PTC INC. (PTC) FY 2022 MD&A

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

Statements in this Annual Report about anticipated financial results, capital developments and growth, as well as about the development of our products, markets and workforce, are forward-looking statements that are based on our current plans and assumptions. Important information about the bases for these plans and assumptions and factors that may cause our actual results to differ materially from these statements is contained below and in Item 1A. “Risk Factors” of this Annual Report.

Unless otherwise indicated, all references to a year reflect our fiscal year that ends on September 30.

Operating and Non-GAAP Financial Measures

Our discussion of results includes discussion of our ARR (Annual Run Rate) operating measure, non-GAAP financial measures, and disclosure of our results on a constant currency basis. ARR and our non-GAAP financial measures, including the reasons we use those measures, are described below in Results of Operations - Operating Measure and Results of Operations - Non-GAAP Financial Measures, respectively. The methodology used to calculate constant currency disclosures is described in Results of Operations - Impact of Foreign Currency Exchange on Results of Operations. You should read those sections to understand our operating measure, non-GAAP financial measures, and constant currency disclosures.

Executive Overview

ARR increased 7% (16% constant currency) to $1,572 million in FY’22 compared to the end of FY’21. Excluding the impact of Codebeamer, which we acquired in the third quarter of FY’22, organic ARR growth was 6% (15% constant currency) in FY’22 compared to FY’21.

FY’22 revenue of $1.93 billion increased 7% over FY’21 (11% in constant currency). FY’22 operating margin of 23% increased approximately 200 basis points over FY’21 and non-GAAP operating margin of 38% increased approximately 300 basis points. Operating margin improvements are due to higher revenue and continued operating expense discipline. FY’22 diluted EPS was $2.65 compared to $4.03 in FY'21. Diluted EPS in FY'22 included a $35 million non-operating charge associated with the decrease in value of an equity investment in a publicly-traded company, offset by a non-operating $30 million credit associated with the sale of a portion of our PLM services business. Diluted EPS in FY'21 benefited from gains associated with an equity investment in a publicly-traded company, and income tax credits related to a release of a previously held valuation allowance. FY'22 non-GAAP diluted EPS was $4.58, representing a 15% increase over non-GAAP diluted EPS of $3.97 in FY'21.

FY’22 operating cash flow of $435 million grew 18% over FY’21; FY’22 free cash flow of $416 million grew 21% over FY’21. FY'22 operating cash flow and free cash flow included an $11.8 million outflow related to acquisition and transaction-related costs and $40.8 million of restructuring payments. We ended FY’22 with cash and cash equivalents of $272 million and gross debt of $1.36 billion, with an aggregate interest rate of 3.9%.

Results of Operations

The following table shows the measures that we consider the most significant indicators of our business performance. In addition to providing operating income, operating margin, diluted earnings per share and cash from operations as calculated under GAAP, we provide our ARR operating measure and non-GAAP operating income, non-GAAP operating margin, non-GAAP diluted earnings per share, and free cash flow for the reported periods. We also provide a view of our actual results on a constant currency basis. Our non-GAAP financial measures exclude the items described in Non-GAAP Financial Measures below. Investors should use our non-GAAP financial measures only in conjunction with our GAAP results.

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For discussion of our FY'21 results and comparison to our FY'20 results, refer to Management's Discussion and Analysis of Financial Conditions and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended September 30, 2021.

(1)
See Non-GAAP Financial Measures below for a reconciliation of our GAAP results to our non-GAAP measures and Impact of Foreign Currency Exchange on Results of Operations below for a description of how we calculate our results on a constant currency basis.

(2)
For the September 30, 2021 period, to facilitate comparability, we removed $6.2 million of ARR associated with a Vuforia AR product that we ceased selling as of September 30, 2021 from our ARR operating measure.

(3)
Recurring revenue is comprised of on-premises subscription, perpetual support, and SaaS, and cloud revenue.

(4)
Cash flow from operations for FY’22 and FY’21 includes $40.8 million and $14.5 million of restructuring payments, respectively. Cash from operations for FY’22 and FY’21 includes $11.8 million and $15.0 million of acquisition and transaction-related payments, respectively. Cash from operations for FY'21 includes $17.9 million in un-forecasted payments related to the prior period tax exposure from a non-U.S. tax dispute.

Impact of Foreign Currency Exchange on Results of Operations

Approximately 55% of our revenue and 40% of our expenses are transacted in currencies other than the U.S. Dollar. Because we report our results of operations in U.S. Dollars, currency translation, particularly changes in the Euro, Yen, Shekel, and Rupee relative to the U.S. Dollar, affects our reported results. Changes in foreign currency exchange rates have been a headwind to reported results in FY’22.

