PARAMETRIC TECHNOLOGY CORP - 10-Q Quarterly Report

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). YES x NO ¨

There were 268,073,578 shares of our common stock outstanding on May 7, 2004 and 268,030,621 shares of our common stock outstanding on April 3, 2004.

The accompanying notes are an integral part of the consolidated financial statements.

The accompanying unaudited consolidated financial statements include the accounts of Parametric Technology Corporation and its wholly owned subsidiaries and have been prepared by management in accordance with generally accepted accounting principles. Unless otherwise indicated, all references to a year reflect our fiscal year, which ends on September 30. The year-end consolidated balance sheet was derived from our audited financial statements. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments, consisting only of those of a normal recurring nature, necessary for a fair presentation of our financial position, results of operations and cash flows at the dates and for the periods indicated. While we believe that the disclosures presented are adequate to make the information not misleading, these unaudited quarterly financial statements should be read in conjunction with the consolidated financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2003.

Deferred revenue primarily relates to software maintenance agreements billed to customers for which the services have not yet been provided. The liability associated with performing these services is included in deferred revenue and, if not yet paid, the related customer receivable is included in other current assets. This maintenance-related customer receivable included in other current assets at April 3, 2004 and September 30, 2003 was $50.4 million and $37.0 million, respectively.

The results of operations for the three and six months ended April 3, 2004 are not necessarily indicative of the results expected for the remainder of the fiscal year. Certain reclassifications have been made for a consistent presentation.

In 2003, we announced and began implementing cost reduction initiatives designed to significantly reduce our operating cost structure. As a continuation of these cost reduction initiatives, in the second quarter and first six months of 2004 we recorded total restructuring and other charges of $16.7 million and $38.3 million, respectively. The charges include costs for severance and termination benefits related to 136 employees and 274 employees terminated during the second and first quarters, respectively, and excess facilities and other costs. The charges for excess facilities are primarily related to gross lease commitments in excess of estimated sublease income for excess facilities. Of the total restructuring and other charges, $0.7 million and $1.6 million for the second quarter and first six months of 2004, respectively, were non-cash for the write-off of leasehold improvements related to the excess facilities.

Over the remainder of 2004, we expect to incur restructuring and other charges aggregating approximately $5 million in conjunction with the continuation of the cost reduction initiatives begun in 2003. These expected restructuring and other charges are incremental to the charges recorded in the first six months of 2004 and will be primarily related to employee severance and termination benefits and excess facilities.

The following table summarizes restructuring accrual activity for the three and six months ended April 3, 2004:

The accrual for facility closures and related costs is included in current liabilities (accrued expenses and other current liabilities) and long-term liabilities (other liabilities) in the consolidated balance sheets, and the accrual for employee severance and related benefits is included in accrued compensation and severance. We expect to make cash disbursements related to these accrued restructuring and other charges of approximately $17 million within the next twelve months. The remaining payments of approximately $34 million primarily relate to excess facilities and are expected to be paid out through 2013.

We offer an employee stock purchase plan (ESPP) for all eligible employees. Under the current plan, which qualifies as an “employee stock purchase plan” under Section 423 of the Internal Revenue Code, shares of our common stock can be purchased at 85% of the lower of the fair market value of the stock on the first or the last day of each six-month offering period, with certain limitations. In addition, we have stock option plans for employees, directors, officers and consultants that provide for issuance of nonqualified and incentive stock options as well as restricted stock awards and stock appreciation rights. The option exercise price is typically the fair market value at the date of grant. These options generally vest over four years and expire ten years from the date of grant, although other vesting terms are permitted. These stock plans are described more fully in Note J to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2003.

We account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under APB No. 25, no compensation cost is recognized when the option exercise price is equal to the market price of the underlying stock on the date of grant. An alternative method of accounting is provided by Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure. Under SFAS No. 123, employee stock options are valued at the grant date using an option pricing model, and compensation cost is recognized ratably over the vesting period.

As permitted by APB No. 25, we generally have not recognized compensation expense in connection with stock option grants to employees, directors and officers under our plans. The following table illustrates the effect on net income (loss) and earnings (loss) per share if we had applied the fair value recognition provisions of SFAS No. 123 to all stock-based awards to employees.

The illustrative disclosures above include the amortization of the fair value of all options over their vesting schedules. The pro forma net loss for all periods includes an income tax valuation allowance fully offsetting any income tax benefit related to the stock-based employee compensation expense for those periods. The effects indicated above of applying SFAS No. 123 are not necessarily representative of the effects on similar illustrative disclosures in future years.

The fair value of options granted has been estimated at the date of grant using the Black-Scholes option-pricing model assuming the following weighted-average assumptions:

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and that are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Our options have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimate.

Basic earnings (loss) per share (EPS) is calculated by dividing net income (loss) by the weighted average number of shares outstanding during the period. Diluted EPS is calculated by dividing net income (loss) by the weighted average number of shares outstanding plus the dilutive effect, if any, of outstanding stock options using the “treasury stock” method.

Stock options to purchase 47.4 million and 68.6 million shares for the second quarter of 2004 and 2003, respectively, and 47.9 million and 70.3 million shares for the first six months of 2004 and 2003, respectively, had exercise prices per share that were greater than the average market price of our common stock for those periods. These shares were excluded from the computation of diluted EPS as the effect would have been anti-dilutive. Due to the net losses generated in the second quarter of 2003 and the first six months of 2004 and 2003, the effect of outstanding stock options for the purchase of an additional 2.8 million, 19.9 million and 1.6 million shares, respectively, was excluded from the computation of diluted EPS as the effect would have been anti-dilutive.

We currently operate within a single industry segment—computer software and related services. Within this single industry segment, we have two reporting segments: our software products operating segment and services operating segment (see Note 7, Segment Information, for further discussion). All of our goodwill and other intangible assets are associated with our software products operating segment. Goodwill and other indefinite lived intangible assets are tested for impairment at least annually, or on an interim basis if an event occurs or circumstances change that would, more likely than not, reduce the fair value of the operating segment below its carrying value. We plan to conduct our annual impairment test as of the end of the third quarter of each year. Other intangible assets with finite lives are tested for impairment if an event occurs or circumstances change that would, more likely than not, reduce the fair value of the operating segment below its carrying value.

The following goodwill and other intangible assets are included in the accompanying consolidated balance sheets:

The change in the carrying amounts of goodwill and other intangible assets for the six months ended April 3, 2004 is affected by foreign currency translation adjustments related to those asset balances that are recorded in non-U.S. currencies.

The aggregate amortization expense for intangible assets with finite lives recorded for the three and six months ended April 3, 2004 was $2.2 million and $4.2 million, respectively, and for the three and six months ended March 29, 2003 was $2.0 million and $4.1 million, respectively. Of those amounts, $1.3 million and $2.7 million for the three and six months ended April 3, 2004, respectively, and $1.5 million and $2.9 million for the three and six months ended March 29, 2003, respectively, was recorded as amortization of other intangible assets and $0.9 million and $1.5 million for the three and six months ended April 3, 2004 and $0.5 million and $1.2 million for the three and six months ended March 29, 2003, respectively, was recorded as cost of license revenue. The estimated aggregate future amortization expense for intangible assets with finite lives remaining as of April 3, 2004 is $3.9 million for the remainder of 2004, $1.6 million for 2005, $1.5 million for 2006 and $0.4 million for 2007.

In January 2003, the Financial Accounting Standards Board (FASB) issued FIN No. 46, Consolidation of Variable Interest Entities and, in December 2003, issued a revision to that interpretation (FIN No. 46R). FIN No. 46R replaces FIN No. 46 and addresses consolidation by business enterprises of variable interest entities that possess certain characteristics. A variable interest entity (VIE) is defined as (a) an ownership, contractual or monetary interest in an entity where the ability to influence financial decisions is not proportional to the investment interest, or (b) an entity lacking the invested capital sufficient to fund future activities without the support of a third party. FIN No. 46R establishes standards for determining under what circumstances VIE’s should be consolidated with their primary beneficiary, including those to which the usual condition for consolidation does not apply. FIN No. 46R requires that if an entity has a controlling financial interest in a VIE, the assets, liabilities and results of activities of the VIE should be included in the consolidated financial statements of the entity. The provisions of FIN No. 46R were effective immediately for all arrangements entered into after January 31, 2003 and in the second quarter of fiscal 2004 for those arrangements entered into prior to January 31, 2003. The adoption of FIN No. 46R did not have a material impact on our financial position or results of operations.

In December 2003, the FASB issued a revision to SFAS No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits (SFAS No. 132R), relating to financial statement disclosures for defined benefit plans. The change replaces existing FASB disclosure requirements for pensions. SFAS No. 132R requires that companies provide more details about their plan assets, benefit obligations, cash flows, benefit costs and other relevant information. SFAS No. 132R will require companies to disclose plan assets by category, such as equity, debt, and real estate and a description of investment policies and strategies and target allocation percentages, or target ranges, for those asset categories. Projections of future benefit payments and an estimate of contributions to be made in the next year to fund pension and other post employment benefit plans also will be required. The guidance for the annual disclosure requirements is effective for fiscal years ending after December 15, 2003.

The following amounts of net periodic pension cost have been recorded in the accompanying consolidated statements of operations:

We have made employer contributions to our pension plans totaling $0.8 million for the first six months of 2004 and expect to make additional contributions of approximately $3.9 million in 2004.

We operate within a single industry segment—computer software and related services. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision-making group is our executive officers. We have two operating segments: (1) software products, which includes license and maintenance revenue (including new releases and technical support); and (2) services, which includes consulting, implementation, education and other support revenue. For external reporting purposes (as shown in our consolidated statements of operations), maintenance revenue is included in Service Revenue. We do not allocate certain sales, marketing or administrative expenses to our operating segments, as these activities are managed separately. Within our software products operating segment, we have two software product categories: (1) our computer aided design, manufacturing and engineering software (design solutions), including our flagship Pro/ENGINEER^® design software, which provide engineering solutions to our customers, and (2) our collaboration and data management technologies (collaboration and control solutions), including our Windchill^® software suite, which provide information management solutions to our customers.

In the second quarter of 2003, with the launch of Pro/ENGINEER Wildfire^™, we began selling a product development system package called “Flex 3C” for Create, Collaborate and Control. This package is configured to meet the needs of the high-end design engineer working in a process-oriented environment. It includes Pro/ENGINEER Wildfire with advanced engineering modules, Windchill ProjectLink^™ and Windchill PDMLink^™ as a data management option. Because the package includes both design solutions and collaboration and control solutions, for purposes of reporting revenues by product categories, we developed a revenue allocation methodology in conjunction with Pro/ENGINEER Wildfire pricing and packaging. New Flex 3C revenue is allocated 90% to our design solutions and 10% to our collaboration and control solutions. Revenue from upgrades to the Flex 3C package is allocated 50% to our design solutions and 50% to our collaboration and control solutions. As we continue to offer packages that include both design solutions products and collaboration and control solutions products, the delineation between the two product lines may become less meaningful and, accordingly, we may revise our product categories.

