacturers improve the competitiveness of their products and product development processes. Our solutions, which include a suite of mechanical computer-aided design tools (our design solutions) and a range of Internet-based collaboration technologies (our collaboration and control solutions), enable manufacturing companies to create virtual computer-based products (digital products), collaborate on designs within the enterprise and throughout the extended supply chain, and control the digital product information throughout the product lifecycle. This results in streamlined engineering processes, improved product quality, optimized product information management and reduced cost and time-to-market cycles. Our PLM software solutions are complemented by the strength and experience of our services organization, as well as third-party systems resellers and other strategic partners, who provide training, consulting, ancillary product offerings, implementation and support to customers worldwide.
Basis of Presentation
Our fiscal year-end is September 30. The consolidated financial statements include the parent company and its wholly owned subsidiaries, including those operating outside the U.S. All intercompany balances and transactions have been eliminated in the financial statements. Certain reclassifications have been made for consistent presentation. The most significant reclassification relates to the 2003 presentation of income taxes receivable. Income taxes receivable totaling $23.3 million were recorded in net accrued income taxes as of September 30, 2003 and have been reclassified to current assets to conform to the 2004 presentation. We prepare our financial statements under generally accepted accounting principles that require management to make estimates and assumptions that affect the amounts reported and the related disclosures. Actual results could differ from these estimates.
Foreign Currency Translation
For our international operations where the functional currency is the local currency, we translate assets and liabilities at exchange rates in effect at the balance sheet date and record translation adjustments in stockholders’ equity. As of September 30, 2004 and 2003, cumulative translation adjustment gains of $3.7 million and $2.9 million, respectively, were included in the accumulated other comprehensive income (loss) component of stockholders’ equity. For our international operations where the U.S. dollar is the functional currency, we remeasure monetary assets and liabilities using exchange rates in effect at the balance sheet date and nonmonetary assets and liabilities at historical rates and record resulting exchange gains or losses in other expense in the statement of operations. We translate income statement amounts at average rates for the period. Transaction gains and losses are recorded in other expense in the statement of operations.
Revenue Recognition
We derive revenues from three primary sources: (1) software licenses, (2) maintenance services and (3) other services, which include consulting and education services. Revenue by type for 2004, 2003 and 2002 was as follows:
PARAMETRIC TECHNOLOGY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
While we apply the guidance of Statement of Position (SOP) No. 97-2, Software Revenue Recognition, and Statement of Position No. 98-9, Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions, both issued by the American Institute of Certified Public Accountants, as well as SEC Staff Accounting Bulletin 104, Revenue Recognition in Financial Statements, we exercise judgment and use estimates in connection with the determination of the amounts of software license and services revenues to be recognized in each accounting period.
For software license arrangements that do not require significant modification or customization of the underlying software, we recognize revenue when: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred (generally, FOB shipping point or electronic distribution), (3) the fee is fixed or determinable, and (4) collection is probable. Substantially all of our license revenues are recognized in this manner.
Our software is distributed primarily through our direct sales force. However, our indirect distribution channel continues to expand through alliances with resellers. Revenue arrangements with resellers are recognized on a sell-through basis; that is, when we receive persuasive evidence that the reseller has sold the products to an end-user customer. We do not offer contractual rights of return, stock balancing, or price protection to our resellers, and actual product returns from them have been insignificant to date. As a result, we do not maintain reserves for product returns and related allowances.
At the time of each sale transaction, we must make an assessment of the collectibility of the amount due from the customer. Revenue is only recognized at that time if management deems that collection is probable. In making this assessment, we consider customer credit-worthiness and historical payment experience. At that same time, we assess whether fees are fixed or determinable and free of contingencies or significant uncertainties. If the fee is not fixed or determinable, revenue is recognized only as payments become due from the customer, provided that all other revenue recognition criteria are met. In assessing whether the fee is fixed or determinable, we consider the payment terms of the transaction and our collection experience in similar transactions without making concessions, among other factors. Our software license arrangements generally do not include customer acceptance provisions. However, if an arrangement includes an acceptance provision, we record revenue only upon the earlier of (1) receipt of written acceptance from the customer or (2) expiration of the acceptance period.
Our software arrangements often include implementation and consulting services that are sold separately under consulting engagement contracts or as part of the software license arrangement. When we determine that such services are not essential to the functionality of the licensed software and qualify as “service transactions” under SOP 97-2, we record revenue separately for the license and service elements of these arrangements. Generally, we consider that a service is not essential to the functionality of the software based on various factors, including if the services may be provided by independent third parties experienced in providing such consulting and implementation in coordination with dedicated customer personnel. If an arrangement does not qualify for separate accounting of the license and service elements, then license revenue is recognized together with the consulting services using either the percentage-of-completion or completed-contract method of contract accounting. Contract accounting is also applied to any software arrangements that include customer-specific acceptance criteria or where the license payment is tied to the performance of consulting services. Under the percentage-of-completion method, we estimate the stage of completion of contracts with fixed or “not to exceed” fees based on hours or costs incurred to date as compared with estimated total project hours or costs at completion. If we do not have a sufficient basis to measure progress towards completion, revenue is recognized upon completion of the contract. When total cost estimates exceed revenues, we accrue for the estimated losses immediately. The use of the percentage-of-completion method of accounting requires significant judgment relative to estimating total contract costs, including assumptions relative to the length of time to complete the project, the nature and complexity of the work to be performed, and anticipated changes in salaries and other costs. When adjustments in estimated contract costs are determined, such revisions may have the effect of adjusting in the current period the earnings applicable to performance in prior periods.
We generally use the residual method to recognize revenues from arrangements that include one or more elements to be delivered at a future date, when evidence of the fair value of all undelivered elements exists. Under the residual method, the fair value of the undelivered elements (e.g., maintenance, consulting and education services) based on vendor-specific objective evidence (VSOE) is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements (i.e., software
PARAMETRIC TECHNOLOGY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
license). If evidence of the fair value of one or more of the undelivered services does not exist, all revenues are deferred and recognized when delivery of all of those services has occurred or when fair values can be established. We determine VSOE of the fair value of services revenues based upon our recent pricing for those services when sold separately. VSOE of the fair value of maintenance services may also be determined based on a substantive maintenance renewal clause, if any, within a customer contract. Our current pricing practices are influenced primarily by product type, purchase volume, maintenance term and customer location. We review services revenues sold separately and maintenance renewal rates on a periodic basis and update, when appropriate, our VSOE of fair value for such services to ensure that it reflects our recent pricing experience.