The results of operations in the table above, and the tables and discussions below about revenue by line of business, product group, and geographic region present both actual percentage changes year over year and percentage changes on a constant currency basis. Our constant currency disclosures are calculated by multiplying the results in local currency for FY'22 and FY'21 by the exchange rates in effect on September 30, 2021. If FY'22 reported results were converted into U.S. dollars using the rates in effect as of September 30, 2021, ARR as of September 30, 2022 would have been higher by $134 million and operating income in FY'22 would have been $27 million higher.

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Revenue

Under ASC 606, the volume, mix, and duration of contract types (support, SaaS, on-premises subscription) starting or renewing in any given period may have a material impact on revenue in the period, and as a result can impact the comparability of reported revenue period-over-period. We recognize revenue for the license portion of on-premises subscription contracts up front when we deliver the licenses to the customer, typically on the start date, and we recognize revenue on the support element of on-premises subscription contracts and stand-alone support contracts ratably over the term. We continue to convert existing support contracts to on-premises subscriptions, resulting in a shift to up-front recognition of on-premises subscription license revenue in the period converted compared to ratable recognition for a perpetual support contract. Revenue from our cloud services (primarily SaaS) contracts is recognized ratably. As we continue to expand our SaaS offerings and release additional cloud functionality into our products, and customers begin to migrate from on-premises subscriptions to SaaS products, we expect that over time a higher portion of our revenue will be recognized ratably. Given the different mix, duration and volume of new and renewing contracts in any period, year-over-year or sequential revenue comparisons can vary significantly.

Revenue by Line of Business

(1)
Includes perpetual licenses and the license portion of subscription sales.

(2)
Includes support on perpetual licenses and the support portion of subscription sales.

The strengthening of the U.S. dollar compared to foreign currencies had a substantial impact on our revenue growth in FY'22. On an actual currency basis, FY'22 revenue increased $126 million (7%), compared to an increase of $202 million (11%) on a constant currency basis.

Software revenue increased in FY’22 compared to FY’21 due to growth of Windchill and Arena revenue in the Americas and contribution from the recently acquired Codebeamer business in Europe, offset by a decline in Creo revenue primarily driven by foreign currency fluctuations in Europe and changes in contract durations. In FY'22, our average durations for on-premises subscriptions starting in the year decreased slightly, resulting in a reduced revenue benefit compared to FY'21, which benefited from significant increases in average contractual durations due to business rule changes.

Professional services revenue in FY’22 compared to FY'21 reflects an increase in revenue associated with large PLM consulting engagements, particularly with automotive, aerospace and defense and consumer electronics customers. Professional services revenue in the first half of FY’21 was negatively impacted by services delivery challenges associated with the COVID-19 pandemic.

Our long-term expectation is that professional services revenue will trend down over time as we migrate more services engagements to our partners and deliver products that require less consulting and training services. As described in Part I, Item 1. Business above, in the second half of FY'22, we accelerated this strategy through the sale of a portion of our PLM services business to ITC Infotech.

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Revenue and ARR by Product Group

(1)
We describe our Product Groups for FY'22 and FY'21 and the change for FY'23, including the products in each group, in Part I, Item 1. Business above.

Windchill software revenue increased by 12% (16% constant currency), driven by a significant increase in on-premises subscription license revenue and an increase in cloud services revenue. Windchill ARR increased 10% (19% constant currency) in FY'22 compared to FY'21.

Arena software revenue increased by 122% (actual and constant currency), driven by an increase in cloud services revenue and an increase in on-premises subscription license revenue. Arena was acquired in January 2021, so it did not contribute to FY'21 revenue for the full year and purchase accounting adjustments to acquired deferred revenue had a greater impact on FY'21 revenue than FY'22. Arena ARR increased by 27% (actual and constant currency) in FY'22 compared to FY'21.

IIoT software revenue increased by 7% (10% constant currency) driven by an increase in cloud services revenue. IIoT ARR increased 14% (21% constant currency) in FY'22 compared to FY'21.

The Codebeamer business, which we acquired in the third quarter, performed well and added a point of ARR growth, taking constant currency ARR growth to 16% for the fourth quarter and full year. Codebeamer generated $9 million of revenue in FY'22, with $6 million of on-premises subscription revenue and $2 million of perpetual support revenue. Codebeamer ARR as of September 30, 2022 was $16 million ($18 million on a constant currency basis).

Creo software revenue decreased by 1% primarily driven by the effect of foreign currency headwinds in Europe. Creo software revenue increased 4% on a constant currency basis. Creo ARR was flat (increased 11% in constant currency) in FY'22 compared to FY'21.