The revenue and operating income (loss) attributable to these operating segments are summarized as follows:

Total long-lived assets by geographic region have not changed significantly from September 30, 2003.

We are currently defending a class action lawsuit claiming violations of the federal securities laws based on alleged misrepresentations regarding our reported financial results for the fiscal years 1999, 2000 and 2001 and revisions to our announced results for 2002. The case is pending in the U.S. District Court for the District of Massachusetts. The consolidated amended complaint was filed on September 15, 2003 and seeks unspecified damages. We have filed a motion to dismiss the consolidated action and the court held a hearing on our motion on April 28, 2004. The motion currently is under consideration by the court. We believe the claims are without merit, and we intend to defend them vigorously. We cannot predict the ultimate resolution of this action at this time, and there can be no assurance that this action will not have a material adverse impact on our financial condition or results of operations.

On May 30, 2003, a lawsuit was filed against us in the U.S. District Court for the District of Massachusetts by Rand A Technology Corporation and Rand Technologies Limited (collectively “Rand”). Rand historically had been our largest distributor. The complaint alleges various breaches of a revised distribution agreement entered into in December 2002, as well as other agreements between Rand and us, and also asserts certain non-contract claims. The complaint, as amended, seeks equitable relief and substantial damages. On November 24, 2003, we filed our substantive response to Rand’s complaint and asserted counterclaims against Rand including, among other things, that Rand’s action in filing the lawsuit constituted a breach of the December 2002 agreement, which established certain dispute resolution procedures and which, we believe, discharged any and all claims arising prior to that date. We believe Rand’s claims are without merit and will continue to contest them vigorously. We also intend diligently to prosecute our counterclaims. We cannot predict the ultimate resolution of this action at this time, and there can be no assurance that this action will not have a material adverse impact on our financial condition or results of operations.

We also are subject to various legal proceedings and claims that arise in the ordinary course of business. We currently believe that resolving these other matters will not have a material adverse impact on our financial condition or results of operations.

We enter into standard indemnification agreements in our ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with patent, copyright or other intellectual property infringement claims by any third party with respect to our current products, as well as claims relating to property damage or personal injury resulting from the performance of services by us or our subcontractors. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. Historically, our costs to defend lawsuits or settle claims relating to such indemnity agreements have been minimal and we accordingly believe the estimated fair value of these agreements is immaterial.

We warrant that our software products will perform in all material respects in accordance with our standard published specifications in effect at the time of delivery of the licensed products for a specified period of time (generally 90 to 180 days). Additionally, we generally warrant that our consulting services will be performed consistent with generally accepted industry standards. In most cases, liability for these warranties is capped. If necessary, we would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history; however, we have never incurred significant cost under our product or services warranties. As a result, we believe the estimated fair value of these agreements is immaterial.

Statements in this Quarterly Report on Form 10-Q about our anticipated financial results and growth, as well as about the development of our products and markets, are forward looking statements that are based on our current plans and assumptions. Important information about the bases for these plans and assumptions and certain factors that may cause our actual results to differ materially from these statements is contained below and in “Important Factors That May Affect Future Results” beginning on page 33.

Over the last several years, we have been transforming Parametric Technology Corporation (PTC) from a one-product company in a mature mechanical computer-aided design, manufacturing and engineering (CAD/CAM/CAE) market to a multi-product company in the emerging product lifecycle management (PLM) market. Our core business focus has been to provide design solutions to customers through our flagship Pro/ENGINEER^® design software. Revenue associated with our design solutions continues to comprise a majority of our revenue today. Although, as discussed below, revenue associated with our design solutions improved sequentially in the second quarter of 2004, the discrete market for computer-aided design solutions has been declining, and our revenue in this market also has declined. The decline in our design solutions revenue is attributable to several factors, including customers’ unwillingness to invest in this market during difficult economic conditions, the relative saturation and increased competitiveness of the North American and European markets for design solutions, as well as the relative difficulty of displacing incumbent software vendors within this finite market.

Although the discrete market for computer-aided design solutions has declined, we believe that there is opportunity for growth in the adjacent collaboration and control solutions market and we have seen these two markets converge into a broader PLM opportunity. The PLM market encompasses the CAD/CAM/CAE markets as well as many previously isolated markets that address various phases of the product lifecycle. These include product data management (PDM), component and supplier management, visualization and digital mockup, enterprise application integration, program and project management, after market service and portfolio management, requirements management, customer needs management, and manufacturing planning.

To position our company to capitalize on the opportunity presented by the emerging PLM market, we have, among other things, significantly remodeled our product lines, overhauled our distribution infrastructure, and created marketing and sales tools aimed at educating our customers on the benefits of our offerings. Much of this investment occurred during the recent economic downturn, which in turn put pressure on our revenue performance and operating profitability. Nevertheless, using cash built up during the 1990s when we experienced sustained growth with our design solutions, as well as using cash generated from our ongoing operations, we were able to proceed with these strategic investments. We believe that our investment in this strategy will contribute to our success over the long term. We recently have introduced award winning products that allow our customers to implement a scalable product development system that meets their requirements for both functionality and return on investment, two critical variables in today’s economic environment. With a good portion of this business transformation investment behind us, beginning in 2003 and continuing during 2004 we embarked on cost cutting initiatives in an effort to improve profitability. Although these reductions may impact overall revenue growth, we expect these cost reductions will improve our overall profitability and provide operating leverage.

Looking forward, our overall performance will depend on, among other factors: (i) improved economic conditions and the strengthening of technology spending in the global manufacturing sector; (ii) our ability to elevate PLM expenditures over other technology spending as a budgetary priority among our customers; (iii) our ability to successfully execute our product strategy to provide an integrated, easy to use and rapidly deployable

suite of PLM software solutions that customers can deploy to create a product development system that meets their evolving requirements; and (iv) our ability to differentiate our products and services from those of our competitors, including larger companies with established enterprise relationships with our customers. Our enhanced suite of PLM software solutions provides the foundation for our future growth, as these solutions expand upon traditional high-end design products (for which the market has declined) and allow us to offer our customers a comprehensive product development system. We must accordingly focus on enhancing and marketing our product and service offerings so that our customers are able to recognize clearly and understand their advantages.

Our performance also will depend on our ability to undertake our strategic initiatives while at the same time executing our current expense control initiatives. Specifically, in 2003, we began implementing cost cutting initiatives (discussed further below) designed to reduce our quarterly operating cost structure to approximately $150 million, excluding restructuring charges, by the end of fiscal 2004. As of the end of the second quarter of 2004, those cost reductions have reduced our quarterly operating cost structure, excluding restructuring charges, to under $150 million. In connection with these reductions, we incurred $38.3 million of restructuring charges in the first six months of 2004 and we expect to incur restructuring charges of approximately $5 million during the remainder of 2004. Our ability to implement these measures while minimizing disruption to our organization will be an important determinant of our future success.

Finally, our success also will depend on other factors, including: (i) our ability to optimize our sales and services coverage and productivity through, among other means, effective utilization and management of our resellers and other strategic partners as well as our own sales force; (ii) our ability to further improve customer satisfaction and to build customer references; (iii) our effective management of our development resources; (iv) our success at penetrating strategic emerging markets; and (v) our ability to migrate our customers to a more robust PLM product development system. We believe that we have made progress on these initiatives; however, spending in our sector of the economy has been weak and prospects remain uncertain. Although recent economic indicators suggest that technology spending is expected to increase modestly in calendar 2004, technology spending in the manufacturing sector is expected to lag behind overall increases in technology spending. In addition, although we likely would benefit from renewed economic growth and improvements in technology spending in the manufacturing sector, any revenue improvement is likely to lag any such growth and increased spending by six to nine months due to the length of our sales cycles.

Additional factors affecting our revenues and operating results are identified under “Important Factors That May Affect Future Results” below.

The following overview of PTC’s business may be helpful in understanding the detailed analysis of our results of operations and financial condition that follows.

PTC, founded in 1985 and headquartered in Needham, MA, develops, markets and supports PLM software solutions and related services that help manufacturers improve the competitiveness of their products and product development processes. Our solutions, which include a suite of mechanical computer-aided design tools (our design solutions) and a range of collaboration and data management technologies (our collaboration and control solutions), enable manufacturing companies to create virtual computer-based products (digital products), collaborate on designs within the enterprise and throughout the extended supply chain, and control the digital product information throughout the product lifecycle. This results in streamlined engineering processes, improved product quality, optimized product information management and reduced cost and time-to-market cycles. Our PLM software solutions are complemented by our experienced services and technical support organizations, as well as resellers, systems integrators, and other strategic partners, who provide training, consulting, ancillary product offerings, implementation and support to customers worldwide.

With our suite of PLM software solutions, we see an opportunity to address several of the key challenges that manufacturing companies face in their product development processes: more frequent change, heterogeneity of systems, and increased communication inside and outside the manufacturing enterprise to support growing outsourcing and increasingly transparent supply chains. Accordingly, we have devoted significant resources into our collaboration and control solutions and their integration with our design software. With our PLM software suite, we can provide our customers a product development system that permits individuals—regardless of their roles in the commercialization of a product, the computer-based tools they use, or their location geographically or in the supply chain—to participate in and impact the product development process across the digital product value chain. We believe that as we continue to implement our strategy for our products to become more tightly integrated and easier to deploy, we can create significant added value for our customers.

Our design solutions and our collaboration and control solutions are aligned under a unified product strategy. The strategy allows us to capitalize on existing product synergies and offer fully leveraged product development solutions that enable the creation, collaboration and control of digital product information across the extended design chain. Our efforts have resulted in the creation of a new offering, the product development system, which is comprised of a suite of integrated products and services offerings. The goal of our product development system approach is to reduce complexity for our customers by ensuring that our solutions, which support core product development processes, work together in a cohesive system. The system delivers a comprehensive footprint that offers the capabilities necessary to improve our customers’ product development processes. These processes involve the entire enterprise and are further extended to include supplier, partner, and customer participants.

