Aspen Technology Inc

NASDAQ:AZPN

Earnings Call Transcript 2018-Q3

[Operator]

Good afternoon. My name is Mika, and I will be your conference operator today. At this time, I would like to welcome everyone to Third Quarter 2018 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session.

Thank you. Mr. Karl Johnsen, you may begin your conference.

[Karl E. Johnsen, Aspen Technology, Inc.]

Thank you. Good afternoon, everyone, and thank you for joining us to review our third quarter fiscal 2018 results for the period ending March 31, 2018. I'm Karl Johnsen, CFO of AspenTech; and with me on the call today is Antonio Pietri, President and CEO.

Before we begin, I will make the usual Safe Harbor statement that during the course of this call we may make projections or other forward-looking statements about the financial performance of the company that involve risks and uncertainties. The company's actual results may differ materially from such projections or statements. Factors that may cause such differences include, but are not limited to, those discussed in today's call and in our Form 10-Q for the third quarter of fiscal year 2018, which is now on file with the SEC.

Also, please note that the following information is related to our current business conditions and our outlook as of today, April 25, 2018. Consistent with our prior practice, we expressly disclaim any obligation to update this information. The structure of today's call will be as follows: Antonio will discuss business highlights from the third quarter; and then I'll review our financial results and our guidance for the fourth quarter and fiscal year 2018 before we open up the call for Q&A.

With that, let me turn the call over to Antonio. Antonio?

[Antonio J. Pietri, Aspen Technology, Inc.]

Thanks, Karl, and thanks to everyone for joining us today. We were pleased with our performance in the quarter, which reflected good execution across the company and a solid demand environment.

Looking at our financial highlights for the quarter, annual spend was $480 million, up 6.3% year-over-year. Total revenue was $125.9 million, above the high end of our guidance range of $120 million to $122 million.

GAAP operating income was $51.2 million and non-GAAP operating income was $57.4 million, which represents a non-GAAP operating margin of 46%. GAAP EPS was $0.52 and non-GAAP EPS was $0.58, both of which outperformed our guidance.

Free cash flow was $78.1 million and we returned $50 million to shareholders by repurchasing 649,000 shares. Our third quarter and year-to-date performance position us well to deliver on our fiscal year annual spend growth target of 5% to 7%, including a one-point to two-point contribution from our APM suite.

From a demand perspective, the third quarter saw a continuation of trends from the first half of the fiscal year. We had solid performance from owner-operator customers, reflected in good demand for both our engineering and MSC suites. We are pleased with the trends we see among these customers and believe they will continue for the foreseeable future.

AspenTech's ability to drive operational efficiencies throughout the asset life cycle is aligned with owner-operators' strategic focus on operational excellence and margin improvement.

From a regional perspective, Europe, North America and Latin America were notable performers, while our SMB business continued to deliver solid growth. Additionally, we're seeing solid early traction from our recently signed partnership with Emerson as its global sales channel engages in identify opportunities involving AspenTech solutions.

Business activity among E&C and upstream customers was similar to what we have seen in recent quarters. On the positive side, in Europe and Asia, we see signs of an improving demand environment. At the same time, demand in North America remains constrained as these customers in this region were much more heavily invested in upstream CapEx projects and are still working through the effects of lower business activity from their customers.

As we have discussed in the past, CapEx spend is the most important driver of E&C demand for AspenTech solutions. Overall, indications are that CapEx budget increases for calendar 2018 are in the range of 5% to 7%. However, much of the growth is focused on shale plays in oil and gas. These projects are less technology-intensive and therefore a less meaningful growth driver for AspenTech.

Looking at our APM business, we were pleased with our performance in the quarter and the increasing customer interest and spend we're seeing in this area. APM annual spend signed in the third quarter was higher than the annual spend signed in the second quarter.

We, again, contracted meaningful transactions for different products in the suite, two of which were in the six-figure range. We also saw good distribution of transactions across regions in North America, Europe and Asia, with a concentration in bulk and specialty chemicals. We believe our year-to-date performance and growing pipeline of opportunities position us well to generate one to two points of APM annual spend growth in fiscal 2018.

The Aspen Mtell product had a strong quarter, and we're seeing a strong customer interest in several industries and geographies. Customers are embracing Mtell's ability to drive improvements in asset uptime by modeling related historical and real-time process and maintenance data to predict future asset behavior and perform prescriptive maintenance.

During the quarter, we also saw solid demand for our Aspen ProMV solution among specialty chemicals customers. ProMV's ability to leverage multivariate analytics to improve the performance of continuous and batch processing runs solves a challenging and expensive problem for these customers. As encouraged as we are by our performance in APM year-to-date, we're even more optimistic about the long-term opportunity for APM compared to when we entered this market. We believe our performance in FY 2018 and the investments we're making are building momentum for the future.

These are some of the reasons for this optimism. First, our pipeline continues to grow and APM now represents 32% of our total pipeline. We're still in the early stages of building a new market segment and educating customers about how the APM suite can improve their business, which makes the high level of customer interest and demand we have developed in the past 18 months even more encouraging. Customers recognize that applying machine learning and data analytics to the maintenance and performance of their physical assets represents a significant opportunity to drive increased reliability and operational efficiencies across their businesses.

Second, as we compete against other companies for business in the space, we're experiencing increasing success against them, and we're proving out the value from the use cases where we have tested the APM capabilities. This is building our confidence in the analytics capabilities in the APM suite. It is important to note that AspenTech is not competing in the IoT platform space. We will integrate into as many of these platforms as required while remaining platform-agnostic. We will remain focused on creating value for our customers through products and solutions that predict process degradation and equipment failure and prescribe actionable insights. Historically, it has been advanced applications sitting on hardware that have created the value for customers. Similarly, we believe it will be the applications on top of IoT platforms that will capture the value to drive optimal reliability for these customers.