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Software Revenue & ARR by Geographic Region

A significant portion of our software revenue is generated outside the U.S. In both FY’22 and FY’21, approximately 40% to 45% of software revenue was generated in the Americas, 35% to 40% in Europe, and 15% to 20% in Asia Pacific.

Americas software revenue growth in FY’22 was driven by Windchill revenue growth of 23%, Arena revenue growth of 133%, and IIoT revenue growth of 10%. The increase in revenue from Arena includes the effect of purchase accounting adjustments to reduce acquired deferred revenue. Americas ARR was up 17%.

Europe software revenue declined in FY’22, driven by a $48 million foreign currency impact associated with the strengthening of the U.S. Dollar compared to foreign currencies. Creo revenue decreased 5% (2% increase in constant currency), partially offset by Windchill revenue growth of 4% (12% constant currency) and the addition of Codebeamer revenue. ARR in Europe was up 16% constant currency.

Asia Pacific software revenue growth in FY’22 included a $19 million foreign currency impact associated with the strengthening of the US Dollar compared to foreign currencies. Creo revenue grew 4% (11% constant currency) and Windchill revenue grew 3% (9% constant currency). ARR in Asia Pacific was up 13% constant currency.

Gross Margin

(1) Non-GAAP financial measures are reconciled to GAAP results under Non-GAAP Financial Measures below.

The strengthening of the U.S. dollar compared to foreign currencies had a substantial impact on our gross margin increase in FY'22. On an actual currency basis, FY'22 gross margin increased $111 million (8%), compared to an increase of $176 million (12%) on a constant currency basis.

License gross margin increased in FY’22 compared to FY’21 due to an increase in license revenue of $44.6 million and a decrease in cost of license of $12.5 million, which was driven by lower amortization expense, royalty expense and compensation costs.

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Support and cloud services gross margin increased in FY’22 compared to FY’21 due to increases in support and cloud services revenue of $76.3 million, partially offset by increases in cost of support and cloud services of $20.7 million, which were driven by higher compensation, maintenance and hosting costs.

Professional services gross margin decreased in FY’22 compared to FY’21 due to increases in professional services costs of $6.7 million, including $5.1 million of stock-based compensation expense recognized in FY'22 related to the sale of a portion of our PLM services business in Q3'22, partially offset by a $5.3 million increase in revenue.

Operating Expenses

The strengthening of the U.S. dollar compared to foreign currencies had a substantial reduction to our operating expense increase in FY'22. On an actual currency basis, FY'22 operating expenses increased $45 million (4%), compared to an increase of $67 million (6%) on a constant currency basis.

Total headcount decreased by 3% in FY'22 to 6,503 from 6,709 at the end of FY'21.

Operating expenses in FY'22 compared to FY'21 increased primarily due to the following:

•
a $34 million increase in restructuring charges primarily due to the restructuring plan initiated in Q1’22;

•
a $9 million increase in travel expenses;

•
a $6 million increase in intangible amortization expense;

•
a $6 million increase in software subscriptions; and

•
a $5 million increase in internal hosting costs;

partially offset by:

•
a $12 million decrease in compensation expense (including benefit costs) due to lower headcount caused by attrition and restructuring actions; and

•
a $6 million decrease in stock-based compensation.

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Interest Expense

Interest expense includes interest under our credit facility and senior notes. Interest expense was higher in FY'22 than FY'21. We had $1,359 million of total debt at September 30, 2022, compared to $1,450 million at September 30, 2021. We repaid $355 million of our revolving credit facility in FY'22, offset by $264 million borrowed at the end of April to fund the acquisition of the Codebeamer business. Loans under the credit facility bear interest at variable rates which reset every 30 to 180 days. As of September 30, 2022, the annual rate for borrowings under the credit facility was 4.1%, which has subsequently increased to 5.7%. For additional detail on the changes in our debt structure, see Note 9. Debt, included in the Notes to Consolidated Financial Statements in this Annual Report.

The average interest rate on our total borrowings was 3.4% in FY'22 and 3.3% in FY'21.

Other Income (Expense)

Interest income represents earnings on the investment of our available cash and marketable securities.

The decrease in Other income, net, in FY’22 over FY’21 was driven by a FY'21 credit of $69 million associated with unrealized gains related to an equity investment in a publicly-traded company. In FY'22, the value of that equity investment decreased, resulting in a $35 million charge. That FY'22 charge was offset by a gain on the sale of a portion of our PLM services business of $30 million and $6 million of gains on the sale of other assets and investments.