Our family of engineering design software encompasses a broad spectrum of engineering disciplines essential to the development of virtually all manufactured products, ranging from consumer products to jet aircraft. Our software tools offer high-performance product design solutions for the creation of digital products that improve product quality and reduce time to market by enabling end-users easily to evaluate multiple design alternatives and to share data with bi-directional associativity. The cornerstone of our design solutions software is Pro/ENGINEER^®, a mechanical design automation technology based on a robust, parametric, feature-based solid modeler, enabling changes made during the design process to be associatively updated throughout the design. Pro/ENGINEER is complemented by functional options and extensions as well as other products for conceptual design, simulation, routed systems design, and manufacturing production. These features allow companies to create more innovative, differentiated and functional products quickly and easily.

In 2003, we commenced shipment of Pro/ENGINEER Wildfire^™, the most recent release of our Pro/ENGINEER design solution and in May 2004 we released version 2.0 of this product. Pro/ENGINEER Wildfire is designed to offer design engineers enhanced ease-of-use and the ability to integrate design tools with our collaboration and control solutions. The product’s new user interface makes it more competitive with lower end modeling tools on the market that are known for ease-of-use, while maintaining the powerful functionality of Pro/ENGINEER. Additionally, Pro/ENGINEER Wildfire is the first CAD system with an embedded web browser and native support for web services. The combination of Pro/ENGINEER and Windchill^® on an integral, Internet-based, interoperable architecture enables us to offer customers a product development system that supports a multi-user, distributed environment and complex product development processes. Pro/ENGINEER Wildfire also offers optional peer-to-peer design conferencing from within the application, enabling enhanced real-time collaboration with a distributed design team.

Since their introduction in 1998, our collaboration and control solutions have evolved to address expanding customer needs. The cornerstone of our collaboration and control solutions is our suite of Windchill^® based products. Windchill is currently sold in two forms based on the common Windchill infrastructure: our Windchill Link solutions and configurable Windchill Modules for enterprise-level PLM.

Our Windchill Link solutions consist of pre-configured, integrated products that utilize the web-based Windchill architecture, as well as components of our design solutions and our Windchill enterprise-level application modules. These point solutions are designed to address specific business-critical manufacturing functions and can be implemented with little configuration in as few as several weeks in accordance with a predefined implementation methodology. These solutions include Windchill PDMLink^™, Windchill ProjectLink^™, Windchill DynamicDesignLink^™ and Windchill PartsLink^™.

We also offer Windchill capabilities in a modular form to support customer-specific configurations that address unique needs within customers’ complex PLM processes. The Windchill Modules architecture and toolsets enable manufacturers to extend the data models and user interface to support unique business processes, such as legacy system replacement and consolidation, complex workflow and document management, and integration and rationalization of diverse systems following merger or acquisition. Unlike other product information management applications based on proprietary architectures and toolsets that discourage tailored configurations, the Windchill Modules architecture and toolsets explicitly enable manufacturers to extend the data models, functionality, and user interface as they see fit.

The Windchill Modules consist principally of the following: a vault for data management to store and retrieve product files; workflow applications for sequencing the flow of product information and change management processes; visualization software for enabling the customer to see a three-dimensional view of product data; and, when desired, data adaptors for connecting to standard computer aided design (CAD) software or standard enterprise resource planning (ERP) systems via standard application interfaces. The Windchill Modules have standard features and functions with capabilities that include product and process management, collaboration, and product planning. The predefined templates (e.g., document folders and workflows) may be used as is or may be configured to the customer’s business environment. For example, the workflow template may be changed to reflect the customer’s organizational approval preferences.

Because all Windchill-based products are built on the same core technology, our customers are able to combine configured Windchill Modules with the Windchill Link solutions. As a result of this flexibility, our customers are not forced to make tradeoffs between competitive differentiation and operational efficiency—both can be realized with Windchill, maximizing competitive advantage.

In late December 2003, we introduced Windchill 7.0, our most recent Windchill release. With Windchill 7.0, we have provided our customers with a seamless user and data environment across Windchill PDMLink and Windchill ProjectLink, thus furthering the integral product development system by combining flexible and streamlined collaborative capabilities with formal control of information and processes. Both capabilities share a common pure Internet architecture to enable communication of information throughout the value chain, as well as a turnkey enterprise application interoperability module that connects to other enterprise systems such as SAP. Windchill 7.0 also includes a number of product-specific enhancements that improve usability and performance, including enhanced distributed product administration, support for product teams and templates, extended support for structured documents, streamlined Microsoft^® Office integration, and advanced audit reporting.

Subsequent to the second quarter of 2004, we announced the acquisition of OHIO Design Automation, Inc., a maker of collaboration solutions for electronics design. This acquisition will allow us to better serve the high technology and electronics industries by enabling the dynamic management of design information from electronics design automation vendors. We have begun to integrate OHIO Design Automation’s technology into the Windchill product line and expect to provide integrated product functionality within six to nine months. In addition, we will continue to offer the technology on a stand-alone basis. Although this is a strategic investment to augment our Windchill solutions, OHIO Design Automation’s revenues on a historic stand-alone basis were not significant.

These design and collaboration and control solutions are part of our overall strategy to provide a portfolio of PLM solutions that address specific business challenges that occur at various points in the product lifecycle.

They are designed to enable manufacturers to implement a product development system appropriate for their particular requirements, allowing them to deliver new products to market faster and manage the complexities of product development throughout an evolving supply chain.

We offer maintenance support plans for our software products. Customers who participate in our maintenance support plans receive periodic software updates and new releases. Active maintenance plan customers also are provided self-service support tools and have direct access to our global technical support team of certified engineers and thus benefit from the knowledge, experience and responsiveness of this ISO 9001 accredited organization, resulting in timely and accurate issue resolution.

Our software solutions and maintenance support offerings are complemented by additional service offerings from our services organization, as well as from resellers, systems integrators and other strategic partners. Our services organization focuses on: Implementation Services (providing a range of technology installation, configuration, and migration services, from pre-packaged “quick start” deployments to full system integration); Process and Technology Adoption Services (designed to help ensure widespread acceptance and utilization of our solutions); and Education Services (providing an extensive role-based curriculum to accelerate adoption of the product development system and realize value across the entire enterprise).

All of our software solutions continue to be distributed primarily through our direct sales force. In tandem with our direct sales force, we utilize an indirect distribution channel. Our indirect distribution channel has been broadened over the last three years through resellers, alliances with systems integrators and other strategic partners. The resellers provide greater geographic and small-account coverage, primarily for our design solutions. Systems integrator partners work with our direct sales force to locate and target potential PLM opportunities.

The following is an overview of our results of operations for the second quarter and first six months of 2004. A detailed discussion regarding these results follows the table below.

The following table shows certain consolidated financial data as a percentage of our total revenue for the second quarter and first six months of 2004 and 2003:

Our revenue consists of software license revenue and service revenue, which includes software maintenance as well as consulting, implementation, education and other technical support revenue. We presently report our revenue in two product categories: (1) our collaboration and data management technologies (collaboration and control solutions), including our Windchill web-based software, and (2) our computer aided design, manufacturing and engineering software (design solutions), including our flagship Pro/ENGINEER design software. The following table illustrates trends from the second quarter and first six months of 2003 to the second quarter and first six months of 2004 in our software license revenue and in our service revenue, as well as in our two product categories:

While total revenue in the second quarter of 2004 increased slightly from the first quarter of 2004, revenue in the second quarter of 2004 continued to be adversely affected by ongoing weakness in technology spending in the global manufacturing economy, continued reluctance of our customers to consummate large, enterprise-wide software purchases, the relative saturation and increased competitiveness of the North American and European markets for design solutions and the relative infancy of the PLM market. We derived 67% and 60% of our total revenue from sales to customers outside of North America in the second quarter of 2004 and 2003, respectively, and 65% and 60% for the first six months of 2004 and 2003, respectively. North American revenues were 19% and 18% lower in the second quarter and first six months of 2004 than in the second quarter and first six months of 2003, while sales in Europe were up 7% and 3% (down 9% and 11% on a consistent foreign currency basis) for the second quarter and first six months of 2004, respectively, and sales in Asia-Pacific were up 6% (down 2% on a consistent foreign currency basis) in the second quarter of 2004 over the same period in 2003 and were flat for the first six months of 2004 compared to the first six months of 2003. On a consistent foreign currency basis, Asia-Pacific revenue grew 16 percent sequentially from the first quarter of 2004. This growth was primarily attributable to several larger deals in Japan, where we completed five of our ten largest transactions during the quarter.

License revenue accounted for 31% and 32% of total revenue in the second quarter of 2004 and 2003, respectively, and 29% and 31% of total revenue in the first six months of 2004 and 2003, respectively. Service revenue, which has a lower gross profit margin than license revenue, accounted for 69% and 68% of total revenue in the second quarter of 2004 and 2003, respectively, and 71% and 69% of total revenue in the first six months of 2004 and 2003, respectively. Maintenance revenue for the second quarter of 2004 was up 5% over the second quarter of 2003 (down 4% on a consistent foreign currency basis) and up 2% sequentially while other

service revenue for the second quarter of 2004 was down 14% over the second quarter of 2003 and down 2% sequentially. Although the decrease in service revenue for both the second quarter and first six months of 2004, as compared to 2003, were less than those in license revenue, service revenue has been, and may continue to be, adversely affected by lower license sales in current and prior periods. Our other service revenue (consulting, implementation, education and other support revenue) also has been adversely affected by the removal of a portion of our services delivery headcount in connection with our cost reductions.

In the second quarter of 2003, with the launch of Pro/ENGINEER Wildfire, we began selling a product development system package called “Flex 3C” for Create, Collaborate and Control. This package is configured to meet the needs of the high-end design engineer working in a process-oriented environment. It includes Pro/ENGINEER Wildfire with advanced engineering modules, Windchill ProjectLink, and Windchill PDMLink as a data management option. Because the package includes both design solutions and collaboration and control solutions, for purposes of reporting revenues by product categories, we allocate revenue from sales of the Flex 3C package among our two product categories. Revenue from sales of new Flex 3C licenses is allocated 90% to our design solutions and 10% to our collaboration and control solutions. Revenue from upgrades to the Flex 3C package is allocated 50% to our design solutions and 50% to our collaboration and control solutions. In line with customer demand for a complete product development system, we foresee that we will continue to offer packages that include both design solutions products and collaboration and control solutions products. As such, the delineation between the two product lines may become less meaningful and, accordingly, we may revise our product categories.