Significant incremental discounts offered in multiple-element arrangements that would be characterized as separate elements are infrequent and are allocated to software license revenues under the residual method. In limited circumstances, where a customer receives a subscription-based license, license revenue is recognized ratably over the term of the arrangement. In limited circumstances, where the right to use the software license is contingent upon current payments of maintenance, fees for software and maintenance are recognized ratably over the initial maintenance term.
Maintenance services generally include rights to unspecified upgrades (when and if available), telephone and Internet-based support, updates and bug fixes. Maintenance revenue is recognized ratably over the term of the maintenance contract on a straight-line basis. It is uncommon for us to offer a specified upgrade to an existing product; however, in such instances, all revenue of the arrangement is deferred until the future upgrade is delivered.
When consulting qualifies for separate accounting, consulting revenues under time and materials billing arrangements are recognized as the services are performed. Consulting revenues under fixed-priced contracts are generally recognized using the percentage-of-completion method. If there is a significant uncertainty about the project completion or receipt of payment for the consulting services, revenue is deferred until the uncertainty is sufficiently resolved. Reimbursements of out-of-pocket expenditures incurred in connection with providing consulting services are included in services revenue, with the offsetting expense recorded in cost of services revenue.
Education services include on-site training, classroom training, and computer-based training and assessment. Education revenues are recognized as the related training services are provided.
Deferred Revenue
Deferred revenue primarily relates to software maintenance agreements billed to customers for which the services have not yet been provided. The liability associated with performing these services is included in deferred revenue and, if not yet paid, the related amount is included in other current assets. The maintenance-related amounts included in other current assets at September 30, 2004 and 2003 were $33.3 million and $37.0 million, respectively. Deferred revenue consisted of the following:
Cash, Cash Equivalents, Marketable Investments and Non-marketable Securities
Our cash equivalents, short-term investments, and marketable investments are invested in debt instruments of financial institutions, government entities and corporations and in mutual funds. We have established guidelines relative to credit ratings,
PARAMETRIC TECHNOLOGY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
diversification and maturities that are intended to maintain safety and liquidity. Cash equivalents include highly liquid investments with maturity periods of three months or less when purchased. Short-term investments include those investments with maturities in excess of three months but less than one year. Marketable investments are those with maturities in excess of one year but less than two years. Our portfolio of investments at September 30, 2004 and 2003 consisted only of cash and cash equivalents.
Investments in non-marketable securities, which include a limited number of strategic minority equity investments, were $0.5 million and $0.8 million as of September 30, 2004 and 2003, respectively, and are included in other long-term assets in the accompanying consolidated balance sheets. These investments are periodically evaluated for impairment based on market conditions, the industry sectors in which the investment entity operates, the viability and prospects of each entity, and the continued strategic importance of the investment to us. A write-down of the related investment is recorded when an impairment is considered other than temporary. Other than temporary write-downs of investments recorded to other expense, net, were $0.2 million, $0.4 million and $1.0 million in 2004, 2003 and 2002, respectively.
Our cash equivalents, short-term and marketable investments are classified as available for sale and reported at fair value, with unrealized gains and losses included in the accumulated other comprehensive income (loss) component of stockholders’ equity and amortization or accretion of premium or discount included in interest income. As of September 30, 2004 and 2003, unrealized gains of $0.1 million and $0.2 million, respectively, are included in the accumulated other comprehensive income (loss) component of stockholders’ equity.
Concentration of Credit Risk and Fair Value of Financial Instruments
The amounts reflected in the consolidated balance sheets for cash and cash equivalents, accounts receivable and accounts payable approximate their fair value due to their short maturities. Financial instruments that potentially subject us to concentration of credit risk consist primarily of investments, trade receivables and derivatives. Our cash, cash equivalents, investments and derivatives are placed with financial institutions with high credit standings. Our credit risk for derivatives is also mitigated due to the short-term nature of the contracts. Our customer base consists of large numbers of geographically diverse customers dispersed across many industries, and no individual customer comprised more than 10% of our net trade accounts receivable as of September 30, 2004 or 2003.
Allowance for Doubtful Accounts
We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. In determining the adequacy of the allowance for doubtful accounts, management specifically analyzes individual accounts receivable, historical bad debts, customer concentrations, customer credit-worthiness, current economic conditions, accounts receivable aging trends and changes in our customer payment terms. Our allowance for doubtful accounts on trade accounts receivable was $6.3 million as of September 30, 2004, $6.8 million as of September 30, 2003, $6.2 million as of September 30, 2002 and $5.6 million as of September 30, 2001. Uncollectible trade accounts receivable written-off, net of recoveries, were $3.6 million, $4.5 million and $3.7 million for 2004, 2003 and 2002, respectively. Bad debt expense was $3.1 million, $5.1 million and $4.3 million in 2004, 2003 and 2002, respectively.
Transfers of Financial Assets
We offer our customers the option to purchase software and services through payment plans. In general, we transfer future payments under certain of these contracts to third-party financial institutions on a non-recourse basis. We record such transfers as sales of the related accounts receivable when we surrender control of such receivables under the provisions of Statement of Financial Accounting Standards (SFAS) No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.
PARAMETRIC TECHNOLOGY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Derivatives
We apply SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. All derivatives, whether designated in a hedging relationship or not, are required to be recorded on the balance sheet at fair value. SFAS No. 133 also requires that changes in the derivative’s fair value be recognized currently in earnings unless specific hedge accounting criteria are met, and that the company formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. The effectiveness of the derivative as a hedging instrument is based on changes in its market value being highly correlated with changes in the market value of the underlying hedged item.
Derivatives are financial instruments whose value is derived from one or more underlying financial instruments, such as foreign currency. We enter into derivative transactions, specifically foreign currency forward contracts and foreign currency option contracts, to manage our exposure to fluctuations in foreign exchange rates. The contracts are primarily in European currencies and Japanese Yen and typically have maturities of less than three months. Any derivative we enter into is designated at inception as a hedge of risks associated with specific assets, liabilities or future commitments and is monitored to determine if it remains an effective hedge. We do not enter into or hold derivatives for trading or speculative purposes.