Third, we have made progress in pricing and packaging our APM software to make it easier for customers to start using these products. Since this is a new segment, we have introduced pricing that gives customers opportunity to test how APM products can improve their businesses and accelerate value to AspenTech. We believe this approach sets up a land and expand strategy that can drive meaningful long-term growth.

Fourth, our growing roster of partners is expanding our go-to-market reach. We now have more than 65 resellers, systems implementers and OEM partners, which are contributing to our growing pipeline. The pipeline in the GEIs and other industries now represents 24% of the total APM pipeline. The combination of factors listed above, the potential market opportunity and the required speed-to-market justify additional investments in our customer-facing organizations to capitalize on the APM opportunity. We are realizing the expected returns on the investments we have made in this category to-date and are confident that additional investments will enhance our ability to establish AspenTech as the category leader and support our growth ambition.

Turning to our third quarter performance in more detail, Energy, Engineering & Construction and Chemicals once again represent a greater than 90% of our business. Energy was the largest contributor, followed by Chemicals and E&C. Looking at our 10 largest transactions in the quarter, we had a healthy mix of Engineering, Manufacturing & Supply Chain and APM transactions.

Once again, several of our largest transactions signed in the quarter were in the APM suite. While there will be variability quarter-to-quarter, we anticipate that all three product suites will be represented in our largest quarterly transactions going forward.

Following is a representative sample of transactions closed in the quarter. First, Borealis, a leading provider of innovative solutions in the fields of polyolefins, base chemicals and fertilizers with its head office in Vienna, Austria, selected Aspen Mtell to improve reliability and availability of key assets at its Stenungsund site in Sweden. Predictive maintenance is a key initiative under this customer's digitalization roadmap. The company's selection of Aspen Mtell was based on its successful performance in a competitive, predictive maintenance proof-of-concept project for a business critical compressor at the site. This initial project effectively demonstrated the tangible benefit of automating much of the data analysis and knowledge work. Their decision to move forward with Aspen Mtell was further supported by the demonstrated rapid speed of deployment, accurate early detection of asset degradation and ability to scale the solution system-wide.

Second, a global chemical company headquartered in Southeast Asia completed an early renewal of its MSC contract with significant growth in annual spend. The growth comes from greater use of our PIMS-AO solution across the customer's facility. The early renewal was achieved despite a highly competitive sales process. The MSC renewal comes after the renewal of this customer's engineering contract earlier in the year. The renewal of the contract highlighted how new adoption processes put in place over the last 12 months, 18 months are having a positive impact on our business.

Third, a global chemical company headquartered in North America amended its MSC contract to purchase a first batch of DMC3 tokens to deploy the technology on a global basis. The business case analysis calls for benefits in the tens of millions of dollars from the rollout of the technology across the customer's chemical and refining assets.

Fourth, another global chemical company headquartered in North America and user of our Engineering and MSC solutions selected Aspen Mtell to deploy in its Industry 4.0 technology's pilot and showcase site. The selection of the Aspen Mtell product came after an extensive competitive evaluation of advanced predictive maintenance solutions. The performance of the technology will be evaluated over the next 12 months with the possibility for expansion to other sites during this phase.

Fifth, after recently purchasing Aspen Mtell, this refining customer in Europe also decided to select PIMS-AO after a long and detailed evaluation of the benefit that would be derived by moving from PIMS to PIMS-AO. The company's focus was on long-term strategic planning, monthly planning, campaign, and crude selection. In addition, the selection of aspenONE Process Explorer, an MES visualization and trending product moved the customer from using a homegrown customized tool to AspenTech software that could better address the areas of monitoring KPIs and supporting daily operation.

And finally, a Canadian independent crude oil and natural gas producer, one of the largest in the world, increased its Engineering tokens entitlement by more than 50% after the recent acquisition of some global upstream assets. This customer is a long term user of AspenTech's Engineering products.

The growth generated in the quarter and our discipline running the business delivered solid profitability in the quarter. We generated a 46% non-GAAP operating margin, which was above our expectations. We continue to hire high-quality employees and extend the product capabilities across our product suite. Our ability to invest in a new product category while maintaining best-in-class margins demonstrates our rigorous approach to spending and the inherent scalability of our model.

As I noted earlier, we intend to make incremental investments in distribution for APM in our core and GEI markets. These investments will be focused on the expansion of customer-facing personnel in the field, the APM sales organizations and the continuing buildup of the APM business consulting team.

The APM suite represents the most exciting opportunity on which the company is currently executing. The suite of technologies is proving out as leading technology assets for predictive and prescriptive capabilities as we compete for business. Similarly, we believe that AI and machine learning, including cognitive learning analytics represent a significant opportunity to enhance the capabilities and value creation of our Engineering and MSC products and solutions. We're evaluating these opportunities.

We're investing in more than just APM as well. During the quarter, we made an exciting acquisition of Apex Optimisation, the inventors of generic dynamic optimization technology. This technology will, for the first time, enable unified production optimization for refiners and petrochemical companies in complex industrial environments by aligning Advanced Process Control capabilities with planning and scheduling.

This dynamic coordination will allow real time capture of how changing plant conditions impact economic incentives. This is an unprecedented capability in these industries and represent the biggest incremental benefits opportunity since we introduced multivariable controller technology in the late 1980s. We estimate that a single multi-unit application of GDOT could generate up to $10 million per year in benefit and many refiners have several implementations.

To wrap up, we performed well in the third quarter and believe we're on track to achieve our full year financial objectives. We're delivering on our asset optimization strategy and establishing AspenTech as a leader in this larger, growing and quickly evolving market. We're increasingly confident that the investments we're making will drive increasing growth and continued strong profitability in the coming years.

With that, let me turn the call over to Karl. Karl?

[Karl E. Johnsen, Aspen Technology, Inc.]