We have been building and diversifying our reseller channel to become less dependent on a small number of distributors and to provide the resources necessary for more effective distribution of our products. Although we typically receive lower revenue per seat for an indirect sale versus a direct sale, we believe that utilizing diverse and geographically dispersed distributors that focus on smaller businesses will provide an efficient and cost effective means to reach these customers, while allowing our direct sales force to focus on higher dollar sales opportunities. License sales from our reseller channel, which are primarily for design solutions, were $14.2 million and $14.0 million in the second quarter of 2004 and 2003, respectively, and $27.6 million and $27.0 million in the first six months of 2004 and 2003, respectively. In 2003, our new major European distributor, Mensch und Maschine, began selling our design solutions and we aligned almost all of our existing European resellers under this new structure. Mensch und Maschine is responsible for building and managing a network of PTC resellers and has devoted resources to training and marketing throughout Europe to help make these resellers successful. While we expect that, over the long-term, this relationship will expand our coverage of the European market, we do not expect that this new relationship will have a material impact on our near-term operating results.

Our largest distributor historically had been Rand A Technology Corporation. Rand’s distribution rights for certain territories expired on December 31, 2003 and, for the remaining territories, expired at the end of March 2004. Rand retains certain rights to provide training and consulting to customers through calendar year 2004, with an option to renew through calendar year 2005. We do not expect that the expiration of Rand’s distribution rights will have a material effect on our operating results, as the customers formerly serviced by Rand may now be serviced by PTC directly or by other PTC resellers. We are also currently involved in a lawsuit with Rand, as described in Part II, Item 1, “Legal Proceedings”. We are uncertain how this lawsuit will impact our future financial results.

The following table illustrates trends from the second quarter and first six months of 2003 to the second quarter and first six months of 2004 in our collaboration and control solutions software license revenue and service revenue:

Total revenue from our collaboration and control solutions software and related services was 25% of our total revenue in both the second quarter of 2004 and 2003, and 26% and 25% of our total revenue in the first six months of 2004 and 2003, respectively.

Total collaboration and control solutions revenue declined 2% year over year and 3% sequentially, the result of decreased license and consulting service revenue partially offset by growth in maintenance revenue. Collaboration and control license revenue in the second quarter of 2004 declined 15% year-over-year and 6% sequentially. The declines in our collaboration and control solutions license revenue are attributable in part to a decrease in the number of large license transactions, which reflects a continued shift by customers toward purchasing PLM solutions in incremental fashion. We are addressing this buying preference with our Windchill Link solutions (described below), as well as with our Product Development System adoption roadmap, which provides customers with a suggested approach for purchasing and implementing our solutions in stages.

The increase in maintenance revenue for all periods presented is attributable to a growing user base of our Windchill solutions and the introduction of our Flex 3C package in 2003. The decrease in other service revenue reflects lower consulting and training revenues primarily resulting from prior period decreases in license revenue. Other service revenues have been also adversely affected by the removal of a portion of our delivery capacity in connection with our cost reductions.

As indicated above, to improve our ability to provide PLM solutions to a broader range of customers and to complement our enterprise offerings, we have introduced Windchill-based point solutions targeted at specific business-critical PLM processes (our Windchill Link solutions). Our Windchill Link solutions license revenue as a percent of our total collaboration and control solutions license revenue was 56% and 62% for the second quarters of 2004 and 2003, respectively. Although the percent of our Windchill Link solutions license revenue as a percent of our total collaboration and control solutions license revenue is down in the second quarter of 2004 from the second quarter of 2003, it is up from 40% in the first quarter of 2004. We believe our Windchill Link solutions address a growing customer demand for better return on investment as they can be implemented easily and quickly. As the requirements of our customers and the general market change, we plan periodically to evaluate the need for additional solutions.

We recently have offered a limited number of qualified resellers the ability to sell our Windchill Link solutions. We also have business relationships with leading systems integrators and other strategic partners to expand the coverage of our distribution and services efforts. While these initiatives may limit some opportunities for service revenue growth within enterprise-level implementations, we believe that these relationships are important to help expand coverage for our collaboration and control software solutions, generate additional license and maintenance revenue, and provide expertise for implementation and support.

The following table illustrates trends from the second quarter and first six months of 2003 to the second quarter and first six months of 2004 in our design solutions software license revenue and service revenue:

Total revenue from our design solutions software and related services was 75% of our total revenue in the second quarter of both 2004 and 2003 and 74% and 75% of our total revenue for the first six months of 2004 and 2003, respectively. Design solutions license revenue of $38.1 million, although representing a 5% quarterly decline year-over-year, represented an improvement of 28% sequentially from the first quarter of 2004. Compared to the second quarter of 2003, design solutions license revenue in the second quarter of 2004 reflects a decrease in the average price per seat of 24%. The decrease in the average price per seat is attributable, in part, to a higher mix of lower-end software packages being sold due to growing acceptance of Pro/ENGINEER Wildfire in the low-end of the MCAD market as well as to an increased mix of sales completed by resellers, for which we receive lower revenue. Sequentially, the average price per seat was up 12%, and the total number of new seats added during the second quarter of 2004 was up both sequentially—14% higher than new seats added during the first quarter of 2004, and year-over-year—25% higher than new seats added in the second quarter of 2003. The decrease in design solutions service revenue is due in large part to the lag effect of license revenue declines in prior periods and has been also adversely affected by the removal of a portion of our delivery capacity in connection with our cost reductions.

Design solutions revenue continues to be adversely affected by: (i) weakness in technology spending in the global manufacturing economy, which has led to a decline in large-dollar license transactions; (ii) increased competition and price pressure from products offering more limited functionality at lower cost; (iii) the relative maturity and saturation of the North American and European markets; and (iv) the difficulty associated with displacing incumbent product design systems in the discrete market for computer-aided design solutions.

To address the decline in our design solutions revenue, we have introduced design solutions packages that have price points, functionality and ease-of-use features that appeal to a broader spectrum of design solution users. Pro/ENGINEER Wildfire, released in February 2003 and updated with Pro/ENGINEER Wildfire 2.0 in May 2004, supports web interfaces and Windchill-based interfaces and provides customers with the opportunity to integrate more readily traditional design solutions with collaboration and control solutions. The product’s user interface makes it more competitive with lower-end modeling tools on the market that are known for ease-of-use, while maintaining the powerful functionality of Pro/ENGINEER. The new web interface, which is unique to Pro/ENGINEER, offers a differentiated design solution to manufacturing companies looking for a complete product development system. All Pro/ENGINEER customers on an active maintenance plan receive Pro/ENGINEER Wildfire as a maintenance release consistent with their current configurations. We also offer various technology and service upgrade packages, allowing customers to upgrade from their existing product configuration to the full suite of Pro/ENGINEER Wildfire functionality.

Total costs and expenses decreased 13% to $156.9 million in the second quarter of 2004, compared to $180.4 million in the second quarter of 2003, and decreased 7% to $334.8 million in the first six months of 2004, compared to $362.0 million in the first six months of 2003. The decrease in the second quarter and first six months of 2004 is due primarily to lower costs related to headcount reductions, partially offset by $16.7 million and $38.3 million in restructuring and other charges in the second quarter and first six months of 2004, respectively. There were no restructuring charges in the second quarter and first six months of 2003. On a consistent foreign currency basis from the comparable prior period, total costs and expenses decreased 17% and 11% in the second quarter and first six months of 2004, respectively, compared to the second quarter and first six months of 2003.

In support of our focus on improving profitability, we announced in 2003 that we would be implementing cost reductions designed to reduce our operating cost structure by the end of fiscal 2004 to approximately $150 million per quarter, excluding restructuring and other charges. Over the past several years, we have made significant investments needed to transform our business from providing a single line of technical software with a direct distribution model to providing a family of enterprise solutions with an expanded channel and partner-involved distribution model. We undertook to reduce our cost structure after completing a significant portion of this transformation and we believe we will be able to maintain product quality and customer satisfaction, even with our reduced cost structure. In conjunction with the continuation of the cost reduction initiatives begun in 2003, we recorded restructuring and other charges of $16.7 million and $38.3 million in the second quarter and first six months of 2004, respectively, primarily as a result of headcount reductions and excess facility costs. We expect to incur incremental restructuring and other charges during the remainder of 2004 of approximately $5 million. These expected charges are primarily related to employee severance and termination benefits and excess facilities and are incremental to the charges recorded in prior periods (see “Restructuring and Other Charges” below and Note 2 of “Notes to Consolidated Financial Statements”).

As a result of these initiatives, our headcount has decreased to 3,028 at the end of the second quarter of 2004 from 3,500 as of September 30, 2003, and 3,787 as of the end of the second quarter of 2003.

Our cost of license revenue consists of fixed and variable costs associated with reproducing and distributing software and documentation as well as royalties owed to third parties for technology embedded in or licensed with our software products. Cost of license revenue was $1.9 million and $2.0 million in the second quarter of 2004 and 2003, respectively, and $4.0 million and $4.6 million for the first six months of 2004 and 2003, respectively. Cost of license revenue as a percentage of license revenue was 4% for the second quarter and first six months of both 2004 and 2003. Cost of license revenue as a percent of license revenue can vary depending on product mix sold and the effect of fixed and variable royalties in relation to the level of license revenue. The decrease in cost of license revenue in the second quarter and first six months of 2004 compared to the second quarter and first six months of 2003 was primarily due to lower royalty costs of approximately $0.3 million and $0.8 million, respectively.

Our cost of service revenue includes costs associated with training, customer support and consulting personnel, such as salaries and related costs, third-party subcontractor fees, the release of maintenance updates, including related royalty costs, and facility costs. Cost of service revenue as a percentage of service revenue was 34% in the second quarter of 2004 and 44% in the second quarter of 2003, and was 39% in the first six months of 2004 and 42% in the first six months of 2003. Cost of service revenue decreased $12.0 million to $38.7 million in the second quarter of 2004 from $50.7 million in the second quarter of 2003 and decreased $10.6 million to $88.7 million in the first six months of 2004 from $99.3 million in the first six months of 2003. These cost decreases were due primarily to headcount reductions, reduced compensation and benefit costs, and lower travel costs, which in the aggregate, decreased by approximately $4.0 million and $4.5 million during the second quarter and first six months of 2004, respectively, compared to the same periods in 2003. In addition, in the second quarter of 2004, as a result of a contract renegotiation finalized in the quarter, we realized a one-time benefit of $5.0 million from the reversal of an accrual established in the fourth quarter of fiscal 2003 for obligations related to our services business. Total service related employee headcount decreased 18% at the end of the second quarter of 2004 compared to the end of the second quarter of 2003.

Our sales and marketing expenses primarily include salaries and benefits, sales commissions, advertising and marketing programs, travel and facility costs. Sales and marketing expenses as a percentage of total revenue were 35% and 45% for the second quarters of 2004 and 2003, respectively, and 36% and 46% for the first six months of 2004 and 2003, respectively. Total sales and marketing employee headcount decreased 28% at the end of the second quarter of 2004 compared to the end of the second quarter of 2003, and total sales and marketing expenses decreased 26% and 28% in the second quarter and first six months of 2004, respectively, as compared to the same periods in 2003. As a result of reduced headcount and lower revenues, compensation and benefit costs, sales commissions and travel expenses were lower by an aggregate of approximately $13.5 million and $28.6 million in the second quarter and first six months of 2004, respectively, compared to the second quarter and first six months of 2003. Additionally, our marketing communications and program costs decreased in the second quarter and first six months of 2004 by approximately $3.0 million and $5.9 million, respectively, compared to the second quarter and first six months of 2003.