We routinely use forward contracts to hedge specific foreign currency-denominated receivables. These contracts, with maturities of less than three months, require us to exchange foreign currencies for U.S. dollars at maturity at rates agreed to at inception of the contracts. All foreign currency transactions and all outstanding forward contracts are marked-to-market at the end of each accounting period with unrealized gains and losses recorded in the statement of operations. As of September 30, 2004 and 2003, we had outstanding forward contracts with notional amounts equivalent to approximately $83.3 million ($58.9 million in Euros, $12.1 million in British Pounds, $6.4 million in Japanese Yen and $5.9 million in other currencies) and $75.7 million ($56.8 million in Euros, $8.1 million in British Pounds, $4.1 million in Japanese Yen and $6.7 million in other currencies), respectively. Net realized and unrealized gains and losses associated with exchange rate fluctuations on forward contracts and the underlying foreign currency exposure being hedged were immaterial for all periods presented.
We periodically use foreign currency option contracts, with maturities of less than one year, to hedge specific forecasted net cash flow transactions that are derived from anticipated international revenue. These hedges are designated as effective cash flow hedging instruments under SFAS No. 133. The premiums to purchase option contracts are capitalized in other assets and recorded in other expense in the period in which the forecasted transaction occurs. The effective portion of the changes in the fair value of the option contracts are recorded in other comprehensive income (loss), and subsequently recognized in license and service revenue in the period in which the forecasted transactions occur. As of September 30, 2004 and 2003, there were no foreign currency option contracts outstanding.
Property and Equipment
Property and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives. Computer hardware and software are typically amortized over three to five years, and furniture and fixtures over three to eight years. Leasehold improvements are amortized over the shorter of their useful lives or the remaining terms of the related leases. Property and equipment under capital leases are amortized over the lesser of the lease terms or their estimated useful lives. Maintenance and repairs are charged to expense when incurred; additions and improvements are capitalized. When an item is sold or retired, the cost and related accumulated depreciation is relieved, and the resulting gain or loss, if any, is recognized in income.
Computer Software Costs
We incur costs to develop computer software to be licensed or otherwise marketed to customers. Research and development costs are expensed as incurred, except for costs of internally developed or externally purchased software that qualify for capitalization. Software development costs incurred subsequent to the establishment of technological feasibility, but prior to the general release of the product, are capitalized and, upon general release, are amortized using the straight-line method over the
PARAMETRIC TECHNOLOGY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
expected life of the related products. The straight-line method approximates the same amount of expense as that calculated using the ratio that current period gross product revenues bear to total anticipated gross product revenues. Computer software costs capitalized in 2004, 2003 and 2002 totaled $1.5 million, $4.1 million and $2.0 million, respectively. In addition, as described in Note D, $1.6 million of software was capitalized in connection with our acquisition of a business in 2004.
Goodwill, Other Intangible Assets and Long-lived Assets
Goodwill is the amount by which the cost of acquired net assets in a business acquisition exceeded the fair values of net identifiable assets on the date of our purchase. All goodwill is attributable to our software products reportable segment.
Prior to October 1, 2002, we amortized goodwill over five to seven years and amortized other intangible assets, such as assembled workforces, customer lists, purchased software and capitalized software, over three to five years. Trademarks, which are also included in other intangible assets, were amortized over seven years. Effective October 1, 2002 with the adoption of SFAS No. 142, Goodwill and Other Intangible Assets, we no longer amortize intangible assets with indefinite useful lives including goodwill, assembled workforce and trademarks. Instead, these assets are evaluated for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. Factors we consider important which could trigger an impairment review include significant underperformance relative to historical or projected future operating results, significant changes in our use of the acquired assets or the strategy for our overall business, significant negative industry or economic trends, a significant decline in our stock price for a sustained period and a reduction of our market capitalization relative to net book value. To conduct these tests of goodwill and indefinite-lived intangible assets, the fair value of the reporting unit is compared to its carrying value. If the reporting unit’s carrying value exceeds its fair value, we record an impairment loss to the extent that the carrying value of goodwill exceeds its implied fair value. We estimate the fair values of our reporting units using discounted cash flow valuation models.
Long-lived assets primarily include property and equipment and intangible assets with finite lives (purchased software, capitalized software and customer lists). In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we periodically review long-lived assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of those assets are no longer appropriate. Each impairment test is based on a comparison of the undiscounted cash flows to the recorded value of the asset. If impairment is indicated, the asset is written down to its estimated fair value based on a discounted cash flow analysis.
Advertising Expenses
Advertising costs are expensed as incurred. Total advertising expenses incurred were $1.1 million, $5.9 million and $8.5 million in 2004, 2003 and 2002, respectively.
Income Taxes
Our income tax expense includes U.S. and international income taxes. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effects of these differences are reported as deferred tax assets and liabilities. Deferred tax assets are recognized for the estimated future tax effects of deductible temporary differences and tax operating loss and credit carryforwards. Changes in deferred tax assets and liabilities are recorded in the provision for income taxes. We assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that it is more likely than not that all or a portion of deferred tax assets will not be realized, we establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we include an expense within the tax provision in the statement of operations.
PARAMETRIC TECHNOLOGY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Earnings Per Share (EPS)
Basic EPS is calculated by dividing net income (loss) by the weighted average number of shares outstanding during the period. Diluted EPS is calculated by dividing net income (loss) by the weighted average number of shares outstanding plus the dilutive effect, if any, of outstanding stock options using the treasury stock method. The following table presents the calculation for both basic and diluted EPS:
Stock options to purchase 48.2 million, 67.4 million and 58.3 million shares for 2004, 2003 and 2002, respectively, had exercise prices per share that were greater than the average market price of our common stock for those periods. These shares were excluded from the computation of diluted EPS as the effect would have been anti-dilutive. Due to the net losses generated in 2003 and 2002, the effect of outstanding stock options for the purchase of an additional 3.5 million and 11.5 million shares for those periods, respectively, was excluded from the computation of diluted EPS as the effect would also have been anti-dilutive.
Stock-Based Compensation
We account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under APB No. 25, no compensation cost is recognized when the option price is equal to the market price of the underlying stock on the date of grant. Compensation expense for restricted stock granted under our employee stock plans is determined based on the difference between the fair market value of the stock at the date of grant and the exercise price, and is recognized ratably over the vesting period. An alternative method of accounting is SFAS No. 123, Accounting for Stock-Based Compensation. Under SFAS No. 123, employee stock options are valued at the grant date using an option pricing model, and compensation cost is recognized ratably over the vesting period.
SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, issued by the Financial Accounting Standards Board in December 2002, amends the disclosure requirements of SFAS No. 123 to require prominent disclosure in both the annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results. As permitted by APB No. 25, we generally have not recognized compensation expense in connection with stock option grants to employees, directors and officers under our plans. The following table illustrates the effect on net income (loss) and net earnings (loss) per share if we had applied the fair value recognition provisions of SFAS No. 123 to all stock-based awards to employees.
PARAMETRIC TECHNOLOGY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The illustrative disclosures above include the amortization of the fair value of options over their vesting schedules. The pro forma net income (loss) for 2004, 2003 and 2002 includes an income tax valuation allowance fully offsetting any income tax benefit related to the stock-based employee compensation expense for those periods. The effects indicated above of applying SFAS No. 123 are not necessarily representative of the effects on similar illustrative disclosures in future years.
The fair value of options and employee stock purchase plan shares granted has been estimated at the date of grant using the Black-Scholes option-pricing model assuming the following weighted-average assumptions:
The weighted average fair value of employee stock options granted was $2.50 in 2004, $1.60 in 2003 and $3.25 in 2002. The weighted average fair value of shares granted under the stock purchase plan was $1.23 in 2004, $0.98 in 2003 and $2.93 in 2002.
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Our options have characteristics significantly different from those of traded options and changes in the subjective input assumptions can materially affect the fair value estimate.
Recent Accounting Pronouncements
Consolidation of Variable Interest Entities
In January 2003, the Financial Accounting Standards Board (FASB) issued FIN No. 46, Consolidation of Variable Interest Entities and, in December 2003, issued a revision to that interpretation (FIN No. 46R). FIN No. 46R replaces FIN No. 46 and addresses consolidation by business enterprises of variable interest entities that possess certain characteristics. A variable interest entity (VIE) is defined as (a) an ownership, contractual or monetary interest in an entity where the ability to influence financial decisions is not proportional to the investment interest, or (b) an entity lacking the invested capital sufficient to fund future activities without the support of a third party. FIN No. 46R establishes standards for determining under what circumstances VIE’s should be consolidated with their primary beneficiary, including those to which the usual condition for consolidation does not apply. FIN No. 46R requires that if an entity has a controlling financial interest in a VIE, the assets, liabilities and results of activities of the VIE should be included in the consolidated financial statements of the entity. The provisions of FIN No. 46R were effective immediately for all arrangements entered into after January 31, 2003 and in the second quarter of fiscal 2004 for those arrangements entered into prior to January 31, 2003. The adoption of FIN No. 46R did not have a material impact on our financial position or results of operations.
Employee Stock-Based Compensation
In March 2004, the FASB issued an Exposure Draft for a Proposed Statement of Financial Accounting Standards, Share-Based Payment. This proposed Statement addresses the accounting for transactions in which a company receives employee services in exchange for (a) equity instruments of the company or (b) liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. This proposed Statement also would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to
PARAMETRIC TECHNOLOGY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Employees, and generally would require that such transactions be accounted for using a fair-value-based method. The FASB has nearly completed its deliberations and is expected to release a final statement by the end of our second quarter of fiscal 2005. During its deliberations to address the comment letters, the FASB has preliminarily indicated that the effective date for this statement would be for periods beginning after June 15, 2005, which would be the fourth quarter of our fiscal 2005. We currently are assessing the impact of this proposed Statement on our share-based compensation programs; however, we expect that the requirement to expense stock options and other equity interests that have been or will be granted to employees will significantly increase our operating expenses and result in lower earnings per share.
The American Job Creations Act
In October 2004, the American Jobs Creation Act of 2004 (“AJCA”) was signed into law. The AJCA contains a series of provisions, several of which are pertinent to us. The AJCA creates a temporary incentive for U.S. multinational corporations to repatriate accumulated income abroad by providing an 85% dividends received deduction for certain dividends from controlled foreign corporations. It has been our practice to permanently reinvest all foreign earnings into our foreign operations. Should we determine that we plan to repatriate any of our foreign earnings, we will be required to establish a deferred tax liability on such earnings through a charge to our income tax provision.
The AJCA also provides U.S. corporations with an income tax deduction equal to a stipulated percentage of qualified income from domestic production activities (“qualified activities”). The deduction, which cannot exceed 50% of annual wages paid, is phased in as follows: 3% of qualified activities in 2005 and 2006; 6% in 2007 through 2009; and 9% in 2010 and thereafter. We believe that we qualify for the deduction. Current accounting literature is unclear on whether the deduction should be accounted for as a special deduction or a tax rate reduction; however, the FASB has reached a tentative conclusion that this would be a special deduction. If treated as a special deduction, the tax benefit of the deduction would generally be accounted for in the periods in which the qualifying activities occur, generally the years in which the deductions are taken on the tax returns. This benefit would be included in our annual effective tax rate, but would not result in a remeasurement of deferred income taxes. If treated as a rate reduction, we would be required to revalue our deferred tax assets and liabilities. We expect the FASB to provide further guidance in the fourth quarter of calendar 2004 as to whether the deduction should be accounted for as a special deduction or a tax rate reduction. The AJCA, as well as the outcome of the FASB’s decision, may have an impact on our tax rate for future years. However, we have maintained a full deferred tax valuation on U.S. deferred taxes (see Note E) and, as a result, we do not expect the AJCA to materially affect our financial position or results of operations.
B. Restructuring and Other Charges, Gain on Sale of a Business and Write-down of Investments
Restructuring and Other Charges
In 2004, we recorded total restructuring and other charges of $42.9 million. The restructuring and other charges were comprised of $21.0 million for severance and termination benefits related to 459 employees terminated during 2004 and $21.9 million related primarily to excess facilities. The charges for excess facilities are primarily related to gross lease commitments in excess of estimated sublease income for excess facilities. Of the total restructuring and other charges recorded in 2004, $1.9 million was non-cash for the write-off of leasehold improvements related to the excess facilities. This restructuring program was completed in the fourth quarter of 2004.
In 2003, we recorded total restructuring and other charges of $30.9 million. The restructuring and other charges were comprised of $17.9 million for severance and termination benefits related to 361 employees terminated during 2003. We also recorded charges of $11.6 million related to excess facilities and $1.4 million of other costs, primarily related to the write-off of acquired technology. The increases in the liability for excess facilities in 2003 related primarily to revised estimates of gross lease commitments in excess of expected sublease income for leases assumed in our 1998 acquisition of Computervision Corporation (Computervision) and consolidating existing leased facilities.
