PTC's Moat Underpinned by Strong Switching Costs

Equity Analyst

Julie Bhusal Sharma

PTC operates in the high-end computer-assisted design software market, but we view this market as mature and don’t foresee significant top-line growth in this area. PTC’s foray into growth areas such as "Internet of Things," AR, and midmarket CAD, on the other hand, will significantly add growth to the top line, in our view, as we expect PTC’s revenue mix to shift significantly to these areas over the next 10 years.

PTC’s Creo software is considered a staple among many large assembly and complex product engineer teams, whether it’s in designing the efficient transportation of fluids or cabling. The small high-end CAD market compared with the mid-market has safeguarded PTC from new entrants to some extent, in our view. However, we think the firm has largely been able to maintain its claim in the CAD industry based on its high switching costs, which we think apply not only to its core CAD offering but also its product lifecycle management software and new growth areas--like its Internet of Things and AR platforms. Still, switching costs alone aren’t enough to drive hefty growth in high-end CAD.

While we expect a mix shift in the future for PTC, a shift to a subscription model from a license-based model is largely in the recent past. PTC has suffered only temporary declines in revenue, margins, and returns on invested capital, in our view. We think the company will be able to recover well from the transition as its converted subscribers mature.

With this expected recovery, we think PTC’s growth areas will be able to contribute to a much greater portion of PTC’s business due to strong partnerships. While PTC’s mid-market SaaS CAD software, Onshape, is within the company’s growth segment, we think Internet of Things will see better success as entering the mid-market will be a tough task. In contrast, partnering with Microsoft and Rockwell Automation, PTC’s Internet of Things platform, Thingworx, has been able to gain greater traction for its solution that is widely known as among the best of breed.

Business Strategy & Outlook

We assign PTC with a narrow moat rating stemming from the company’s significant switching costs. PTC’s switching costs result from the role its software play in engineering mission critical products as well as the time-consuming implementation required to switch from PTC offerings.

PTC’s core solutions, which represent 80% of total revenue, are 3D Modelling (CAD) software Creo and product lifecycle management (PLM) software Windchill. Creo is best known for specialized CAD functions like advanced assembly design, cabling design, and advanced surfacing. For larger assembly design, Creo is often preferred due to its speed and stability--giving way to use cases in auto and aerospace and defense manufacturing. In addition, while most industrial CAD software includes some extent of simulation capabilities, Creo’s simulation features are considered in the top tier, especially after partnering with Ansys to feature live simulation capabilities--which does not require days or weeks of “meshing”--or, manually dividing a 3D model’s topology into discrete sections. 

Due to more detailed capabilities, Creo is considered a high-end CAD software. The high-end CAD software market is fragmented, and we think that Dassault Systèmes’ Catia and Siemens’ NX software are PTC’s greatest competition in the market. While customers often mix and match CAD software, this is often the case between low-, mid-, and high-end CAD software rather than mixing software from one tier, such as having both Catia and Creo. We think that between Creo and its close competitors there are significant nuances to why a company has selected one or the other as its high-end CAD provider. For example, Catia is often preferred for sheet metal and surfacing work, whereas Creo is often favored when designing complex structures and piping design. While both software have the capabilities of the other, we think that how a company prioritizes features like piping design versus surfacing work defines why it selects one high-end software over the other in the first place. 

Because of these priorities related to mission critical product functions reflected in the choice to use Creo, we think that Creo exhibits high switching costs. While we suspect that the quality in these design functions are merging between Creo and its top competitors, we think that switching costs are strengthened by the learning curve of the software. Changing an engineering team to a Catia team from a Creo team would involve significant retraining and pose significant risks. To paint a picture, in 2006, production of Airbus’ A380 aircraft failed and cost Airbus $6 billion when partnering DaimlerChrysler aerospace engineers worked on different design software than that of Airbus engineers, leading to copper and aluminum wiring for the plane being too short from the two softwares calculating wire bend radii differently. Due to the risks a software switch entails in mission critical functions, we think there’s much inertia in remaining a “Creo shop.”

PTC’s PLM solution, Windchill, can be thought of as the repository of all info about a given product, including specifications and information on supply sourcing. In the PLM space, PTC competes with Dassault Systèmes, Siemens, Oracle, and SAP. According to customer reviews, Windchill and SAP’s Quality Management software appear to be more highly rated product lifecycle management tools over competitors like Siemens and Oracle. Irrespective of ratings, we think that switching costs are significant in the PLM space and exist due to the hefty implementation involved in switching PLM providers. Implementation would require integrating a PLM system with other business operations like a company’s suppliers as well as its CAD software. In addition, retraining on PLM would require significant time. 

PTC has recently expanded from its core CAD and PLM solutions into Internet of Things and Augmented Reality (AR) offerings--largely via acquisition. In 2013, PTC acquired ThingWorx, which is now the backbone of its Internet of Things platform that works to solve two types of monitoring. For one, the platform can be used to connect products once in the hands of their customers--like a vending machine manufacturer monitoring vending machines in use to estimate the next time each vending machine will require servicing. On the other hand, the ThingWorx platform can be used on the factory floor, using CAD and simulation software to predict machinery failures, best utilization practices, and perform analytics. In both cases, PTC is well regarded in the Internet of Things space for its interoperability among industrial hardware. After acquiring Kepware in 2016, the Thingworx platform is able to communicate with an estimated 70% of hardware without customized coding from system integrators via the Kepware server, with only Software AG comparing in the extent of connectivity. Through PTC’s partnership with Rockwell Automation in 2018, the company hopes to become a better-known name on the factory floor, given that PTC’s has been historically best known in the engineer design shop. 

Despite PTC’s size relative to Internet of Things competitors like Siemens, we consider PTC as one of the software leaders in Internet of Things. We believe Thingworx Enterprise Edition sells at a premium over competitors, which we think is reflective of PTC’s high quality Internet of Things platform. On the augmented reality side, PTC bought Vuforia in 2015, which used CAD software to publish AR experiences for industrial training and machine maintenance. Customers include John Deere, a top Japanese automotive OEM, and Bose’s automotive division. We think PTC’s Internet of Things and AR solutions pose significant switching costs given the intense implementation required to reconnect devices and specifications when changing Internet of Things or AR vendors.

We do not think PTC exhibits a strong network effect given that the company’s CAD and PLM software are more specialized than the average product design and product lifecycle offerings. Considering how fragmented the high-end CAD market for product design is, we think this lessens the benefits of CAD and PLM software being taught in graduate programs. Due to the fragmentation, companies often require extensive training when orienting new hires rather than expecting new graduates to already be trained on their software of choice. We think that software like Autodesk’s Inventor or Dassault Systèmes’ SolidWorks have a more expansive university presence given that they specialize in meeting mid-market CAD needs, which makes up the majority of the CAD market.

Narrow

Economic Moat

PTC, Inc. is a global software company, which engages in the provision of portfolio of innovative digital solutions that work together to transform how physical products are engineered, manufactured, and serviced. It operates through the Software Products and Professional Services segments. The Software Products segment includes license, subscription, and related support revenue for its products. The Professional Services segment consists of consulting, implementation, and training services. The company was founded in 1985 and is headquartered in Boston, MA.

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