Our research and development expenses consist principally of salaries and benefits, costs of computer equipment and facility expenses. Research and development expenses as a percentage of total revenue were 16% and 19% in the second quarter of 2004 and the second quarter of 2003, respectively, and 17% and 19% in the first six months of 2004 and 2003, respectively. Total research and development employee headcount decreased 14% at the end of the second quarter of 2004 compared to the end of the second quarter of 2003, and total research and development expenses decreased 16% and 12% in the second quarter and first six months of 2004, respectively,

as compared to the same periods in 2003. The decreases are due primarily to headcount reductions, shifting certain development activities to lower cost locations, and to lower depreciation and telecommunication costs.

Our general and administrative expenses include the costs of our corporate, finance, information technology, human resources and administrative functions as well as bad debt expense. General and administrative expenses as a percentage of total revenue were 9% and 10% in the second quarter of 2004 and 2003, respectively, and 9% for the first six months of both 2004 and 2003. Compared to the prior year, these costs decreased 14% and 9% in the second quarter and first six months of 2004. The decrease is primarily related to lower headcount and, as a result, lower salaries and benefits expense. General and administrative headcount was 16% lower at the end of the second quarter of 2004 compared to the end of the second quarter of 2003.

These costs represent the amortization of acquired intangible assets. Amortization of intangible assets was $1.3 million and $1.5 million in the second quarter of 2004 and 2003, respectively, and $2.7 million and $2.9 million in the first six months of 2004 and 2003, respectively. For a further discussion, see Critical Accounting Estimates—Valuation of Goodwill and Other Intangible Assets below and Note 5 of “Notes to Consolidated Financial Statements.”

Cash disbursements related to restructuring and other charges totaled $28.7 million and $5.4 million in the first six months of 2004 and 2003, respectively. Amounts accrued and not yet paid at April 3, 2004 related to the current quarter and all prior period restructuring initiatives totaled $50.9 million. We expect to make cash disbursements related to these accrued restructuring and other charges of approximately $17 million within the next twelve months. The remaining accruals of approximately $34 million primarily relate to excess facilities and are expected to be paid out through 2013.

Other income (expense), net includes interest income, costs of hedging contracts, certain realized and unrealized foreign currency transaction gains or losses, charges incurred in connection with financing customer contracts and exchange gains or losses resulting from the required period-end currency remeasurement of the financial statements of our subsidiaries that use the U.S. dollar as their functional currency. A large portion of our revenue and expenses is transacted in foreign currencies. To reduce our exposure to fluctuations in foreign exchange

rates, we routinely engage in hedging transactions involving the use of foreign currency forward contracts and, from time-to-time, foreign currency option contracts, primarily in the Euro and in Asian currencies. Other income (expense), net was $0.2 million and $(0.9) million in the second quarter of 2004 and 2003, respectively, and $(0.3) million and $(1.5) million in the first six months of 2004 and 2003, respectively. Other income, net was higher in 2004 compared to 2003 primarily due to lower charges in connection with financing customer contracts, which were $1.3 million in the first six months of 2004 compared to $2.4 million in the first six months of 2003.

Our effective tax rate was 60% on pre-tax income of $8.0 million in the second quarter of 2004 compared to 49% on a pre-tax loss of $10.2 million in the second quarter of 2003 and was 72% on a pre-tax loss of $13.6 million in the first six months of 2004 and 30% on a pre-tax loss of $20.4 million in the first six months of 2003. The difference between the statutory federal income tax rate benefit of 35% and the effective tax rate provisions is due primarily to U.S. operating losses that could not be benefited and to income taxes payable in certain foreign jurisdictions. Due to the uncertainty regarding the realizability of deferred tax assets, we recorded in 2002 a full valuation allowance to completely offset our deferred tax assets (that are primarily related to operating loss carryforwards generated in recent years). The full valuation allowance was still recorded in the second quarters and first six months of 2004 and 2003.

In the normal course of business, PTC and its subsidiaries are examined by various taxing authorities, including the Internal Revenue Service (IRS) in the United States. In fiscal 2004, the IRS concluded its field examination of our income tax returns for fiscal years 1998 through 2000. Our case is currently undergoing a review by the Joint Committee on Taxation. Although the outcome of this review cannot be presently determined, we expect that it may reach a favorable conclusion within the next three to nine months. A favorable resolution would result in a reduction to our tax provision in the quarter of resolution and would result in a tax refund to us above amounts that are already anticipated. We do not expect that an unfavorable outcome would affect our tax provision or result in any reduction in refund amounts we have recorded as receivable.

At April 3, 2004, accrued income taxes of $11.3 million includes and is reflected net of expected refunds of U.S. federal income taxes and related interest of approximately $23 million.

The number of worldwide employees was 3,028 at April 3, 2004, compared to 3,787 at March 29, 2003. The decrease over the prior year is primarily a result of terminations associated with the reductions in workforce described above.

We have prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States. In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our reported revenues, results from operations, and net income (loss), as well as on the value of certain assets and liabilities on our balance sheet. These estimates, assumptions and judgments about future events and their effects on our results cannot be determined with certainty, and are made based on our historical experience and on other assumptions that are believed 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. While there are a number of accounting policies, methods and estimates affecting our financial statements, described in Note A to the Consolidated Financial Statements included in our Form 10-K for the year ended September 30, 2003, the areas that are our most important critical accounting policies include revenue recognition, valuation of goodwill and intangible assets, accounting for income taxes, allowance for accounts and other receivables, transfers of financial assets and restructuring charges. These areas

are described below. A critical accounting policy is one that is both material to the presentation of our financial statements and requires us to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations. They may require us to make assumptions about matters that are highly uncertain at the time of the estimate, and different estimates that we could have used, or changes in the estimate 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.

We exercise judgment and use estimates in connection with the determination of the amounts of software license and services revenues to be recognized in each accounting period. Our primary judgments involve the following:

We derive revenues from three primary sources: (1) software licenses, (2) maintenance services and (3) other services, which include consulting and education services. Revenue by type for the second quarter and first six months of 2004 and 2003 are as follows:

For software license arrangements that do not require significant modification or customization of the underlying software, we recognize revenue when: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred (generally, FOB shipping point or electronic distribution), (3) the fee is deemed fixed or determinable, and (4) collection is probable. Substantially all of our license revenues are recognized in this manner.

At the time of each sale transaction, we must make an assessment of the collectibility of the amount due from the customer. Revenue is only recognized at that time if management deems that collection is probable. In making this assessment, we consider customer credit-worthiness and historical payment experience. At that same time, we assess whether fees are fixed or determinable and free of contingencies or significant uncertainties. If the fee is not fixed or determinable, revenue is recognized only as payments become due from the customer, provided that all other revenue recognition criteria are met. In assessing whether the fee is fixed or determinable, we consider the payment terms of the transaction and our collection experience in similar transactions without making concessions, among other factors. Our software license arrangements generally do not include customer acceptance provisions. However, if an arrangement includes an acceptance provision, we record revenue only upon the earlier of (1) receipt of a written acceptance or (2) expiration of the acceptance period.

Our software arrangements often include implementation and consulting services that are sold separately under consulting engagement contracts or as part of the software license arrangement. When we determine that such services are not essential to the functionality of the licensed software and qualify as “service transactions” under SOP 97-2, we record revenue separately for the license and service elements of these arrangements. Generally, we consider that a service is not essential to the functionality of the software when the services may be provided by independent third parties experienced in providing such consulting and implementation in coordination with dedicated customer personnel. If an arrangement does not qualify for separate accounting of the license and service elements, then license revenue is recognized together with the consulting services using either the percentage-of-completion or completed-contract method of contract accounting. Contract accounting is also applied to any software arrangements that include customer-specific acceptance criteria or where the license payment is tied to the performance of consulting services. Under the percentage-of-completion method, we estimate the stage of completion of contracts with fixed or “not to exceed” fees based on hours or costs incurred to date as compared with estimated total project hours or costs at completion. If we do not have a sufficient basis to measure progress towards completion, revenue is recognized upon completion of the contract. When total cost estimates exceed revenues, we accrue for the estimated losses immediately. The use of the percentage-of-completion method of accounting requires significant judgment relative to estimating total contract costs, including assumptions relative to the length of time to complete the project, the nature and complexity of the work to be performed, and anticipated changes in salaries and other costs. When adjustments in estimated contract costs are determined, such revisions may have the effect of adjusting, in the current period, the earnings applicable to performance in prior periods.

We generally use the residual method to recognize revenues from arrangements that include one or more elements to be delivered at a future date, when evidence of the fair value of all undelivered elements exists. Under the residual method, the fair value of the undelivered elements (e.g., maintenance, consulting and education services) based on vendor-specific objective evidence (VSOE) is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements (i.e., software license). If evidence of the fair value of one or more of the undelivered services does not exist, all revenues are deferred and recognized when delivery of all of those services has occurred or when fair values can be established. We determine VSOE of the fair value of services revenues based upon our recent pricing for those services when sold separately. VSOE of the fair value of maintenance services may also be determined based on a substantive maintenance renewal clause, if any, within a customer contract. Our current pricing practices are influenced primarily by product type, purchase volume, maintenance term and customer location. We review services revenues sold separately and maintenance renewal rates on a periodic basis and update, when appropriate, our VSOE of fair value for such services to ensure that it reflects our recent pricing experience.

Our net goodwill and other intangible assets totaled $49.8 million and $51.9 million as of April 3, 2004 and September 30, 2003, respectively. We assess the impairment of goodwill and other identifiable indefinite lived intangible assets on at least an annual basis and whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. Factors we consider important that could trigger an impairment review include significant underperformance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets or the strategy for our overall business, significant negative industry or economic trends, a significant decline in our stock price for a sustained period, or a reduction of our market capitalization relative to net book value.

We adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets effective October 1, 2002 and, as a result, we no longer amortize goodwill and certain intangible assets with indefinite useful lives. The goodwill impairment test prescribed by SFAS No. 142 requires us to identify reporting units and to determine estimates of the fair values of our reporting units as of the date we test for impairment. We have two reporting units—our software products operating segment and our services operating segment—as described in Note 7 of “Notes to Consolidated Financial Statements.” All goodwill is attributable to

our software products operating segment. To conduct these tests of goodwill, the fair value of the reporting unit is compared to its carrying value. If the reporting unit’s carrying value exceeds its fair value, we record an impairment loss to the extent that the carrying value of goodwill exceeds its fair value. We estimate the fair values of our reporting units using discounted cash flow valuation models. Those models require estimates of future revenues, profits, capital expenditures and working capital for each unit. We estimate these amounts by evaluating historical trends, current budgets, operating plans and industry data. We completed the initial impairment review as of the beginning of fiscal 2003 and our annual impairment review as of the end of the third quarter of 2003 and concluded that, as of October 1, 2002 and June 28, 2003, no impairment charge was required. We plan to conduct our annual impairment test of goodwill and indefinite lived assets as of the end of the third quarter of each fiscal year. There can be no assurance that at the time subsequent impairment reviews are completed an impairment charge will not be recorded in light of the factors described above. If a charge were deemed necessary in the future, it would directly affect net income (loss) for the period in which the charge was taken.

For long-lived assets and identifiable intangible assets, other than goodwill and indefinite-lived intangible assets, we reassess the recoverability of the asset based on projected undiscounted future cash flows over the asset’s remaining life if an event occurs or circumstances change that would, more likely than not, reduce the fair value of the operating segment below its carrying value. When 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. Determining the fair value of individual assets and goodwill includes significant judgment by management. Different judgments could yield different results.

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 where the ultimate tax outcome is uncertain. Some of these uncertainties arise as a consequence of revenue-sharing and cost-reimbursement arrangements among related entities and the differing tax treatment of revenue and cost items across various jurisdictions.

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 sheet. 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 deferred tax assets will not be realized, we must establish a valuation allowance as a charge to income tax expense. As of April 3, 2004 and September 30, 2003, we have fully reserved for deferred tax assets, primarily related to net operating loss carryforwards. The decision to record the valuation allowance required significant management judgment. Had we not recorded this valuation allowance, we would have reported materially different results. If the realization of deferred tax assets in the future is considered more likely than not, a reduction in the valuation allowance would increase net income in the period such determination is made. Net deferred tax liabilities at April 3, 2004 were $0.5 million, comprised of deferred tax assets of $152.4 million, a valuation allowance of $131.5 million and deferred tax liabilities of $21.4 million. Our deferred tax assets consist primarily of net operating loss carryforwards.

Management judgment is required in assessing the collectability of customer accounts and other receivables, for which we generally do not require collateral. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. In determining the adequacy of the allowance for doubtful accounts, management specifically analyzes individual accounts receivable, historical bad debts, customer concentrations, customer credit-worthiness, current economic and accounts receivable aging trends and changes in our customer payment terms. The following table summarizes our accounts receivable and related reserve balances as of April 3, 2004 and September 30, 2003:

If the financial condition of our customers were to deteriorate, additional allowances might be required, resulting in future operating expenses that are not included in the allowance for doubtful accounts. Concentration of credit risk with respect to trade receivables is not significant.

We offer our customers the option to purchase software and services through payment plans. In general, we transfer future payments under certain of these contracts to third-party financing institutions on a non-recourse basis. We record such transfers as sales of the related accounts receivable when we surrender control of such receivables under the provisions of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.

We periodically record restructuring charges resulting from restructuring our operations (including consolidations and/or relocations of operations), changes in our strategic plan, or managerial responses to declines in demand, increasing costs, or other environmental factors. The determination of restructuring charges requires management judgment and may include costs related to employee benefits, such as costs of severance and termination benefits, and costs for future lease commitments on excess facilities, net of estimated future sublease income. In determining the amount of the facilities charge, we are required to estimate such factors as future vacancy rates, the time required to sublet properties and sublease rates. These estimates will be reviewed and potentially revised quarterly based on known real estate market conditions and the credit worthiness of subtenants, and may result in revisions to established facility reserves. We have accrued $45.7 million as of April 3, 2004 related to excess facilities representing gross lease commitments, with agreements expiring at various dates through November 2012, of approximately $83.8 million, net of committed and estimated sublease income of approximately $36.2 million and $1.9 million of present value factor. We have entered into signed sublease arrangements for approximately $22.3 million, with the remaining $13.9 million based on future estimated sublease arrangements, including $11.4 million for space currently available for sublease. If our sublease assumptions prove to be inaccurate, we may need to make changes in these estimates that would affect our results of operations and potentially our financial condition.

Accounting policies, guidelines and interpretations related to our Critical Accounting Policies 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 result in a material impact on our financial position and results of operations.

Our operating activities, the proceeds from our issuance of stock under stock plans and existing cash and investments provided sufficient resources to fund our employee base, capital asset needs, acquisitions and financing needs, in all periods presented.

As of April 3, 2004, cash and cash equivalents totaled $221.7 million, up from $205.3 million at September 30, 2003. We invest our cash with highly rated financial institutions and in diversified domestic and international money market mutual funds. The portfolio is primarily invested in short maturity investments to minimize interest rate risk and to ensure cash is available to meet requirements as needed. The increase in cash and cash equivalents during the first six months of 2004 consisted primarily of $15.2 million provided by operations (including payments toward restructuring and other charges) and $4.8 million provided by financing activities.

Cash provided by operations was $15.2 million in the first six months of 2004, compared to $3.1 million in the first six months of 2003. Cash provided by operations in the first six months of 2003 included the receipt of a U.S. federal income tax refund of $48.2 million partially offset by the disbursement of $10.6 million for a cash contribution to a U.S. defined benefit pension plan. Cash provided by operations in the first six months of 2004 was primarily affected by improved operating performance and improved cash collections of seasonal annual customer maintenance contract renewals, partially offset by higher cash expenditures for restructuring and other charges in 2004 ($28.7 million, compared to $5.4 million in 2003).

Cash used by investing activities was $5.7 million in the first six months of 2004, compared to $13.3 million in the first six months of 2003, and was primarily for the acquisition of property and equipment and other intangible assets. Our expenditures for property and equipment consist primarily of computer equipment, software, office equipment and facility improvements. Financing activities provided cash of $4.8 million in the first six months of 2004 and $3.9 million in the first six months of 2003 from the issuance of common stock under our employee stock option plans. Through April 3, 2004, we had repurchased, at a cost of $366.8 million, a total of 31.2 million shares of the 40.0 million shares authorized by the Board of Directors to be repurchased under our repurchase program. There were no repurchases during the first six months of 2004 and 2003.

We lease office facilities and certain equipment under operating leases that expire at various dates through 2014, including an operating lease agreement related to our headquarters office in Needham, Massachusetts entered

into in 2000, which expires in 2013, subject to certain renewal rights. These leases qualify for operating lease accounting treatment and, as such, are not included on our balance sheet. At September 30, 2003, our total contractual obligations, which include future minimum lease payments, net of sublease income, under noncancellable operating leases, pension obligations, and other purchase obligations was $286.3 million (less than one year, $60.0 million; one to three years, $76.6 million; three to five years, $54.3 million; and thereafter $95.4 million). Total contractual obligations have not changed significantly from September 30, 2003. For further information on these obligations, refer to Contractual Obligations on page 26 of our Form 10-K for the year ended September 30, 2003.

In April 2004, we acquired OHIO Design Automation, Inc., a provider of electronic design verification, visualization and collaboration solutions. The all-cash transaction closed on April 7, 2004 and was valued at approximately $12 million, $9.8 million of which was paid at the closing.

We believe that existing cash and cash equivalents, together with cash generated from operations, an expected refund of U.S. federal income taxes within the next three to nine months, and the issuance of common stock under our stock plans, will be sufficient to meet our working capital, financing and capital expenditure requirements through at least the next twelve months. Over the next four quarters, we expect to incur cash disbursements estimated at $17 million for restructuring and other charges incurred in the current and prior periods. Capital expenditures for 2004 are currently anticipated to continue at lower levels than fiscal 2003. Although we were profitable in the second quarter of 2004 after several quarters of operating losses, our cash position could be adversely affected if we are unable to sustain operating profitability.

In accordance with recently issued accounting pronouncements, we will be required to comply with certain changes in accounting rules and regulations. See Note 6 of “Notes to Consolidated Financial Statements” included herein.

The following are some of the factors that could affect our future results. They should be considered in connection with evaluating forward-looking statements contained in this Quarterly Report on Form 10-Q and otherwise made by us or on our behalf, because these factors are among those that could cause actual results and conditions to differ materially from those projected in forward-looking statements.

Our operating results fluctuate within each quarter and from quarter-to-quarter making our future revenues and operating results difficult to predict

While our sales cycle varies substantially from customer to customer, we usually realize a high percentage of our revenue in the third month of each fiscal quarter, and this revenue tends to be concentrated in the later part of that month. Our orders early in a quarter will not generally occur at a rate which, if sustained throughout the quarter, would be sufficient to assure that we will meet our revenue targets for any particular quarter. Moreover, our transition from a one-product company to a multi-product company, our increased utilization of indirect distribution channels through alliances with resellers, systems integrators, and other strategic partners and our shift in business emphasis to a more solutions-oriented sales process have resulted in more unpredictable and often longer sales cycles for products and services. Accordingly, our quarterly results may be difficult to predict prior to the end of the quarter. Any inability to obtain large orders or orders in large volumes or to make shipments or perform services in the period immediately preceding the end of any particular quarter may cause

the results for that quarter to fall short of our revenue targets. In addition, our operating expenses are based on expected future revenue and are largely fixed for the short term. As a result, a revenue shortfall in any quarter could cause our earnings for that quarter to fall below expectations as well. Any failure to meet our quarterly revenue or earnings targets could adversely impact the market price of our stock.

Other factors that may cause quarter-to-quarter revenue and earnings fluctuations or that may affect our ability to make quarter end shipments include the following:

In addition, the levels of quarterly or annual software or service revenue in general, or for particular geographic areas, may not be comparable to those achieved in previous periods.

Our revenue growth and profitability depends on the overall demand for software and related services. This demand can be adversely affected by unfavorable economic conditions, as customers reduce or defer spending on information technology improvements. We may be especially prone to this as a result of the relatively large license transactions we have historically relied upon. Accordingly, general economic and business conditions may affect our future operating results. A softening demand for software caused by a prolonged slowdown of the economy would result in decreased revenue or lower revenue growth rates. If the recent unfavorable economic conditions continue, the economic slowdown has the potential to continue to materially and adversely affect us.

Political/social events in recent years, including the outbreak of Severe Acute Respiratory Syndrome and concerns regarding terrorism, continue to put further pressure on economic conditions both domestically and internationally. The potential turmoil that may result from such events contributes to the uncertainty of the economic climate, further reducing predictability and our ability to develop and implement long-term strategic plans. In light of the foregoing, the impact of these or future similar conditions may have a materially adverse impact on our business, operating results, and financial position.