In 2002, we recorded restructuring and other charges of $31.2 million primarily associated with a reduction in workforce and for excess facilities. The restructuring charges were comprised of $17.3 million for severance and termination benefits related to
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approximately 310 employees who were notified or terminated during 2002 and $13.9 million related to excess facilities. The excess facilities charge was primarily comprised of an increase to Computervision lease liabilities for existing excess facilities, needed as a result of changing real estate market conditions and related actions taken by several subtenants.
The following table summarizes restructuring and other charges reserve activity for the three years ended September 30, 2004:
The accrual for facility closures and related costs is included in accrued expenses and other current liabilities and other long-term liabilities in the consolidated balance sheet, and the accrual for employee severance and related benefits is included in accrued compensation and benefits. As of September 30, 2004, of the $43.3 million remaining in accrued restructuring charges, $12.0 million was included in other current liabilities and $31.3 million was included in other long-term liabilities, principally for facility costs to be paid out through 2014.
Gain on Sale of a Business
In 2002, we completed the sale of our ICEM® surfacing business for $10.2 million in cash, resulting in a pre-tax gain of $8.7 million.
Write-down of Investments
We periodically review equity investments for impairment based on market conditions, the industry sectors in which the investment entity operates, the viability and prospects of each entity, and the continued strategic importance of the investment to us. A write-down of the related investment is recorded when an impairment is considered other than temporary. In 2004, 2003 and 2002, we recorded write-downs on several equity investments, included in other expense, net, of $0.2 million, $0.4 million and $1.0 million, respectively, to reflect other-than-temporary declines in valuation. At September 30, 2004 and 2003, equity investments included in other long-term assets were $0.5 million and $0.8 million, respectively.
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C. Property and Equipment
Property and equipment consisted of the following:
Depreciation expense was $26.9 million, $33.5 million and $34.0 million in 2004, 2003 and 2002, respectively. Capital leases as of September 30, 2004 and 2003 were not material.
D. Goodwill and Other Intangible Assets
On October 1, 2002, in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, we stopped amortizing goodwill and adopted a new policy for measuring goodwill and indefinite-lived intangible assets for impairment. We currently operate within a single industry segment-computer software and related services. Within this single industry segment as described in Note L, Segment Information, we have two reportable segments: (1) software products and (2) services. All of our goodwill and other intangible assets are associated with our software products reportable segment. Under our new policy, goodwill and other intangible assets are tested for impairment at least annually, or on an interim basis if an event occurs or circumstances change that would, more likely than not, reduce the fair value of the reporting segment below its carrying value. We completed our annual impairment review as of July 3, 2004 and concluded that no impairment charge was required as of that date. There have not been any events or changes in circumstances since July 3, 2004 that indicate that the carrying values of goodwill or other intangible assets may not be recoverable.
Goodwill and other intangible assets consisted of the following:
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The change in the carrying amounts of goodwill and other intangible assets at September 30, 2004 from September 30, 2003 is due, in part, to foreign currency translation adjustments related to those asset balances that are recorded in non-U.S. currencies.
In April 2004, we acquired OHIO Design Automation, Inc. (OHIO-DA), a provider of electronics design collaboration software, for $9.8 million in cash. The purchase price was allocated to assets acquired and liabilities assumed based on our estimates of fair value. The values assigned included intangible assets of $1.8 million for customer lists and $1.6 million for purchased software, which are being amortized over estimated useful lives of 5 years and 3 years, respectively. The excess purchase price over the amounts allocated to assets acquired and liabilities assumed of $7.0 million was recorded as goodwill. Upon the fulfillment of certain specified conditions, an additional $2.0 million related to the acquisition will be paid through April 2007. Any such contingent payments will be recorded as operating expenses as incurred. Results of operations of OHIO-DA have been included in our consolidated financial statements since the acquisition date. Values assigned to intangible assets are not deductible for tax purposes. Our results of operations prior to the acquisition, if presented on a pro forma basis, would not differ materially from our reported results.
The aggregate amortization expense for intangible assets for 2004, 2003 and 2002 was $8.2 million, $9.1 million and $39.4 million, respectively. Of those amounts, $5.2 million, $5.9 million, $35.8 million, respectively, was recorded as amortization of other intangible assets and $3.0 million, $3.2 million and $3.6 million, respectively, was recorded as cost of license revenue. The estimated aggregate future amortization expense for intangible assets with finite lives remaining as of September 30, 2004 is $2.8 million for 2005, $2.6 million for 2006, $1.2 million for 2007, $0.4 million for 2008 and $0.2 million for 2009.
The following table sets forth the net loss for 2002, as adjusted to exclude amortization expense related to goodwill and other intangible assets that are no longer being amortized under SFAS No. 142:
E. Income Taxes
Our income (loss) before taxes consisted of the following:
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Our provision for (benefit from) income taxes consisted of the following:
The reconciliation between the statutory federal income tax rate and our effective income tax rate is shown below:
As described below, in 2004, we received notification from the Internal Revenue Service (IRS) that we would be receiving a tax refund related to income tax returns for the years 1998 through 2000 totaling $39.5 million, which resulted in a nonrecurring tax benefit of $18.9 million in 2004.
We made net income tax payments of approximately $5.7 million in 2004, and we received net refunds of approximately $53.3 million and $3.5 million in 2003 and 2002, respectively.
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The significant temporary differences that created deferred tax assets and liabilities are shown below:
As a result of operating losses incurred in recent years and uncertainty as to the extent and timing of profitability in future periods, we concluded in 2002 that it is more likely than not that the net deferred tax assets would not be realized and, accordingly, we increased our deferred tax valuation allowance for our remaining net deferred tax assets in 2002. Although we have net income before tax in 2004 of $37.0 million, we have maintained a full deferred tax valuation allowance as a result of continuing operating losses in the United States, which is the source of the majority of the net deferred tax assets. In 2004, the valuation allowance was increased by $10.5 million primarily to reserve for additional Computervision net operating loss (NOL) carryforwards recorded as a result of the conclusion of the IRS examination of our income tax returns for 1998 through 2000 discussed below.