Income Taxes

In FY’22 and FY’21, our effective tax rate is impacted by our corporate structure in which our foreign taxes are at a net effective tax rate lower than the U.S. rate. A significant amount of our foreign earnings is generated by our subsidiaries organized in Ireland and the Cayman Islands. In FY’22 and FY’21 the foreign rate differential predominantly relates to those earnings. In addition to the foreign rate differential, our tax rate differed from the statutory federal income tax rate due to the net effects of the Global Intangible Low-Taxed Income (GILTI) and Foreign Derived Intangible Income (FDII) regimes (together referred to as U.S. Tax reform), and the excess tax benefit related to stock-based compensation.

Additionally in FY’22, our results include tax expense relating to the book over tax basis difference on goodwill disposed of as part of the sale of a portion of our PLM service business. As a result of the net effect of these items in 2022, our effective tax rate did not differ significantly from the U.S. federal income tax rate.

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In FY’21, our tax rate includes a benefit due to the release of the valuation allowance on the majority of our U.S. net deferred tax assets.

Our results for the twelve months ended September 30, 2021, include a charge of $37.3 million related to the effects of a tax matter in the Republic of Korea (South Korea) of $34.4 million, and the resulting impact on U.S. income taxes of $2.9 million. The charge related to an assessment with respect to various tax issues, primarily foreign withholding taxes, in South Korea. We made additional payments of approximately $20 million to the tax authorities in South Korea in FY’21 for the years 2016 to 2021.

Liquidity and Capital Resources

Cash, cash equivalents and restricted cash

We invest our cash with highly rated financial institutions and in diversified domestic and international money market mutual funds. cash and cash equivalents include highly liquid investments with original maturities of three months or less. At September 30, 2022, cash and cash equivalents totaled $272 million, compared to $327 million at September 30, 2021.

A significant portion of our cash is generated and held outside the U.S. As of September 30, 2022, we had cash and cash equivalents of $11 million in the U.S., $105 million in Europe, $128 million in Asia Pacific (including India) and $28 million in other non-U.S. countries. We have substantial cash requirements in the U.S., but we believe that the combination of our existing U.S. cash and cash equivalents, marketable securities, our ability to repatriate cash to the U.S., future U.S. operating cash flows and cash available under our credit facility will be sufficient to meet our ongoing U.S. operating expenses and known capital requirements.

Cash provided by operating activities

Cash provided by operating activities was $435 million in FY'22 compared to $369 million in FY'21. The year-over-year increase is primarily due to approximately $170 million of higher cash collections, offset by $30 million more in salary and salary-related payments, a $57 million increase in disbursements largely related to prepayments made in FY'22, and a $12 million increase in tax-related payments.

Restructuring payments totaled $41 million in FY'22, compared to $15 million in FY'21. Cash paid for income taxes was $55 million in FY'22 compared to $58 million in FY'21.

Cash used in investing activities

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Cash used in investing activities in FY'22 reflects $278 million ($264 million of which we borrowed under our credit facility) used to acquire the Codebeamer business in FY'22, compared to $718 million used in FY’21 for the Arena acquisition, offset by FY'22 proceeds from the sale of a portion of our PLM services business of $33 million and proceeds from the sale of investments of $47 million. For additional detail on our acquisitions, see Note 6. Acquisitions and Disposition of Business of Notes to Consolidated Financial Statements in this Annual Report.

Cash (used in) provided by financing activities

Cash used in financing activities in FY’22 reflects borrowings of $264 million, offset by repayments of $355 million under our credit facility, repurchases of common stock of $125 million, payments of withholding taxes related to stock-based awards of $69 million and proceeds from the issuance of common stock of $21 million. In FY'21, net borrowings of $600 million were offset by $168 million of repayments under our credit facility, repurchases of common stock of $30 million, and payments of withholding taxes related to stock-based awards of $53 million.

Outstanding Debt

As of September 30, 2022, we had:

As of September 30, 2022, we were in compliance with all financial and operating covenants of the credit facility and the note indentures. Any failure to comply with such covenants under the credit facility would prevent us from being able to borrow additional funds under the credit facility, and, as with any failure to comply with such covenants under the note indentures, could constitute a default that could cause all amounts outstanding to become due and payable immediately. Loans under the credit facility bear interest at variable rates which reset every 30 to 180 days. As of September 30, 2022, the annual rate for borrowings outstanding was 4.1%, which has subsequently increased to 5.7%.

Our credit facility and our Senior Notes are described in Note 9. Debt of Notes to the Consolidated Financial Statements in this Annual Report.