Thanks, Antonio. I will now review our financial results for the third quarter fiscal year 2018, beginning with annual spend and then finish with our fourth quarter guidance and updated outlook for fiscal 2018.

Annual spend, which is a proxy for the annualized value of our recurring term license and maintenance business at the end of each period was approximately $480 million at the end of the third quarter. This represents an increase of approximately 6.3% on a year-over-year basis and 2.3% sequentially.

Total revenue was $125.9 million for the third quarter, above the high end of our guidance range and an increase of 5.5% compared to the prior year period. The outperformance in the quarter was driven by the recognition of cash basis revenue, closing more business than typical in the beginning of the quarter and higher services revenue.

Looking at revenue by line item. Subscription and software revenue was $118.1 million for the third quarter, an increase from $111.7 million in the prior year period and $117.7 million last quarter. Services and other revenue was $7.7 million, an increase from $7.6 million in the year ago period and $7.2 million last quarter.

When looking at sequential comparisons, remember that we recognize subscription revenue on a daily basis. The third quarter has two fewer days in the second quarter, which equates to approximately a $2.6 million sequential decline.

Turning to profitability, beginning on a GAAP basis. Gross profit was $113.1 million in the quarter, with a gross margin of 89.8%, which compares to $107 million and gross margin of 89.7% in the prior year period. Operating expenses for the quarter were $61.9 million compared to $54.7 million in the year ago period. Total expenses, including cost of revenue, were $74.7 million, which was up from $67 million in the year ago period and from $70.4 million last quarter.

The year-over-year increase in operating expenses primarily reflect the investments we are making in the APM suite and the sequential increase is a result of the seasonal impact of resetting of payroll taxes and benefits for many employees at the start of the calendar year. Operating income was $51.2 million for the third quarter of fiscal 2018 compared to $52.3 million in the year ago period.

Net income for the quarter was $37.8 million, or $0.52 per share, compared to net income of $35.8 million, or $0.47 per share, in the third quarter of fiscal 2017.

Turning to non-GAAP results. Excluding the impact of stock-based compensation expense, amortization of intangibles associated with acquisition and acquisition-related fees, we reported non-GAAP operating income for the third quarter of $57.4 million, representing a 45.6% non-GAAP operating margin compared to non-GAAP operating income and margin of $57.4 million, 48.1%, respectively, in the year ago period.

Non-GAAP net income was $42.3 million, or $0.58 per share, in the third quarter of fiscal 2018 based on 72.7 million shares outstanding and was above the high end of our guidance range of $0.50. This compares to non-GAAP net income of $39.4 million, or $0.52 per share, in the third quarter of fiscal 2017 based on 76.2 million shares outstanding.

Turning to the balance sheet and cash flow. The company ended the quarter with $71.1 million in cash and marketable securities compared to $48.7 million at the end of last quarter. During the third quarter, we repurchased approximately 649,000 shares of our stock for $50 million. We remain on track to repurchase $200 million of our stock in fiscal 2018.

Looking at our deferred revenue balance. It was $288.5 million at the end of the third quarter, representing a 7.5% increase compared to the end of the year ago period. On a sequential basis, deferred revenue increased $29.9 million. As a reminder, a deferred revenue balance is heavily influenced by the timing of invoices and over the course of the year we expect deferred revenue growth to generally be in line with underlying growth in the business. However, there can be some quarter-to-quarter variability.

From a cash flow perspective, we generated $73.1 million of cash from operations during the third quarter and $78.1 million of free cash flow after taking into consideration the net impact of capital expenditures, capitalized software, litigation and acquisition-related payments. A onetime litigation payment in the quarter of $4.3 million represents the cash component of the settlement we discussed last quarter. A reconciliation of GAAP to non-GAAP result is provided in the tables within our press release, which is also available on our website.

I'd now like to close with our fourth quarter guidance and updated outlook for the full year fiscal 2018. For the fourth quarter, we expect revenue in the range of $123 million to $125 million, non-GAAP operating income of $55 million to $57 million, and non-GAAP EPS of $0.53 to $0.55 per share. On a GAAP basis, we expect operating income of $48 million to $50 million and income per share of $0.47 to $0.49 per share.

Turning to the full year. We are raising our revenue guidance in the range of $496 million to $499 million and continue to expect subscription and software to comprise greater than 90% of revenue, with our services and other revenue representing the remainder. From an expense perspective, we are adjusting our assumption for total GAAP expenses to $287 million to $289 million, which compares to our previous guidance of approximately $284 million to $287 million.

Taken together, we are updating our GAAP operating guidance to a range of $207 million to $210 million for fiscal 2018, with GAAP net income of approximately $144 million to $146 million. We now expect GAAP net income per share to be in the range of $1.97 to $2 compared to our previous guidance of $1.90 to $1.95.

From a non-GAAP perspective, we are adjusting our non-GAAP operating income guidance to $234 million to $237 million and now expect non-GAAP income per share to be in the range of $2.24 to $2.27, which compares to our previous guidance of $2.16 to $2.21.

With respect to annual spend growth in fiscal 2018, we are maintaining our guidance of 5% to 7% annual spend growth. From a free cash flow perspective, we are increasing our fiscal year guidance to $195 million to $200 million versus our previous guidance of $190 million to $195 million. Our fiscal 2018 free cash flow guidance assumes cash tax payments of approximately $55 million to $60 million.

From a timing perspective, we are required to pay 50% of our anticipated cash taxes in the second quarter, with the remaining 50% paid equally in the third and fourth quarters. In Q2, our quarterly tax payment was due before the new legislation was passed and was based on our previous effective tax rate of 34%.

In summary, we are pleased with our performance in the third quarter from both a financial and operational perspective. We are executing well and are confident the investments we're making will drive continued strong financial performance in the future.

With that, I will now hand it back over to the operator to begin Q&A.

[Operator]

Your first question comes from the line of Monika Garg from KeyBanc. Your line is open.