Moreover, the uncertain economic conditions have hampered our ability to make measured predictions as to our business, reducing our ability to develop and implement long-term business strategies and models.

We utilize third parties, such as resellers, systems integrators, and other strategic partners for the distribution and implementation of our software solutions, which makes it more difficult to manage the sales process

We have entered into relationships with groups of geographically dispersed resellers and systems integrators to promote, sell and implement our products, which can result in a reduction in our control over the sales process and the delivery of services to our customers. The successful utilization of third parties will depend on:

Part of our success in the past has resulted from our ability to implement new initiatives. Our future operating results will continue to depend upon:

We are dependent on key personnel whose loss could cause delays in our product development and sales efforts

Our success depends upon our ability to attract and retain highly skilled technical, managerial and sales personnel. Competition for such personnel in the high technology industry is intense. We assume that we will continue to be able to attract and retain such personnel. The failure to do so, however, could have a material adverse effect on our business.

We must continually modify and enhance our products to keep pace with changing technology, and we may experience delays in developing and debugging our software

We must continually modify and enhance our products to keep pace with changes in computer software, hardware and database technology, as well as emerging Internet standards. We must also continually expend efforts to review and fix errors (“bugs”) found in our current and upcoming software releases. Our ability to remain competitive will depend on our ability to:

Also, as is common in the computer software industry, we may from time to time experience delays in our product development and “debugging” efforts. Our performance could be hurt by significant delays in developing, completing or shipping new or enhanced products. Moreover, if significant bugs were found in our software products, we may be impacted by negative customer reaction and could experience delays in our new product development efforts, as development resources may need to be shifted toward our debugging efforts. Among other things, such delays could cause us to incorrectly predict the fiscal quarter in which we will realize revenue from the shipment of the new or enhanced products and give our competitors a greater opportunity to market competing products.

We may be unable to price our products competitively or distribute them effectively

Our success is tied to our ability to price our products and services competitively and to deliver them efficiently, including our ability to:

We currently derive our license and service revenues from a group of related PLM software products and services and we expect this to continue into the future. As a result, factors affecting the demand for PLM software solutions or pricing pressures on this single category could have a material adverse effect on our financial condition and results of operations.

A large amount of our revenues are related to sales to customers in the discrete manufacturing sector. A decline in spending in this sector could have a material adverse effect on our financial condition and results of operations.

We depend on sales from outside the United States that could be adversely affected by changes in the international markets

A significant portion of our business comes from outside the United States. Accordingly, our performance could be adversely affected by economic downturns in Europe or the Asia/Pacific region. Another consequence of significant international business is that a large percentage of our revenues and expenses are denominated in foreign currencies that fluctuate in value. Although we may enter into foreign exchange forward contracts and foreign exchange option contracts to offset a portion of the foreign exchange fluctuations, unanticipated events may have a material impact on our results. Other risks associated with international business include:

We may not be able to obtain copyright or patent protection for the software products we develop or our other trademarks

Our software products and our other trademarks, including our company names, product names and logos, are proprietary. We protect our intellectual property rights in these items by relying on copyrights, trademarks, patents and common law safeguards, including trade secret protection, as well as restrictions on disclosures and transferability contained in our agreements with other parties. Despite these measures, there can be no assurance that the laws of all relevant jurisdictions will afford adequate protection to our products and other intellectual property. The software industry is characterized by frequent litigation regarding copyright, patent and other intellectual property rights. While we have not, to date, had any significant claims of this type asserted against us, there can be no assurance that someone will not assert such claims against us with respect to existing or future products or other intellectual property or that, if asserted, we would prevail in such claims. In the event a lawsuit of this type is filed, it could result in significant expense to us and divert the efforts of our technical and management personnel, whether or not we ultimately prevail. Certain of our products also contain technology developed and licensed from third parties. We may likewise be susceptible to infringement claims with respect to these third party technologies.

Increasing competition in the computer aided design marketplace may reduce our revenues

There are an increasing number of competitive design products. Some competitive products have reached a level of functionality whereby product differentiation is less likely, in and of itself, to dislodge incumbent design systems, given the training, data conversion, and other startup costs associated with system replacement. We recently have introduced the next major release of our design solutions, Pro/ENGINEER Wildfire, which focuses on PLM interoperability and ease-of-use. Although Pro/ENGINEER Wildfire and other initiatives are designed to address these competitive pressures, increased competition and further market acceptance of competitive products could have a negative effect on pricing and revenue for our products, which could have a material adverse affect on our results.

In addition, our design software is capable of performing on a variety of platforms. Several of our competitors focus on single platform applications, particularly Windows-based platforms. There can be no assurance that we will have a competitive advantage with multiple platform applications.

We continue to enhance our existing product line by releasing updates as well as new products/modules. Our competitive position and operating results could suffer if:

Growth in certain segments of the computer aided design solutions industry has slowed and, coupled with decreased functional differentiation among flexible engineering tools, may adversely affect our ability to penetrate the market for new customers and recapture our market share. Over the long term, we believe our emphasis on PLM solutions will allow us to differentiate our design solutions from the competition and stabilize sales of our design solutions products while we seek to increase sales of our collaboration and control solutions. However, the strategy may not be successful or may take longer than we plan. There could be a material adverse affect on our operating results in any quarter if these assumptions prove to be incorrect.

III. Collaboration and Control Solutions and Overall PLM Related Considerations

We are attempting to capitalize on a market opportunity known as Product Lifecycle Management (PLM). It may be that our assumptions about this market opportunity are wrong, which could adversely affect our results

We have identified PLM as a new market opportunity for us, and have devoted significant resources toward capitalizing on that opportunity. Our collaboration and control solutions, together with our design solutions, allow us to offer a suite of PLM solutions and related services targeted at this market. This suite includes software and services that utilize Internet technologies to permit our customers’ employees, suppliers and customers to collaboratively develop, build, distribute and manage products throughout their entire lifecycle. Because the market for software products that allow companies to collaborate on product information on an enterprise-wide level is newly emerging and because companies have not traditionally linked customers and suppliers in this process directly, we cannot be certain as to the size of this market, whether it will grow, or whether companies will elect to utilize our products rather than attempt to develop applications internally, acquire them from other sources or to forego PLM initiatives altogether.

In addition, companies that have already invested substantial resources in other methods of sharing product information in the design-through-manufacture process may be reluctant to adopt a new approach that may replace, limit or compete with their existing systems or methods. We expect that we will continue to need to educate prospective customers about the uses and benefits of our products. Demand for and market acceptance of our products will be affected by the success of those efforts.

Our Windchill technology, which is central to our PLM strategy, is not yet well established in the marketplace

The success of our PLM strategy will depend in large part on the ability of our Windchill-based solutions to meet customer expectations, especially with respect to:

The software is still relatively new. If our customers cannot successfully deploy large-scale implementation projects or if they determine that we or our partners are unable to accommodate large-scale deployments, our operating results may be affected.

We are pursuing a strategy to provide a series of easily deployable PLM solutions that address specific business challenges that arise at points along the product lifecycle timeline (our Windchill Link solutions). These Windchill Link solutions utilize our web-based Windchill architecture as well as components of our design solutions. By offering pre-configured, fully integrated applications that can be implemented quickly, our strategy is designed both to solve customers’ problems relating to costly, large-scale implementation projects and to provide customers with the ability to deploy a product development system that meets their evolving requirements. If we are unable to provide these solutions or are unable to meet customer expectations, our overall revenue may be adversely affected.

Our Windchill Link point solutions, as well as our utilization of third party service providers, may crowd out service revenue

Our introduction of our Windchill Link point solutions, which provide customers more autonomy over solving their problems, and our partnerships with third party service providers that provide implementation services directly to customers, may have an adverse affect on our service revenue. We believe that entering into these relationships and offering these solutions will best serve to expand the coverage of our PLM software solutions, generate additional license revenue and provide the necessary expertise for their implementation and support. If these assumptions prove to be inaccurate or if projected additional license revenue and/or broader market coverage does not materialize, our revenues may be adversely affected.

PLM software solutions must meet our customers’ expectations for integration with existing systems to generate references for new accounts

Our PLM software must integrate with our customers’ and their partners’ existing computer systems and software programs. Ours is one of the first PLM solutions, and thus many customers will be facing these integration issues for the first time, particularly in the context of collaborating with customers, supply chain partners and other members of the extended enterprise. Our customers could become dissatisfied with our products or services if systems integration proves to be difficult, costly or time consuming, and thus our operating results may be adversely affected. Moreover, due to the emerging nature of the industry and technology, the sales process relies in large part on customer references. Accordingly, if our customers become dissatisfied, future business and revenues may be adversely affected.

Competition may increase, which may reduce our profits and limit or reduce our market share

The market for our PLM software solutions is new, highly fragmented, rapidly changing and increasingly competitive. We expect competition to intensify, which could result in price reductions for our products and services, reduced gross margins and loss of market share. Our primary competition comes from:

In addition, our services organization may face increasing competition for follow-on consulting, implementation and education services from other third-party consultants and service providers, including those of larger, better known consulting firms that exert considerable influence within portions of our customer base.

To overcome the influence of larger enterprise software and consulting firms within our customer base, we must successfully demonstrate the technological superiority of our offerings as well as customer return on investment.

If the Internet does not continue to develop or reliably support the demands placed on it by electronic commerce, we may experience a loss of sales

Our success depends upon continued growth in the use of the Internet as a medium of collaboration and commerce. The use of the Internet for collaboration and commerce is still relatively new. As a result, a sufficiently broad base of companies and their supply chain may not adopt or continue to use the Internet as a medium of exchanging product information. Our PLM strategy would be seriously harmed if:

Our PLM strategy will also be seriously harmed if the Internet infrastructure is not able to support the demands placed on it by increased usage or the limited capacity of networks to transmit large amounts of data, or if delays in the development or adoption of new equipment standards or protocols required to handle increased levels of Internet activity, or increased governmental regulation, cause the Internet to lose its viability as a means of communication between manufacturers and their customers and supply chain partners.

Our stock price has been highly volatile; this may make it harder to resell your shares at the time and at a price that is favorable to you

Market prices for securities of software companies have generally been volatile. In particular, the market price of these stocks has been and may continue to be subject to significant fluctuations unrelated or disproportionate to the operating performance of these companies. The trading prices and valuations of these stocks, and of ours, may not be predictable. Negative changes in the public’s perception of the prospects of software companies, or of PTC, could depress our stock price regardless of our results.