Share Repurchase Authorization

Our Articles of Organization authorize us to issue up to 500 million shares of our common stock. Our Board of Directors has authorized us to repurchase up to $1 billion of our common stock through September 30, 2023. We may use cash from operations and borrowings under our credit facility to make any such repurchases. All shares of our common stock repurchased are automatically restored to the status of authorized and unissued.

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In FY'22 and in FY'21 we repurchased 1.05 million shares for $125 million and approximately 0.23 million shares in the open market for $30 million, respectively.

Our long-term goal is to return approximately 50% of our free cash flow to shareholders via share repurchases, while also taking into consideration the interest rate environment and strategic initiatives and acquisitions, which could cause us to reduce, suspend, or cease repurchases.

Expectations for Fiscal 2023

We believe that existing cash and cash equivalents, together with cash generated from operations and amounts available under the credit facility and otherwise, will be sufficient to meet our working capital and capital expenditure requirements (which we expect to be approximately $20 million in FY’23) through at least the next twelve months and to meet our known long-term capital requirements.

Our expected uses and sources of cash could change, our cash position could be reduced, and we could incur additional debt obligations if we engage in strategic transactions, retire debt, or repurchase shares, any of which could be commenced, suspended, or completed at any time. Any share repurchases or debt retirement will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. Such debt retirement or issuance, share repurchases, or strategic transactions may be material. We regularly borrow under our credit facility to make strategic acquisitions and expect to continue to do so, and may substantially increase our indebtedness to pursue strategic acquisitions, which would increase our debt repayment obligations, including related interest obligations.

Contractual Obligations

At September 30, 2022, our future contractual obligations were related to debt, leases, pension liabilities, unrecognized tax benefits, and purchase obligations. See Note 9. Debt, Note 19. Leases, Note 14. Pension Plans, and Note 8. Income Taxes of Notes to Consolidated Financial Statements in this Annual Report for information about those obligations, which Notes are incorporated by reference into this section. Our purchase obligations were approximately $161.4 million, with $64.2 million expected to be paid in FY'23 and $97.2 million thereafter. Purchase obligations represent minimum commitments due to third parties, including royalty contracts, research and development contracts, telecommunication contracts, information technology maintenance contracts in support of internal-use software and hardware, financing leases, operating leases with original terms of less than 12 months, and other marketing and consulting contracts. Contracts for which our commitment is variable, based on volumes, with no fixed minimum quantities, and contracts that can be canceled without payment penalties are not included in the purchase obligation amounts above. The purchase obligations included above are in addition to amounts included in Current liabilities and Prepaid expenses recorded on our September 30, 2022 Consolidated Balance Sheet.

As of September 30, 2022, we had letters of credit and bank guarantees outstanding of approximately $15 million (of which $0.5 million was collateralized).

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Operating Measure

ARR

ARR (Annual Run Rate) represents the annualized value of our portfolio of active subscription software, cloud, SaaS, and support contracts as of the end of the reporting period.

We believe ARR is a valuable operating metric to measure the health of a subscription business because it captures expected subscription and support cash generation from customers. Because this measure represents the annualized value of customer contracts as of a point in time, it does not represent revenue for any particular period or remaining revenue that will be recognized in future periods.

Non-GAAP Financial Measures

The non-GAAP financial measures presented in the discussion of our results of operations and the respective most directly comparable GAAP measures are:

•
free cash flow—cash flow from operations

•
non-GAAP gross margin—GAAP gross margin

•
non-GAAP operating income—GAAP operating income

•
non-GAAP operating margin—GAAP operating margin

•
non-GAAP net income—GAAP net income

•
non-GAAP diluted earnings or loss per share—GAAP diluted earnings or loss per share

Free cash flow is cash flow from operations net of capital expenditures, which are expenditures for property and equipment and consist primarily of facility improvements, office equipment, computer equipment, and software. We believe that free cash flow, in conjunction with cash from operations, is a useful measure of liquidity since capital expenditures are a necessary component of ongoing operations.

The non-GAAP financial measures other than free cash flow exclude, as applicable: stock-based compensation expense; amortization of acquired intangible assets; acquisition and transaction-related charges included in general and administrative expenses; restructuring and other charges, net; non-operating charges; and income tax adjustments.

The items excluded from these non-GAAP financial measures are normally included in the comparable measures calculated and presented in accordance with GAAP. Our management excludes these items when evaluating our ongoing performance and/or predicting our earnings trends, and therefore excludes them when presenting non-GAAP financial measures. Management uses non-GAAP financial measures in conjunction with our GAAP results, as should investors.

Stock-based compensation is a non-cash expense relating to stock-based awards issued to executive officers, employees and outside directors, consisting of restricted stock units. We exclude this expense as it is a non-cash expense and we assess our internal operations excluding this expense and believe it facilitates comparisons to the performance of other companies in our industry.