[Antonio J. Pietri, Aspen Technology, Inc.]

Hi, Monika.

[Monika Garg, KeyBanc Capital Markets, Inc.]

[Technical Difficulty] (00:27:41).

[Antonio J. Pietri, Aspen Technology, Inc.]

Monika, you are breaking up pretty badly. We can hardly hear you.

[Monika Garg, KeyBanc Capital Markets, Inc.]

[Technical Difficulty] (00:27:50).

[Antonio J. Pietri, Aspen Technology, Inc.]

You must be calling from an Internet or over a WiFi or something?

[Monika Garg, KeyBanc Capital Markets, Inc.]

[Technical Difficulty] (00:28:02).

[Antonio J. Pietri, Aspen Technology, Inc.]

Yeah, operator, I think we need to move to the next caller. Monika, please try again.

[Operator]

Your next question comes from the line of Rob Oliver from Baird. Your line is open.

[Rob Oliver, Robert W. Baird & Co., Inc.]

Right. Thank you, operator. Hi, guys. Thank you very much for taking my question. A couple of questions. One, just, Antonio, you talked about some of the pricing – the firming up of the pricing around the APM suite. And I wanted to just dig in a little bit more on that and hopefully get a little bit of color. Can you talk a little bit about some of the decisions you made on pricing and then more specifically, some of the ways that – I know customers that are in pilots are looking at asset optimisation and APM; don't necessarily want to get locked into any kind of one technological platform right now. And so it sounds like a really smart strategy to sort of ease the barrier to adoption and create the groundwork for a land and expand strategy. Can you talk more specifically about how you're doing that? And then I just have a quick follow-up. Thanks.

[Antonio J. Pietri, Aspen Technology, Inc.]

Yeah, sure. Well, look, first of all the goal here is both to accelerate value for customers and also accelerate value to AspenTech. I had talked almost to – with every single investor we've met over the last year about the difficulty that we had trying to converge on pricing with our customers knowing that this is a new market, there's no, really price references and therefore customers were trying to really understand what was fair value.

The reality really is and was that a lot of these customers were going to try for the first time these technologies. As you would expect, there was a hesitation about how much to commit to such a first step. And therefore, we've done two things. One, we want to make sure that if customers commit to testing the technology, well, they are doing it for an entire site as opposed to a piece of equipment, which is something that I think we've been able to land successfully with most of the customer that are purchasing Mtell or some of the other products.

On the other hand, considering that it is the first time that all these customers implemented the technology, we've also been able to come to a pricing range where they feel more comfortable doing this, deploying the technologies on a first site knowing that further expansion of the technology into other sites then will require different price points. So that's really the strategy, and as a result of that, we've been able to unlock many of the opportunities that we've been working on for the last six, nine months.

[Rob Oliver, Robert W. Baird & Co., Inc.]

Great. Thanks. And just one quick follow-up. It sounds [Technical Difficulty] (31:34-31:39)...

[Antonio J. Pietri, Aspen Technology, Inc.]

Rob, you are now the one breaking up, so started – was able to hear the first few words of your question and then you went away.

[Operator]

Your next question comes from the line of Matt Pfau from William Blair. Your line is open.

[Antonio J. Pietri, Aspen Technology, Inc.]

Hi, Matt.

[Matthew Charles Pfau, William Blair & Co. LLC]

Hey guys. Can you hear me all right?

[Antonio J. Pietri, Aspen Technology, Inc.]

Yes. Thank you.

[Matthew Charles Pfau, William Blair & Co. LLC]

All right. Perfect. So wanted to circle back on APM and the – or the competition comments that you made. I guess, curious as to what's driving the increased win rates or improved performance against competition that you're seeing. Is it the functionality that your product has, or is it more to do that maybe some of your competitors are stumbling a bit or going through organizational changes that are hindering their ability to compete with you?

[Antonio J. Pietri, Aspen Technology, Inc.]

Yeah. No, Matt, I don't know if we're having better success rates, because the fact is that this is the first go-round with most of the competitors. But certainly, we're very satisfied with our success rate.

And look, as we are learning more and more about competition, as customers are testing especially our machine learning technology, I'd like to think that really on our ProMV product we have yet to see one of our – a competitor out there. But on machine learning, there's key differentiators on that technology.

If you go back to my prepared notes under the Borealis analysis – and we've issued a press release, a joint press release with Borealis is now on the wire – you can reference the reasons that they attribute to why they selected AspenTech, such as automation of the data analysis and knowledge work. The rapid speed of deployment, not only are we able now to demonstrate in a very short time, two, three weeks to these customers how Mtell can identify potential failures in their equipment. But the speed of deployment of the technology, the speed of training and how quickly these customers ramp up on the know-how of the technology and then their ability to implement it on their own is clearly being demonstrated against the competition.

So as we learn – as we compete more and more, we're learning. It doesn't mean that new competitors won't show up, because this is a very crowded space. But we are very – we're satisfied with what we're seeing at the moment as we compete against some of these companies.

[Matthew Charles Pfau, William Blair & Co. LLC]

Okay, great. And then it sounds like you're more bullish on APM than perhaps previously and it already accounts for roughly a third of your total pipeline. So I guess as we think about longer term, has your expectations perhaps changed about what the proper mix of APM should be in your pipeline?

Or I guess when you think about your growth, what percentage of your growth do you expect to come from APM? Has that changed as a result of some of the commentary that you laid out?

[Antonio J. Pietri, Aspen Technology, Inc.]

Matt, look, certainly we are more optimistic about APM. If you go back to even three months ago – about nine months ago, 12 months ago, we were launching a brand-new business. We had a thesis that this had the potential to be very successful.

Over time, the proof points are coming through, things are getting validated for us, and that's why as time passes, we feel more optimistic about the investments that we have made to acquire these companies and these technologies, about the investments that we're making internally to stand up a whole new organization including a whole new sales function, R&D, and so on.