At September 30, 2004 and 2003, accrued income taxes of $39.4 million and $29.2 million, respectively, primarily represented income taxes payable and related income tax accruals. At September 30, 2004 and 2003, income taxes receivable of $39.5 million and $23.3 million, respectively, represented expected refunds of U.S. federal income taxes and related interest. In the normal course of business, PTC and its subsidiaries are examined by various taxing authorities, including the IRS in the United States. In 2004, the IRS concluded its examination of our income tax returns for years 1998 through 2000, and notification of a $39.5 million refund amount was received in the fourth quarter of 2004. The refund resulted in a nonrecurring tax benefit of $18.9 million in 2004 and the recording of $6.5 million of additional tax-effected NOLs available for carryforward, which were offset by an increase in our deferred tax valuation allowance. The $39.5 million refund was received in the first quarter of 2005.
For U.S. tax return purposes, NOLs and tax credits are generally available to be carried forward to future years subject to certain limitations. At September 30, 2004, we had U.S. federal NOL carryforwards of $106.7 million, which expire in 2023 and 2024, available to offset taxable income in future years. In addition, we have U.S. federal NOL carryforwards of $166.0 million resulting from the January 1998 acquisition of Computervision, which expire beginning in 2008 through 2018. The utilization of the Computervision NOLs has been limited as a result of the change in ownership rules under the Internal Revenue Code. We also
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have loss carryforwards in non-U.S. jurisdictions totaling $16.5 million, the majority of which do not expire. There are other limitations imposed on the utilization of such NOLs that could further restrict the recognition of any tax benefits.
The cumulative amount of undistributed earnings of our subsidiaries for which U.S. income taxes have not been provided, totaled approximately $73.4 million and $59.2 million as of September 30, 2004 and 2003, respectively.
F. Commitments and Contingencies
Leasing Arrangements
We lease office facilities and certain equipment under operating leases expiring at various dates through 2014. Certain leases require us to pay for taxes, insurance, maintenance and other operating expenses in addition to rent. Lease expense, net of sublease income, was $32.9 million, $39.5 million and $49.1 million in 2004, 2003 and 2002, respectively. At September 30, 2004, our future minimum lease payments net of sublease income under noncancellable operating leases are as follows:
As a result of restructuring and cost saving initiatives in current and prior years, certain leased facilities are excess. As of September 30, 2004, we had $41.7 million reserved for facility obligations in excess of sublease income. Our total future rental income under current sublease arrangements for excess facilities is $24.0 million. The future minimum lease payments above include minimum future lease payments for excess facilities, net of sublease income under existing sublease arrangements.
As of September 30, 2004 and 2003, we had letters of credit outstanding of approximately $6.4 million, of which $0.4 million was collateralized, and $7.5 million, of which $0.4 million was collateralized, respectively, primarily related to our corporate headquarters lease in Needham, Massachusetts.
Legal Proceedings
Certain class action lawsuits were filed by shareholders in the second and third quarters of 2003 against us and certain of our current and former officers and directors in the U.S. District Court for the District of Massachusetts claiming violations of the federal securities laws based on alleged misrepresentations regarding our reported financial results for the fiscal years 1999, 2000 and 2001 and our announced results for 2002. The consolidated amended complaint was filed in the fourth quarter of 2003 and sought unspecified damages. We filed a motion to dismiss the consolidated action with prejudice and the court held a hearing on our motion in the third quarter of 2004. On November 3, 2004, the court granted our motion to dismiss and entered an order dismissing the consolidated action. The plaintiffs did not file a notice of appeal from the court’s order within the applicable period of time for them to do so, which should conclude the litigation.
On May 30, 2003, a lawsuit was filed against us in the U.S. District Court for the District of Massachusetts by Rand A Technology Corporation and Rand Technologies Limited (collectively “Rand”). Rand historically had been our largest distributor. The complaint alleges various breaches of a revised distribution agreement entered into in December 2002, as well as other agreements between Rand and us, and also asserts certain non-contract claims. The complaint, as amended, seeks equitable relief
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and substantial damages. On November 24, 2003, we filed our substantive response to Rand’s complaint and asserted counterclaims against Rand including, among other things, that Rand’s action in filing the lawsuit constituted a breach of the December 2002 agreement, which established certain dispute resolution procedures and which, we believe, discharged any and all claims arising prior to that date. We believe Rand’s claims are without merit and will continue to contest them vigorously. We also intend diligently to prosecute our counterclaims. We cannot predict the ultimate resolution of this action at this time, and there can be no assurance that this action will not have a material adverse impact on our financial condition or results of operations.
We also are subject to various legal proceedings and claims that arise in the ordinary course of business. We currently believe that resolving these other matters will not have a material adverse impact on our financial condition or results of operations.
Guarantees and Indemnification Obligations
We enter into standard indemnification agreements in our ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with patent, copyright or other intellectual property infringement claims by any third party with respect to our current products, as well as claims relating to property damage or personal injury resulting from the performance of services by us or our subcontractors. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. Historically, our costs to defend lawsuits or settle claims relating to such indemnity agreements have been minimal and we accordingly believe the estimated fair value of these agreements is immaterial.
We warrant that our software products will perform in all material respects in accordance with our standard published specifications in effect at the time of delivery of the licensed products for a specified period of time (generally 90 to 180 days). Additionally, we generally warrant that our consulting services will be performed consistent with generally accepted industry standards. In most cases, liability for these warranties is capped. If necessary, we would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history; however, we have never incurred significant cost under our product or services warranties. As a result, we believe the estimated fair value of these agreements is immaterial.
G. Stockholders’ Equity
Preferred Stock
We may issue up to 5.0 million shares of our preferred stock in one or more series. Our Board of Directors is authorized to fix the rights and terms for any series of preferred stock without additional shareholder approval. In November 2000, our Board of Directors authorized and designated 500,000 shares of preferred stock as Series A Junior Participating Preferred Stock for issuance pursuant to our Shareholder Rights Plan discussed below in Note H. As of September 30, 2004 and 2003, there were no outstanding shares of preferred stock.
Common Stock
Our Articles of Organization authorize us to issue up to 500 million shares of our common stock. Shares of common stock outstanding are shown below:
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Our Board of Directors has authorized us to repurchase up to 40.0 million shares. Through September 30, 2004, we had repurchased 31.2 million shares at a cost of $366.8 million. The repurchased shares were available to be used for stock option exercises, employee stock purchase plans and potential acquisitions. In 2002, all remaining shares of treasury stock, 13.5 million, were retired and restored to the status of authorized but unissued shares. Beginning in 2003 and continuing into the future, all shares of our common stock repurchased are automatically restored to the status of authorized and unissued.