Amortization of acquired intangible assets is a non-cash expense that is impacted by the timing and magnitude of our acquisitions. We believe the assessment of our operations excluding these costs is relevant to our assessment of internal operations and comparisons to the performance of other companies in our industry.

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Acquisition and transaction-related charges included in General and administrative expenses are direct costs of potential and completed acquisitions and expenses related to acquisition integration activities, including transaction fees, due diligence costs, severance and professional fees. Subsequent adjustments to our initial estimated amount of contingent consideration associated with specific acquisitions are also included within acquisition and transaction-related charges. Other transactional charges include third-party costs related to structuring unusual transactions. We do not include these costs when reviewing our operating results internally. The occurrence and amount of these costs will vary depending on the timing and size of acquisitions and transactions.

Restructuring and other charges, net includes excess facility restructuring charges (credits); impairment and accretion expense charges related to the lease assets of exited facilities; sublease income from previously impaired facilities; and severance costs resulting from reductions of personnel and third-party professional consulting fees related to modifications of our business strategy. These costs may vary in size based on our restructuring plan.

Non-operating charges (credits) includes gains or losses associated with sales or changes in value of assets or liabilities which are generally investing or financing in nature, and are inconsistent with our ordinary operating activities. In FY'22, we recorded gains associated with the sale of assets, including the sale of a portion of our PLM services business. Additionally in FY'22, we recorded a loss associated with the reduction in value of an equity investment in a publicly-traded company. In FY'21, we recorded a gain related to the change in value of an equity investment in a publicly-traded company.

Income tax adjustments include the tax impact of the items above and assumes that we are profitable on a non-GAAP basis in the U.S. and one foreign jurisdiction. It also eliminates the effect of the valuation allowance recorded against our net deferred tax assets in those jurisdictions. Additionally, we exclude other material tax items that we do not include when reviewing our operating results internally.

We use these non-GAAP financial measures, and we believe that they assist our investors, to make period-to-period comparisons of our operational performance because they provide a view of our operating results without items that are not, in our view, indicative of our core operating results. We believe that these non-GAAP financial measures help illustrate underlying trends in our business, and we use the measures to establish budgets and operational goals (communicated internally and externally) for managing our business and evaluating our performance. We believe that providing non-GAAP financial measures also affords investors a view of our operating results that may be more easily compared to the results of other companies in our industry that use similar financial measures to supplement their GAAP results.

The items excluded from the non-GAAP financial measures often have a material impact on our financial results and such items often recur. Accordingly, the non-GAAP financial measures included in this Annual Report should be considered in addition to, and not as a substitute for or superior to, the comparable measures prepared in accordance with GAAP. The following tables reconcile each of these non-GAAP financial measures to its most closely comparable GAAP measure on our financial statements.

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(1)
Non-operating net credits for FY'22 include a $29.8 million gain on the sale of a portion of our PLM services business, a $3.4 million gain on sale of an asset, and a $3.0 million gain on sale of an investment, offset by a $34.8 million expense recognized due to the reduction in value of an equity investment in a publicly-traded company. Non-operating credits for FY'21 include a $68.8 million gain associated with an increase in value of an equity investment in a publicly-traded company.

(2)
Income tax adjustments reflect the tax effects of non-GAAP adjustments which are calculated by applying the applicable tax rate by jurisdiction to the non-GAAP adjustments listed above. In FY'22, adjustments include tax expense of $15.5 million related to the sale of a portion of our PLM services business, of which $8.1 million pertains to the basis difference in goodwill. Our FY'21 GAAP results included benefits of $179.7 million related to the release of the valuation allowance on the majority of our U.S. net deferred tax assets. As we were profitable on a non-GAAP basis, the FY'21 tax provision was calculated assuming there was no valuation allowance. Additionally, our non-GAAP results for FY'21 excluded tax expenses of $34.8 million related to a non-U.S. prior period tax exposure, primarily related to foreign withholding taxes.

Operating margin impact of non-GAAP adjustments:

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Critical Accounting Policies and Estimates

We have prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our reported revenues, results of operations, and net income, as well as on the value of certain assets and liabilities on our balance sheet. These estimates, assumptions and judgments are made based on our historical experience and on other assumptions that we believe to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time.

The accounting policies, methods and estimates used to prepare our financial statements are described generally in Note 2. Summary of Significant Accounting Policies of Notes to Consolidated Financial Statements in this Annual Report. The most important accounting judgments and estimates that we made in preparing the financial statements involved:

•
revenue recognition;

•
accounting for income taxes; and

•
valuation of assets and liabilities acquired in business combinations.