And of course, the pipeline continues to grow. And more importantly, as time passes, we believe that all these factors are really contributing to building the momentum in the business. The hard part about establishing a new business is activating the business, is introducing momentum and have the momentum build. We believe we're achieving that. And on that basis, we're more optimistic about the future of APM. We'll limit our guidance to one year at a time, so we believe we'll get into the one-point to two-point range for APM in 2018. And then in August, which is when we will give guidance for FY 2019, we'll talk about how much we believe APM will contribute to growth in fiscal year 2019.

[Matthew Charles Pfau, William Blair & Co. LLC]

Okay. And last one for me, just wanted to hit on renewals and what you're seeing there specifically around E&Cs. Has there been any improvement and are you still sort of tracking to that 5% to 6% attrition rate that you had previously anticipated for the year?

[Antonio J. Pietri, Aspen Technology, Inc.]

Yeah. No, look, certainly like we said, E&Cs, that flow of renewals continue through the quarters. We're tracking to that 5% to 6% attrition rate. As I said also in the prepared remarks, we do see an improving environment in Europe and Asia-Pacific. There seems to be more activity starting to come up in those regions. North America is still challenged and that's where -- and this is where you still see – or you're seeing more and more M&A as a result I think of the lack of growth in that area. But we are doing our best against the renewal environment from E&Cs and upstream. But again, we believe will be in the range of 5% to 6% attrition.

[Matthew Charles Pfau, William Blair & Co. LLC]

Got it. Thanks, guys. Appreciate it.

[Antonio J. Pietri, Aspen Technology, Inc.]

Thank you.

[Operator]

Your next question comes from the line of Monika Garg from KeyBanc. Your line is open.

[Antonio J. Pietri, Aspen Technology, Inc.]

All right, Monika, let's try this again.

[Monika Garg, KeyBanc Capital Markets, Inc.]

Yes. Can you hear me now?

[Antonio J. Pietri, Aspen Technology, Inc.]

Yeah, I can hear you now.

[Monika Garg, KeyBanc Capital Markets, Inc.]

Perfect. So Antonio, maybe could you provide some examples of how APM is helping companies predict prescriptive and equipment breakdowns and how much savings these companies could achieve with APM solutions?

[Antonio J. Pietri, Aspen Technology, Inc.]

Yes, sure. I mean, look, I'll be careful because I have to keep the confidentiality of our customers. But I can give you two quick examples. Oil company in Australia, big investment in oil and gas in that sector. They operate a large LNG facility. This facility has four huge compressors. One of the compressors was a bad actor, meaning as failing twice a year. Every time it failed, it cost $40 million in revenue losses and profitability. So twice a year, it's an $80 million issue.

They tried to address – identify the problem with the manufacturer of the compressor; they were not able to. They brought in their own data scientists, couldn't solve the problem. They learned that AspenTech had now a set of solutions in the machine learning space. We applied our Mtell technology using a set of historical data and in a week's time, we were able to identify for them the failure points in the compressor and eventually they have addressed that issue. That's $80 million per year.

Similarly, we've talked about one of the railroad companies here in the United States. Over three years they expect to save over $200 million by avoiding locomotive failures. Certainly, Borealis and the issue that we're having with this business-critical compressor at their Stenungsund site, every time one of those – when their compressor failed, meant significant also loss of revenue and profitability.

So really, the process is now down to a handful of weeks, where we use historical data, both process, equipment and the maintenance data, put it through Mtell. We identified the failure signatures or patterns in the data, compare that against the maintenance records, then we use a set of process historical data where we're not told what the failures were. And based on the agents (41:48) that were developed with the first set of data, then we identify the failures in that second set of data and then the customer discloses whether we were correct or not.

And we have a high rate of accuracy or success predicting these failures. And on that basis, customers are making the decision to deploy the technology on these assets. Of course, they are being careful and their decision is initially to sort of dip a toe in the water, meaning, let's do it on one side and see if it works. But the expectation is that as they get comfortable with the technology, they'll start rolling out the technology to multiple sites and across their enterprises.

And this is why we now refer to a Land and Expand strategy because we're clearly seeing that customers want to – they believe; that's step number one, let's make them believers. But they want to test it and then once they get comfortable with it, we expect that they'll be rolling it out to other sites.

[Monika Garg, KeyBanc Capital Markets, Inc.]

Thanks, helpful. So the examples you just provided, seems like the APM solution, the companies are saving huge amount of money, $80 million in one case, $200 million, other one. So I think question is, how are you looking to price APM solution so that you can drive the right value for this product?

[Antonio J. Pietri, Aspen Technology, Inc.]

Yeah. Well, Monika, and that's – I think that's been the – the challenge that we have with customers around converging on the proper pricing. The use cases and the value capture are huge. Similarly, there's competition in the market and while we believe that we have something that is good and is demonstrating its value,

we're also faced with competition and in that context, then we need to sort of converge on a price point that we're – makes them comfortable. So – but look, this is an evolving market and time will tell where this market goes, but we're optimistic at the moment.

[Monika Garg, KeyBanc Capital Markets, Inc.]

Got it. Thanks. Just a last one here for Karl. Karl, you have raised cash flow guidance for two quarters in a row. What is leading to better-than-expected cash flows? Thank you.

[Karl E. Johnsen, Aspen Technology, Inc.]

Sure. So last quarter, it was really all around the anticipated cash savings related to the tax reform. This quarter is just better line of sight of where we see the year ending up. We had an over-performance in Q3 on collections and we have line of sight through the end of the year. So we've raised to where we expect to be coming in.

[Monika Garg, KeyBanc Capital Markets, Inc.]

Got it. Thank you so much.

[Antonio J. Pietri, Aspen Technology, Inc.]

Thank you.

[Operator]

Your next question comes from the line of David Hynes from Canaccord. Your line is open.