H. Shareholder Rights Plan
In November 2000, our Board of Directors adopted a Shareholder Rights Plan and declared a dividend distribution of one share purchase right (a “Right”) for each outstanding share of our common stock to stockholders of record at the close of business on January 5, 2001. Each share of common stock newly issued after that date also will carry with it one Right. Each Right will entitle the record holder to purchase from us one one-thousandth of a share of our Series A Junior Participating Preferred Stock at an exercise price of $60.00 per unit subject to adjustment. The Rights become exercisable ten (10) days after the earlier of our announcement that a person has acquired 15% or more of our outstanding common stock or an announcement of a tender offer which would result in a person or group acquiring 15% or more of our common stock; in either case, the Board of Directors can extend the 10 day period. If we have not redeemed or exchanged the Rights and a person becomes the beneficial owner of 15% or more of our common stock (a “Triggering Event”), each holder of a Right will have the right to purchase shares of our common stock having a value equal to two times the exercise price of the Right. If, at any time following the Triggering Event, we are acquired in a merger or other business combination transaction in which we are not the surviving corporation or more than 50% of its assets or earning power is sold to a person or group, each holder of a Right shall have the right to purchase shares of common stock of the acquiring person, group or company having a value equal to two times the exercise price of the Right. The Rights expire on January 5, 2011, and may be redeemed by us for $.001 per Right.
I. Stock Plans
Employee Stock Purchase Plans
We offer an employee stock purchase plan for all eligible employees. Under the current plan, which qualifies as an “employee stock purchase plan” under Section 423 of the Internal Revenue Code, shares of our common stock can be purchased at 85% of the lower of the fair market value of the stock on the first or the last day of each six-month offering period. Employee purchases in any year are limited to the lesser of $25,000 worth of stock, determined by the fair market value of the common stock at the time the offering begins, or 15% of his or her base pay. The shareholders have approved that 18.0 million shares of common stock be reserved for issuance under the plan. During fiscal 2004, 2003 and 2002, employees purchased 2.2 million, 3.7 million and 2.1 million shares at average prices of $3.02, $1.98 and $3.76, respectively.
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Stock Option Plans
We have stock option plans for employees, directors, officers and consultants that provide for issuance of nonqualified and incentive stock options. The option exercise price is typically the fair market value at the date of grant. These options generally vest over four years and expire ten years from the date of grant. As of September 30, 2004, 20.6 million shares were available for grant and 66.3 million shares were reserved for stock options granted and outstanding.
Certain employees have disposed of stock acquired through the employee stock purchase plan and the exercise of incentive stock options earlier than the mandatory holding period required for certain tax treatment. These dispositions, together with the tax benefits realized from the exercise of nonqualified stock options, create tax benefits that were recorded as increases to additional paid-in capital in 2002. In 2004 and 2003, the tax benefit was not recorded due to the uncertainty of its realization.
For various price ranges, information for options outstanding and exercisable at September 30, 2004 was as follows:
Valuation of Stock Plans
We generally have not recognized compensation expense in connection with stock option grants to employees, directors and officers under our plans. We have recognized compensation expense of $0.4 million, $0.5 million and $0.2 million in 2004, 2003 and 2002, respectively, in connection with a restricted stock grant to an executive officer of the company in May 2002, as prescribed by APB No. 25 and its interpretations, and stock option grants to consultants as prescribed by EITF 96-18, Accounting for Equity Instruments with Variable Terms That Are Issued for Consideration Other Than Employee Services under FASB Statement No. 123. The impact on net income (loss) and earnings (loss) per share, had compensation expense for employee stock option and stock purchase plans been determined based on fair value at the grant dates as prescribed by SFAS No. 123 is disclosed in Note A.
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J. Employee Benefit Plan
We offer a savings plan to eligible U.S. employees. The plan is intended to qualify under Section 401(k) of the Internal Revenue Code. Participating employees may defer up to 15% of their pre-tax compensation, as defined, but not more than statutory limits. Prior to January 1, 2004, we contributed 50% of the amount contributed by the employee, up to a maximum of 10% of the employee’s earnings. Effective January 1, 2004, the employer match was reduced to 6% of the employee’s earnings. Our matching contributions vest at a rate of 25% per year of service. We made matching contributions of $3.1 million, $5.2 million and $5.4 million in 2004, 2003 and 2002, respectively.
K. Pension Plans
We maintain defined benefit pension plans covering certain employees of Computervision, which we acquired in 1998. Benefits are based upon length of service and average compensation and generally vest after five years of service. The prepaid (accrued) pension cost was actuarially computed using assumptions applicable to each subsidiary plan and economic environment. We adjust our minimum pension liability related to our plans due to changes in actuarial assumptions and performance of plan investments, as shown below.
U.S. Pension Plan
Effective April 1, 1990, the benefits under the U.S. pension plan were frozen indefinitely. We contribute all amounts deemed necessary on an actuarial basis to satisfy Internal Revenue Service funding requirements. Plan assets consist primarily of mutual funds invested in equity and fixed income securities.
International Pension Plans
Effective in 1998, benefits under the international plans were frozen indefinitely. Plan assets consist primarily of investments in local government securities and insurance company investments.
The following table presents the actuarial assumptions used in accounting for the pension plans:
In selecting the expected long-term rate of return on assets, we considered the current investment portfolio and the investment return goals in the plans’ investment policy statements. We, with input from the plans’ professional investment managers, also considered the average rate of earnings expected on the funds invested or to be invested to provide plan benefits. This process included determining expected returns for the various asset classes that comprise the plans’ target asset allocation. This basis for selecting the long-term asset return assumptions is consistent with the prior year.
For the U.S. plan, the long-term total return goal, presently 7.50%, includes income plus realized and unrealized gains and/or losses on the plan assets. Utilizing generally accepted diversification techniques, the plan’s assets, in aggregate and at the
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individual portfolio level, are invested so that the total portfolio risk exposure and risk-adjusted returns best meet the plan’s long-term liabilities to employees. Plan asset allocations are reviewed periodically and rebalanced to achieve target allocation among the asset categories when necessary.
The international plans’ assets are invested primarily in fixed income securities. The rate of return is expected to be in line with fixed income local government bonds with comparable terms.