A critical accounting policy is one that is both material to the presentation of our financial statements and requires us to make subjective or complex judgments that could have a material effect on our financial condition and results of operations. Critical accounting policies require us to make assumptions about matters that are uncertain at the time of the estimate, and different estimates that we could have used, or changes in the estimates that are reasonably likely to occur, may have a material impact on our financial condition or results of operations. Because the use of estimates is inherent in the financial reporting process, actual results could differ from those estimates.

Accounting policies, guidelines and interpretations related to our critical accounting policies and estimates are generally subject to numerous sources of authoritative guidance and are often reexamined by accounting standards rule makers and regulators. These rule makers and/or regulators may promulgate interpretations, guidance or regulations that may result in changes to our accounting policies, which could have a material impact on our financial position and results of operations.

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Revenue Recognition

We record revenues in accordance with the guidance provided by ASC 606, Revenue from Contracts with Customers. For a full description of our revenue accounting policy, refer to Note 2. Summary of Significant Accounting Policies, included in the Notes to Consolidated Financial Statements in this Annual Report.

Our sources of revenue include: (1) subscriptions, (2) perpetual licenses, (3) support for perpetual licenses and (4) professional services. Subscriptions include term-based on-premises licenses, Software-as-a-Service (SaaS), and hosting services.

Judgments and Estimates

Determination of performance obligations. Our subscriptions are frequently sold as a bundle of products and services, typically pairing on-premises term software licenses with support and/or cloud services over the same term. On-premises software is typically determined to be a distinct performance obligation and is thus recognized separately from the support and/or cloud components. On-premises license software revenue is generally recognized at the point in time that the software is made available to the customer, while the support and cloud software revenue components are recognized over the term of the contract. In cases where subscriptions include cloud functionality and on-premises software, an assessment has been performed to determine whether the cloud services are distinct from the on-premises software. In the substantial majority of instances, cloud services provide incremental functionality to customers and have been considered distinct and recognized separately from the on-premises software. This assessment could have a significant impact on the timing of revenue recognition and may change as our product offerings evolve.

Allocation of transaction price. We estimate the standalone selling price of each identified performance obligation and use that estimate to allocate the transaction price among said performance obligations. The estimated standalone selling price is determined using all information reasonably available to us, including market conditions and other observable inputs. Significant judgment is used in determining the standalone selling prices of the on-premises license, support, and cloud components of our subscription products. These estimates are subject to change as our product offerings change and could have a significant impact due to the difference in the timing of revenue recognition for on-premises licenses and support and/or cloud.

Right to exchange. Our multi-year, non-cancellable on-premises subscription contracts provide customers with an annual right to exchange software within the original subscription with other software. We account for this right as a liability. For most contracts, we use the expected value method to determine the liability associated with this right across a portfolio of contracts. Where contracts are outside of the standard portfolio of contracts due to contract size, longer contract duration, or other unique contractual terms, we use the most likely amount method to determine the liability for each individual contract. In both circumstances, the transaction price is constrained based on our estimates, which impacts the amount of revenue recognized. Changes in these estimates could significantly impact revenue for any given period.

Accounting for Income Taxes

As part of the process of preparing our consolidated financial statements, we are required to calculate our income tax expense based on taxable income by jurisdiction. There are many transactions and calculations about which the ultimate tax outcome is uncertain; as a result, our calculations involve estimates by management. Some of these uncertainties arise as a consequence of revenue-sharing, cost-reimbursement and transfer pricing arrangements among related entities and the differing tax treatment of revenue and cost items across various jurisdictions. If we were compelled to revise or to account differently for our arrangements, that revision could affect our recorded tax liabilities.

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The income tax accounting process also involves estimating our actual current tax liability, together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheets. We must then 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 our deferred tax assets will not be realized, we must establish a valuation allowance as a charge to income tax expense.

As of September 30, 2022, we have a valuation allowance of $17.8 million against net deferred tax assets in the U.S. and a valuation allowance of $4.5 million against net deferred tax assets in certain foreign jurisdictions. We have concluded, based on the weight of available evidence, that a full valuation allowance is not required against our U.S. net deferred tax assets as they are more likely than not to be realized in the future. We will continue to reassess our valuation allowance requirements each financial reporting period.

The valuation allowance recorded against net deferred tax assets of certain foreign jurisdictions is established primarily for our capital loss carryforwards, the majority of which do not expire. However, there are limitations imposed on the utilization of such capital losses that could further restrict the recognition of any tax benefits.