[David E. Hynes, Canaccord Genuity, Inc.]

Hey guys. How you are doing? And excellent numbers. So, Antonio it sounds like you are seeing some pretty nice returns on the sales and marketing investments you're making on the APM side. At the same time, it sounds like the channel's building up pretty well, right? I think you said 65 partners.

So, curious, kind of as you are seeing this unfold, I'm curious kind of how are you thinking about balancing direct and partner sales on the APM side? And then as we think about implications on your sales and marketing investments, is this going to be a case where we see kind of a bump up in sales and marketing spend and then it plateaus again?

Do you expect sales and marketing continue to grow? Just help us think about how this plays out and kind of implications on margins.

[Antonio J. Pietri, Aspen Technology, Inc.]

Okay. Well, yeah. Let me give you an answer. So, look our field organization and the process industries is going direct on APM. And basically we just had to make the APM suite available to them and they are executing on that.

On the GEI side we have a two-pronged strategy; one, mainly a channels strategy where we're activating all these partners, 65-or-so to-date, but we're also building a direct sales organization and we're at the beginnings of that. Now, we have a VP of Sales that we hired was available in the market and we hired from a company that we see in the market often competing against us. He's building a direct sales team. But we also have a partners organization that is building this channel.

Channels, yeah, you have to sign the agreements, but then you have to enable the channel, you have to train the channel, give them – support them with marketing material and so on. And there will be some activation time before we start seeing a return on that investment. The pipeline is starting to reflect that over the last really nine months we've been working much more aggressively in building this channel. And now, we see the pipeline.

Going forward, look, I've said in many investor meetings and also conferences that we're not going to get ahead of our skis. As we see the returns, we will invest. And my comments on my prepared remarks are because we believe that momentum is building in the APM area and therefore, further investments in sales and really in partner enablement is required.

Time will tell whether this is a one-time investment in sales and plateaus, or as APM delivers growth we hire to keep up with the growth that we believe will be there. And again, I don't want to get ahead of my skies with any sort of predictions, but based on the pipeline that we see and the pipeline – certainly, there's two more months for the Q4 quarter, but then we're into FY 2019. We think it's prudent to start putting some more investment that will – for which we'll see the return on it in FY 2019.

[David E. Hynes, Canaccord Genuity, Inc.]

Yes, okay. That makes perfect sense. It's about any moment now and then as you see the success you kind of invest behind the curve. So, helpful. On the E&C side, you talked about, obviously different demand dynamics based on geography. Can you just remind me what percent of that business is North American versus what percent is Europe and Asia?

[Antonio J. Pietri, Aspen Technology, Inc.]

Yeah. Well..

[David E. Hynes, Canaccord Genuity, Inc.]

Ballpark numbers are fine.

[Antonio J. Pietri, Aspen Technology, Inc.]

Yes, I know – I don't believe we've ever really given you that split. But we have said that North America is about 35% of our revenues and the rest is the rest of the world. So, E&Cs have been around for a long time, so I guess you could assume is more or less a normal distribution of revenue to a region to the component of E&Cs.

[David E. Hynes, Canaccord Genuity, Inc.]

Okay. And then last one, just on Apex, the acquisition. Obviously, some big ROI to your customers can be delivered there. Just help us frame that in terms of what they were generating in terms of revenue, maybe how that contributed to annual spend in the quarter. Just anything you can give us in terms of kind of financial profile on Apex would be helpful.

[Antonio J. Pietri, Aspen Technology, Inc.]

On Apex, well, let me look at – so Apex, again, as a early-stage company, although they've been working on this for 10 years when we bought them, they had a different model, most of the licenses they sold were perpetual. They had a much bigger component of professional services revenue. Certainly, a part of what we're doing is, is we're re-profiling how we think about the business model for Apex; subscription licenses, making it a much bigger software business than a services business.

But most of the revenue that existed in APM went through purchase accounting. And Karl can explain to you what happens there with revenue, but none of that is in the books. Our plan here is, we'll release the first version of the GDOT product soon. We'll start then taking that to market. It will take us a little longer to fully integrate it into the suite and with other products and there will be releases in the future. But we are already seeing opportunities in the market where we're submitting bids for the product to be implemented. Part of our strategy will be to enable an ecosystem of implementers for Apex or GDOT so that there's others out there implementing the solution like there's many companies out there implementing our products today.

[David E. Hynes, Canaccord Genuity, Inc.]

Yeah.

[Antonio J. Pietri, Aspen Technology, Inc.]

But we believe that GDOT, which is the name of the product, has the potential to be – or the TAM of it is as straight as that of – on a dollar basis, the TAM of it is as great as that of APC in the marketplace. So we're very excited about it, and it's something that I know our MSC organization is counting with to drive further growth in the future.

[David E. Hynes, Canaccord Genuity, Inc.]

Perfect. Okay. Thanks, guys. I'll pass the line.

[Antonio J. Pietri, Aspen Technology, Inc.]

Thank you.

[Operator]

Your next question comes from the line of Gal Munda from Berenberg Capital. Your line is open.

[Antonio J. Pietri, Aspen Technology, Inc.]

Hi, Gal.

[Unknown Speaker]

Hey, this is actually Alex (00:52:32) on for Gal. Thanks for taking my question. I just had a quick question on – if you could give some more color on the Emerson partnership? Just how much growth you expect that to add in the midterm, what does the ramp look like on that? And then also, do you expect any more partnerships with other potential resellers down the line? And then also, just on the growth of the pipeline, what do you expect further growth of the core versus APM?

[Antonio J. Pietri, Aspen Technology, Inc.]