The actuarially computed components of net periodic pension cost are shown below:
The following tables display the change in benefit obligation, plan assets, funded status and amounts recognized in the balance sheet:
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(1) Included in the accumulated other comprehensive income (loss) component of stockholders’ equity (in accordance with SFAS No. 130, Reporting Comprehensive Income).
Our 2004 and 2003 consolidated balance sheets include the minimum pension liability of $50.1 million and $51.3 million, respectively, in other long-term liabilities and the net prepaid benefit cost of $14.9 million and $16.0 million, respectively, in prepaid expenses and other noncurrent assets. The increase (decrease) in the minimum pension liability, totaling $(1.2) million, $5.4 million and $7.7 million for 2004, 2003 and 2002, respectively, has been included in other comprehensive income (loss) in the accompanying Statements of Comprehensive Income (Loss). The increase in the minimum pension liability in 2003 and 2002 was due primarily to changes in the discount rate actuarial assumptions and, in 2002, the investment underperformance of plan assets.
The following table shows the percentage of total plan assets for each major category of plan assets:
We periodically review the pension plans’ investments in the various asset classes. The current asset allocation target is 60% equity securities and 40% fixed income securities for the U.S. plan and 100% fixed income securities for the international plans. The plan’s investment managers are provided specific guidelines under which they are to invest the assets assigned to them. In general, investment managers are expected to remain fully invested in their asset class with further limitations of risk as related to investments in a single security, portfolio turnover and credit quality.
The U.S. plan’s investment policy prohibits the use of derivatives associated with leverage and speculation or investments in securities issued by PTC, except through index-related strategies and/or commingled funds. An investment committee oversees management of the pension plan’s assets.
Based on actuarial valuations and, in 2003, additional voluntary contributions, we contributed $2.7 million, $10.7 million and $4.1 million in 2004, 2003 and 2002, respectively, to the plans. We have no minimum funding requirements in 2005. However, we may, at our discretion, make voluntary contributions to the plans.
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As of September 30, 2004, benefit payments expected to be paid over the next ten years are outlined in the following table:
L. Segment Information
We operate within a single industry segment-computer software and related services. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision-making group is our executive officers. We have two reportable segments: (1) software products, which include license and maintenance revenue (including new releases and technical support); and (2) services, which include consulting, implementation education and other support revenue. For external reporting purposes (as shown in our consolidated statements of operations), maintenance revenue is included in Service Revenue. We do not allocate certain sales, marketing or administrative expenses to our operating segments, as these activities are managed separately. Within our software products reportable segment, we have two software product categories: (1) our computer aided design, manufacturing and engineering software (design solutions), including our flagship Pro/ENGINEER® design software, which provides engineering solutions to our customers, and (2) our collaboration and data management technologies (collaboration and control solutions), including our Windchill® software suite, which provide information management solutions to our customers.
In the second quarter of 2003, with the launch of Pro/ENGINEER Wildfire, we began selling a product development system package called “Flex 3C” for Create, Collaborate and Control. It includes Pro/ENGINEER Wildfire with advanced engineering modules, Windchill ProjectLink, and Windchill PDMLink as a data management option. Because the package includes both design solutions and collaboration and control solutions, for purposes of reporting revenues by product groups, we developed a revenue allocation methodology in conjunction with Pro/ENGINEER Wildfire pricing and packaging. New Flex 3C revenue is allocated 90% to our design solutions and 10% to our collaboration and control solutions. Revenue from upgrades to the Flex 3C package is allocated 50% to our design solutions and 50% to our collaboration and control solutions. As we continue to offer packages that include both design solutions products and collaboration and control solutions products, the delineation between the two product lines may become less meaningful and, accordingly, we may revise our product categories.
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The revenue and operating income (loss) attributable to these operating segments are summarized as follows:
(1) Maintenance revenue is included in Service Revenue in the consolidated statement of operations.
(2) The operating income (loss) reported does not represent the total operating results for each operating segment as it does not contain an allocation of sales, marketing, corporate and general administrative expenses incurred in support of the operating segments.
(3) We recorded restructuring and other charges of $42.9 million, $30.9 million and $31.2 million in 2004, 2003 and 2002, respectively. In 2004, 2003 and 2002, software products included $9.5 million, $6.6 million and $2.2 million, respectively; services included $12.2 million, $2.5 million and $4.1 million, respectively; distribution expenses included $16.5 million, $13.9 million and $10.2 million; and unallocated expenses included $4.7 million, $7.9 million and $14.6 million, respectively, of the restructuring and other charges recorded in those respective periods. The unallocated expenses in 2003 and 2002 include $6.4 million and $12.6 million, respectively, related to an increase in reserves on excess facilities. See Note B.
(4) Represents all sales and marketing expenses including the related portion of restructuring and other charges.
(5) Unallocated expenses represent all corporate and general and administrative expenses including the related portion of restructuring and other charges.
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Data for the geographic regions in which we operate is presented below:
(1) Includes revenue in Germany totaling $72.7 million, $71.3 million and $69.3 million for 2004, 2003 and 2002, respectively.
(2) Includes revenue in Japan totaling $111.8 million, $100.4 million and $95.3 million for 2004, 2003 and 2002, respectively.
Our international revenue is presented based on the location of our customer. We license products to customers worldwide. Our sales and marketing operations outside the United States are conducted principally through our international sales subsidiaries throughout Europe and the Asia/Pacific region. Intercompany sales and transfers between geographic areas are accounted for at prices that are designed to be representative of unaffiliated party transactions.
R EPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and Board of Directors of Parametric Technology Corporation:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, cash flows, stockholders’ equity and comprehensive income (loss) present fairly, in all material respects, the financial position of Parametric Technology Corporation and its subsidiaries at September 30, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note D to the consolidated financial statements, on October 1, 2002, the Company changed its method of accounting for goodwill and certain other intangible assets upon adoption of Statement of Financial Accounting Standards No. 142.
/s/ PricewaterhouseCoopers LLP
Boston, Massachusetts
December 7, 2004
FIVE-YEAR SUMMARY OF SELECTED FINANCIAL DATA
(1) Total assets as of September 30, 2003 reflects the reclassification of income taxes receivable totaling $23.3 million from accrued income taxes to current assets to conform to the 2004 presentation.
QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
(in thousands, except per share data)
(1) The common stock prices are based on the NASDAQ National Market daily closing stock price. Our common stock is traded on the NASDAQ National Market under the symbol “PMTC”.