Prior to the passage of the U.S. Tax Act, the Company asserted that substantially all of the undistributed earnings of its foreign subsidiaries were considered indefinitely invested and accordingly, no deferred taxes were provided. Pursuant to the provisions of the U.S. Tax Act, these earnings were subjected to a one-time transition tax and there is therefore no longer a material cumulative basis difference associated with the undistributed earnings. We maintain our assertion to permanently reinvest these earnings outside the U.S. unless repatriation can be done substantially tax-free, with the exception of a foreign holding company formed in 2018 and our Taiwan subsidiary. If we decide to repatriate any additional non-U.S. earnings in the future, we may be required to establish a deferred tax liability on such earnings. The amount of unrecognized deferred tax liability on the undistributed earnings would not be material.

In the normal course of business, PTC and its subsidiaries are examined by various taxing authorities, including the Internal Revenue Service (IRS) in the U.S. We regularly assess the likelihood of additional assessments by tax authorities and provide for these matters as appropriate. We are currently under audit by tax authorities in several jurisdictions. Audits by tax authorities typically involve examination of the deductibility of certain permanent items, transfer pricing, limitations on net operating losses and tax credits. Although we believe our tax estimates are appropriate, the final determination of tax audits and any related litigation could result in material changes in our estimates.

Valuation of Assets and Liabilities Acquired in Business Combinations

In accordance with business combination accounting, we allocate the purchase price of acquired companies to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. Determining these fair values requires management to make significant estimates and assumptions, especially with respect to intangible assets.

Our identifiable intangible assets acquired consist of developed technology, core technology, tradenames, customer lists and contracts, and software support agreements and related relationships. Developed technology consists of products that have reached technological feasibility. Core technology represents a combination of processes, inventions and trade secrets related to the design and development of acquired products. Customer lists and contracts and software support agreements and related relationships represent the underlying relationships and agreements with customers of the acquired company’s installed base. We have generally valued intangible assets using a discounted cash flow model. Critical estimates in valuing certain of the intangible assets include but are not limited to:

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future expected cash flows from software license sales, customer support agreements, customer contracts and related customer relationships and acquired developed technologies and trademarks and trade names and

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discount rates used to determine the present value of estimated future cash flows.

In addition, we estimate the useful lives of our intangible assets based upon the expected period over which we anticipate generating economic benefits from the related intangible asset.

Net tangible assets consist of the fair values of tangible assets less the fair values of assumed liabilities and obligations. Except for deferred revenues, net tangible assets were generally valued by us at the respective carrying amounts recorded by the acquired company, if we believed that their carrying values approximated their fair values at the acquisition date. For acquisitions completed prior to FY'22, the values assigned to deferred revenue reflect an amount equivalent to the estimated cost plus an appropriate profit margin to perform the services related to the acquired company’s software support contracts. During FY'22, we adopted ASU 2021-08, whereby deferred revenue for acquisitions completed in FY'22 reflect the amounts that would have been deferred as of the acquisition date in accordance with ASC 606.

In addition, uncertain tax positions and tax-related valuation allowances assumed in connection with a business combination are initially estimated as of the acquisition date and we reevaluate these items quarterly with any adjustments to our preliminary estimates being recorded to goodwill provided that we are within the measurement period (up to one year from the acquisition date) and we continue to collect information in order to determine their estimated values. Subsequent to the measurement period or our final determination of the estimated value of uncertain tax positions or tax-related valuation allowances, whichever comes first, changes to these uncertain tax positions and tax-related valuation allowances will affect our provision for income taxes in our Consolidated Statements of Operations.

Our estimates of fair value are based upon assumptions believed to be reasonable at that time, but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur, which may affect the accuracy or validity of such assumptions, estimates or actual results.

When events or changes in circumstances indicate that the carrying value of a finite-lived intangible asset may not be recoverable, we perform an assessment of the asset for potential impairment. This assessment is based on projected undiscounted future cash flows over the asset’s remaining life. If the carrying value of the asset exceeds its undiscounted cash flows, we record an impairment loss equal to the excess of the carrying value over the fair value of the asset, determined using projected discounted future cash flows of the asset.

Recent Accounting Pronouncements

In accordance with recently issued accounting pronouncements, we will be required to comply with certain changes in accounting rules and regulations, none of which are expected to have a material impact on our consolidated financial statements. Refer to Note 2. Summary of Significant Accounting Policies of Notes to the Consolidated Financial Statements in this Annual Report for all recently issued accounting pronouncements, which is incorporated herein by reference.

Off-Balance Sheet Arrangements

We have not created, and are not party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt or operating parts of our business that are not consolidated (to the extent of our ownership interest therein) into our financial statements. We have not entered into any transactions with unconsolidated entities whereby we have subordinated retained interests, derivative instruments or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to us.

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