Yeah. Okay, so there's a lot there to unpack. Look, Emerson – certainly Emerson is and was, or was and is very interested in access to basically leading products in the advanced solution space, especially our Advanced Process Control technology, our operator training simulation solution and the APM suite and they are taking that to market. In that process, they are identifying opportunities, but their real focus is on the implementation of these solutions. They consider themselves sort of a master automation control company, systems integrator, and they see the value from the relationship as having the opportunity to be the ones that are basically implementing our products. Of course, if they are involved in a sale, they'll get a commission, a fee for that.

How much is this going to represent? Look, time will tell, but we're hopeful. We announced the partnership in mid-February. So we're here two months later and there's already a good number of opportunities that they've identified and we have in our pipeline. So we see a very fast activation of their sales channel vis-à-vis the AspenTech solutions. So, how much this will be in the future? Again, time will tell.

Look, yeah, it's an easy assumption to think that there could be other industrial companies out there interested in partnering with Aspen Technology. We are the independent software company in the space. There's other industrials that are competing against AspenTech and then another group of industrials that don't have the solutions to be competing against those other industrials that do have competing products. So we're facilitating also an acceleration of our products to the market, but also enabling them to compete on a more equal footing against these industrials that have solutions.

[Unknown Speaker]

Okay. Thanks. And then also, just on the growth of the pipeline, if you could just speak to the growth of the APM versus the core business?

[Antonio J. Pietri, Aspen Technology, Inc.]

Well, look, the core business pipeline continues to grow. Of course, you can assume our Engineering pipeline has been impacted by the downturn and that is the case. But our MSC pipeline is solid and continues to grow. And the APM pipeline, there's just been an acceleration of pipeline in that area because there's also – I believe our sales organization is seeing the traction in the marketplace and they are trying to take advantage of it.

So, at some point, the growth rate of the APM pipeline will normalize, if you will. And I'm sure we won't be seeing this accelerated growth of the APM pipeline, but as we expand the partnerships into the GEIs and we enable that team as well, that, that will contribute to the expansion of the APM pipeline.

So the one thing to note here I guess is that again, the MSC and Engineering products are constrained to the process industries in a way. APM is going to have a much broader playing field because it will be the process industries and then these five GEIs, but we're also finding opportunity in other industries.

I can tell you that we have a company that is evaluating Mtell to deploy it on a building to monitor the environmental systems in that building. And that's an exciting opportunity for us. So APM will have a much, much bigger TAM available to it than MSC and Engineering have really ever had.

[Unknown Speaker]

Okay. Perfect. Thank you.

[Operator]

Your next question comes from the line of Steve Koenig from Wedbush. Your line is open.

[Steve R. Koenig, Wedbush Securities, Inc.]

Thank you very much. Hi gentlemen, thank you. Congrats on the quarter. Just two questions for you. First one, can you give us a little color on – maybe breakdown or color on the acceleration you've seen in annual spend so far this year. I think you started at 3%, you're at the level of 6% now. I assume that one to two points of growth on APM is mostly showing up in that acceleration as that settled in after Q1. Is the balance of it then mostly MSC?

Is there any from Engineering? And then you see vertical (58:41); that's pretty much not accelerating yet. And related to that why wouldn't the annual spend continue to go higher in Q4? I think you started the year expecting it to accelerate in the second half and you're seeing that deceleration. So why couldn't that continue?

[Antonio J. Pietri, Aspen Technology, Inc.]

Well, let me look. We started the year at 4.1% which is where we ended fiscal year 2017. We had a very low growth quarter in Q1 as a result of those renewals that I talked about. I believe our growth rate dropped into the 3% range. We came back in Q2 and we had a stronger quarter that brought the growth rate a little bit up and then we've had a solid Q3 which now puts us at 6.3% for the trailing 12 months. Q4s, even in the previous two fiscal years that were very difficult fiscal years from a growth standpoint, we posted decent growth those two Q4s, Q4 2016 and Q4 2017. We look at our Q4 and we're satisfied with the pipeline of business that we have. And if we execute well, we believe we'll be able to deliver against that 5% to 7% range that we talked about.

[Steve R. Koenig, Wedbush Securities, Inc.]

Okay. If I could squeeze one more in. So you guys have been pretty – very consistent I'll say, not just pretty consistent – very consistent saying that patience is required to see CapEx improve in E&C. And now you're saying you're potentially seeing some improvement in Asia and Europe. What's it going to take to see higher oil prices, as they move up, translate to better CapEx and then translating to better pipelines for you in E&C and in Engineering and then in higher annual spend? Does that just take time? And if so, how much time?

[Antonio J. Pietri, Aspen Technology, Inc.]

Well, I mean, look, the dynamic, I think it's complicated but very simple actually. As oil demand increases – and if assuming you believe that oil demand will continue to increase – the shale oil producers have been able to sort of supply that extra demand and now there's – I believe that the market is balanced. As we go – as we move forward in the future and demand continues to increase, the question will be, okay, what is the ability of shale oil producers to continue to ramp up their demand over time? What is their ceiling, if they have a ceiling? What is the extra capacity that exists in Saudi Arabia and some of the other OPEC countries and non-OPEC, at Brazil, Russia, and so on?

But eventually, look, demand has to start outstripping supply in a way that then signals to oil companies, especially the international oil companies that neither the shale oil producers nor the NOCs, the National Oil Companies, will be able to meet that increasing demand for then these – both the National Oil Companies and the IOCs to start putting CapEx to work to develop new conventional oil fields, which will then drive more projects for the Engineering companies and then backlog and therefore demand for AspenTech software.

So look, oil prices, they hit $75 actually this morning, but the CapEx is constrained; it's being driven more by geopolitics than anything else. But there has to be a conviction in oil companies, both IOCs and NOCs that demand is outstripping supply and there isn't a producer out there that can actually come into the market and supply so that they start then investing in CapEx.

In all of these, look, conventional oil plays are not like shale oil and you invest, and two, three months later, you're producing a lot of oil. Conventional oil plays take three to five years to start producing, and there's people out there that argue that the world will see an oil shortage in 2020, 2021, that could lead to a spike in oil prices and therefore, at that point, you probably see CapEx starting to work a lot more. But look, that's all argumentative and in another scenario many that are out there. And all these changes what the people believe that the renewables are going to take up some of the demand from oil and so on and so forth.

Our focus is on executing. That's not under our control. We're trying to mitigate the attrition as best as we can. But I've also said that the likely scenario here is that if we go through the full cycle, the full renewal cycle at the end of that cycle, we will have reset every E&C agreement and our attrition will drop, and we'll get back two, three points of growth in that scenario. So we'll see what happens.

[Steve R. Koenig, Wedbush Securities, Inc.]

That sounds great. Well, thank you for the thoughtful answer.

[Antonio J. Pietri, Aspen Technology, Inc.]

Okay. Thank you.

[Operator]

Your next question comes from the line of Mark Schappel from Benchmark. Your line is open.

[Antonio J. Pietri, Aspen Technology, Inc.]

Hi, Mark.

[Mark W. Schappel, The Benchmark Co. LLC]

Hi. Thanks for taking my question. Antonio, just one question. With respect to Apex, I was wondering if you could just review for us how Apex complements your existing Advanced Process Control software.

[Antonio J. Pietri, Aspen Technology, Inc.]

Yeah. Look, this is -- in all of these, of course, APM, is getting a lot of the headlines. But Apex and GDOT is actually a very exciting acquisition for us. There's always been a gap between what the plan and the schedule say have to be done in a refinery or a chemical plant and what actually the multivariable controllers are doing. And therefore, the coordination of the plan and schedule with APC is always been missing and there's always been the thought that if you could coordinate what a refinery plan or plans, the scheduler schedules with what the APC controllers are doing to deliver that schedule, that there would be a lot of value creation.

And Apex, really, started working on this problem 10 years ago and they've cracked the code. Not only have they cracked the code, but they've done it in a way that is simplified the degree of complexity of implementing the solution. And I believe that's partly why they have that in their name, they have the word generic because they really dumb down the complexity of driving optimization and they've made it simple. So the real opportunity here is that now you're going to be able to coordinate planning scheduling with APC. The APC controllers will be doing what is required to meet the schedule and the plan across multiple units that represent a diesel train or a gasoline train, and that represents up to $10 million of value in the refinery or in a chemical plant and you'll probably have three to five of these applications in a refinery. So it's a lot of money for these customers and that's why we are excited about this.

[Mark W. Schappel, The Benchmark Co. LLC]

Great. Thank you. That's helpful.

[Antonio J. Pietri, Aspen Technology, Inc.]

Yeah. Thank you.

[Operator]

Your last question comes from the line of Shankar Subramanian from Bank of America. Your line is open.

[Antonio J. Pietri, Aspen Technology, Inc.]

Hi, Shankar.

[Shankar Subramanian, Bank of America Merrill Lynch]

Thank you. Thank you for taking – Hi. Thank you for taking the time to explain to us on the APM. But I have a question on the MSC business. You talked about the oil situation and how it would have impacted CapEx. Chemical capacity has been – and out there in the past five years. And I think there's a second wave that could come in the next couple of years. Is there any incremental color you could provide around that? And how this year, it's proceeding and may be some color on maybe 2019 and 2020, how you think it will play out (01:08:15)?

[Antonio J. Pietri, Aspen Technology, Inc.]

Yeah sure. Yeah, no, good question. I appreciate the focus on MSC because it's a business that does well for us. So you're right, first wave chemical investments in the United States about $120 billion I believe.

And now there's a second wave that has been announced and while there were questions about whether it's going to happen is actually happening. And again it's a lot of money in the second wave.

One of the things that as you peel the onion of AspenTech's performance, the E&C business and upstreams are being impacted by oil and that means attrition of our engineering software use.

At the same time, we've said that in my prepared remarks that the owner-operators continue to do very well for us, and that performance is being driven by better demand for our engineering and MSC products.

What that really means is that we're seeing not only solid demand from owner-operators and MSC but also for our engineering products. That demand for our engineering products out of owner-operators is mitigating the attrition that we're seeing from E&Cs and upstream.

And that growth that we see and part of it or a significant part of it is through our Aspen product which is the modeling and simulation tool that is specifically used by chemical companies.

So while HYSYS is being impacted on the E&C and upstream side we're seeing better growth of our Aspen Plus product coming out of chemical producers supported by these waves of construction and used by engineering companies but also the owner-operators.

And also there's HYSYS growth out of the owner-operators in refining but Aspen Plus has been doing very well which is in line with the investments that we're seeing in chemical.

[Shankar Subramanian, Bank of America Merrill Lynch]

Got it. Got it. Just one last question on the APM, related to the annual contract value of that you will get in the APM contract. And if you compare it against the prior launches you had of the new product do you – how well does it compare to it and do you see the same level of expansion that you think you will get – you have seen before in the prior launches?

[Antonio J. Pietri, Aspen Technology, Inc.]

Yes. I mean, prior launches, you have to go back many years, but the fact that I've been in this company for 25 years gives me some perspective. And look, the early days of APC, it was hand-to-hand combat, one implementation at a time. Very low value capture for companies like AspenTech. In a wave in the old days, there was a bigger focus on services and therefore, some of these companies were happy to get a little bit of licenses and a lot of services.

In the case of APM, we're focused on it as a software business, and we're focused on accelerating value to AspenTech. The fact that we have now gone through (01:11:59) also says that we are able to monetize the value for AspenTech faster and bigger.

[Shankar Subramanian, Bank of America Merrill Lynch]

Okay, thank you.

[Antonio J. Pietri, Aspen Technology, Inc.]

Okay. It looks like we've come to the end of our call. Appreciate all the questions and your participation in the call, and look forward to seeing you in conferences and other events out there. Thank you.

[Operator]

This concludes today's conference call. You may now disconnect.