Also, traditionally, a large percentage of our common stock has been held by institutional investors. Purchases and sales of our common stock by certain of these institutional investors could have a significant impact on the market price of the stock. For more information, please see our proxy statement with respect to our most recent annual meeting of stockholders and Schedules 13D and 13G filed with the SEC with respect to our common stock.

Although we were profitable in the second quarter of 2004 after several quarters of operating losses, our liquidity position may be adversely affected if we are unable to sustain operating profitability, which may lead to a diminished ability to implement strategic initiatives and/or make investments in our operational infrastructure.

We are currently defending two lawsuits in which we could be liable for damages

We are currently defending two lawsuits as described in Part II, Item 1: “Legal Proceedings.” We believe the claims in each of these matters are without merit, and we intend to defend them vigorously. We cannot predict the ultimate resolution of these actions at this time, and there can be no assurance that these actions will not have a material adverse impact on our financial condition or results of operations.

Other than as disclosed in this report on Form 10-Q, there have been no significant changes in our market risk exposure as described in Item 7A: “Quantitative and Qualitative Disclosures About Market Risk” to our 2003 Annual Report on Form 10-K.

(a) Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this quarterly report. Based on this evaluation, our principal executive officer and principal financial officer concluded that these disclosure controls and procedures are effective and designed to ensure that the information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the requisite time periods.

(b) Changes in Internal Control Over Financial Reporting. There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) identified in connection with the evaluation of our internal control that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

At the Annual Meeting of Stockholders of the Company held on March 3, 2004, the stockholders of the Company:

(i) elected Noel G. Posternak and Michael E. Porter as Class II directors of the Company to hold office until the 2007 Annual Meeting (subject to the election and qualification of their successors and to their earlier death, resignation or removal); (ii) approved an increase in the number of shares of our common stock issuable under our 2000 Employee Stock Purchase Plan (“2000 ESPP”); and (iii) confirmed the selection by the Board of Directors of PricewaterhouseCoopers LLP as our independent auditors for the fiscal year ended September 30, 2004. The votes were as follows:

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.


PARAMETRIC TECHNOLOGY CORPORATION

By:		/s/ CORNELIUS F. MOSES, III
		Cornelius F. Moses, III *Executive Vice President and* *Chief Financial Officer* *(Principal Financial Officer)*


		Page Number

Part I—FINANCIAL INFORMATION

Item 1.	Unaudited Financial Statements:

	Consolidated Balance Sheets as of April 3, 2004 and September 30, 2003	1

	Consolidated Statements of Operations for the three and six months ended April 3, 2004 and March 29, 2003	2

	Consolidated Statements of Cash Flows for the six months ended April 3, 2004 and March 29, 2003	3

	Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended April 3, 2004 and March 29, 2003	4

	Notes to Consolidated Financial Statements	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	41

Item 4.	Controls and Procedures	41

Part II—OTHER INFORMATION

Item 1.	Legal Proceedings	42

Item 4.	Submission of Matters to a Vote of Security Holders	42

Item 6.	Exhibits and Reports on Form 8-K	43

	Signature	44


	April 3, 2004			September 30, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	221,665		$	205,312
Accounts receivable, net of allowance for doubtful accounts of $6,541 and $6,845, respectively		154,827			140,151
Prepaid expenses		28,781			29,616
Other current assets		54,397			41,007

Total current assets		459,670			416,086
Property and equipment, net		62,541			73,563
Goodwill (Note 5)		38,301			37,404
Other intangible assets, net (Note 5)		11,537			14,447
Other assets		33,623			36,190

Total assets	$	605,672		$	577,690

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	17,949		$	20,569
Accrued expenses and other current liabilities		49,350			48,296
Accrued compensation and severance		53,481			55,620
Deferred revenue		214,082			173,015

Total current liabilities		334,862			297,500
Other liabilities		91,505			85,032
Commitments and contingencies (Note 8)
Stockholders’ equity:
Preferred stock, $0.01 par value; 5,000 shares authorized; none issued		—			—
Common stock, $0.01 par value; 500,000 shares authorized; 268,031 and 266,383 shares issued, respectively		2,680			2,664
Additional paid-in capital		1,657,277			1,652,303
Accumulated deficit		(1,445,329	)		(1,421,963	)
Accumulated other comprehensive loss		(35,323	)		(37,846	)

Total stockholders’ equity		179,305			195,158

Total liabilities and stockholders’ equity	$	605,672		$	577,690


	Three months ended					Six months ended
	April 3, 2004		March 29, 2003			April 3, 2004			March 29, 2003
Revenue:
License	$	50,971	$	55,284		$	94,488		$	106,761
Service		113,737		115,742			227,030			236,232

Total revenue		164,708		171,026			321,518			342,993

Costs and expenses:
Cost of license revenue		1,914		1,978			4,041			4,623
Cost of service revenue		38,656		50,694			88,676			99,324
Sales and marketing		57,132		77,629			115,317			159,072
Research and development		26,780		31,942			56,359			63,842
General and administrative		14,364		16,654			29,324			32,177
Amortization of intangible assets (Note 5)		1,336		1,460			2,745			2,941
Restructuring and other charges (Note 2)		16,680		—			38,300			—

Total costs and expenses		156,862		180,357			334,762			361,979

Operating income (loss)		7,846		(9,331	)		(13,244	)		(18,986	)
Other income (expense), net		177		(887	)		(313	)		(1,452	)

Income (loss) before income taxes		8,023		(10,218	)		(13,557	)		(20,438	)
Provision for income taxes		4,852		4,951			9,809			6,121

Net income (loss)	$	3,171	$	(15,169	)	$	(23,366	)	$	(26,559	)


Earnings (loss) per share—Basic and Diluted (Note 4):	$	0.01	$	(0.06	)	$	(0.09	)	$	(0.10	)
Weighted average shares outstanding—Basic		267,515		263,796			266,895			263,193
Weighted average shares outstanding—Diluted		273,601		263,796			266,895			263,193


	Six months ended
	April 3, 2004			March 29, 2003
Cash flows from operating activities:
Net loss	$	(23,366	)	$	(26,559	)
Adjustments to reconcile net loss to net cash flows from operating activities:
Depreciation and amortization		18,742			21,235
Other non-cash costs and expenses		3,375			974
Changes in operating assets and liabilities that provided (used) cash:
Accounts receivable		(7,053	)		184
Accounts payable and accrued expenses		(8,196	)		401
Accrued compensation and severance		(4,005	)		(7,600	)
Deferred revenue		34,624			(3,594	)
Income taxes		5,545			51,546
Other current assets and prepaid expenses		(8,416	)		(22,057	)
Other noncurrent assets and liabilities		3,922			(11,436	)

Net cash provided by operating activities		15,172			3,094

Cash flows from investing activities:
Additions to property and equipment		(4,500	)		(11,305	)
Additions to other intangible assets		(1,192	)		(1,980	)
Purchases of investments		—			(10,417	)
Proceeds from sales and maturities of investments		—			10,400

Net cash used by investing activities		(5,692	)		(13,302	)

Cash flows from financing activities:
Proceeds from issuance of common stock		4,771			3,905

Net cash provided by financing activities		4,771			3,905

Effect of exchange rate changes on cash and cash equivalents		2,102			1,441

Net increase (decrease) in cash and cash equivalents		16,353			(4,862	)
Cash and cash equivalents, beginning of period		205,312			178,825

Cash and cash equivalents, end of period	$	221,665		$	173,963


	Three months ended					Six months ended
	April 3, 2004		March 29, 2003			April 3, 2004			March 29, 2003
Net income (loss)	$	3,171	$	(15,169	)	$	(23,366	)	$	(26,559	)

Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment, net of tax of $0 for all periods		855		(1,346	)		2,045			(509	)
Net unrealized gain (loss) on securities, net of tax of $0 for all periods		724		(215	)		478			(232	)

Other comprehensive income (loss)		1,579		(1,561	)		2,523			(741	)

Comprehensive income (loss)	$	4,750	$	(16,730	)	$	(20,843	)	$	(27,300	)


	Three months ended April 3, 2004									Six months ended April 3, 2004
	Employee Severance and Related Benefits			Facility Closures and Other Costs			Total			Employee Severance and Related Benefits			Facility Closures and Other Costs			Total
Beginning balance	$	6,104		$	43,640		$	49,744		$	4,843		$	38,106		$	42,949
Charges to operations		6,951			9,729			16,680			19,216			19,084			38,300
Cash disbursements		(9,175	)		(5,661	)		(14,836	)		(20,179	)		(8,554	)		(28,733	)
Non-cash utilization		—			(663	)		(663	)		—			(1,591	)		(1,591	)

Balance, April 3, 2004	$	3,880		$	47,045		$	50,925		$	3,880		$	47,045		$	50,925


	2004		2003
Expected life of options (years)	4.0		4.0
Expected life of ESPP shares (months)	6.0		6.0
Risk-free interest rates for options	3.0-3.4	%	2.9-3.2	%
Risk-free interest rates for ESPP shares	1.2-3.3	%	2.4-3.0	%
Volatility	75	%	75	%
Dividend yield	—		—


	April 3, 2004						September 30, 2003
	Gross Carrying Amount		Accumulated Amortization		Net Book Value		Gross Carrying Amount		Accumulated Amortization		Net Book Value
Goodwill and intangible assets with indefinite lives (not amortized):
Goodwill	$	143,614	$	105,313	$	38,301	$	140,310	$	102,906	$	37,404
Trademarks		10,197		6,099		4,098		9,925		5,939		3,986

Sub-total		153,811		111,412		42,399		150,235		108,845		41,390
Intangible assets with finite lives (amortized):
Purchased software		28,842		26,842		2,000		28,482		24,482		4,000
Capitalized software		22,547		17,114		5,433		21,354		15,636		5,718
Customer lists		8,901		8,901		—		8,631		7,946		685
Other		316		310		6		316		258		58

Sub-total		60,606		53,167		7,439		58,783		48,322		10,461

Total goodwill and other intangible assets	$	214,417	$	164,579	$	49,838	$	209,018	$	157,167	$	51,851


	April 3, 2004			September 30, 2003
	(in thousands)
Gross accounts receivable	$	161,368		$	146,996
Allowance for doubtful accounts		(6,541	)		(6,845	)

Net accounts receivable	$	154,827		$	140,151

Accounts receivable reserves as a percentage of gross accounts receivable		4.1	%		4.7	%


	Votes For	Votes Withheld or Opposed
Election of Directors:
Michael E. Porter	220,459,945	12,834,046
Noel G. Posternak	201,689,769	31,604,222


	Votes For	Votes Against	Votes Abstaining
Approve an increase in the number of shares issuable under the 2000 ESPP by 8,000,000 shares:	173,281,096	14,585,206	1,481,850



10.1*		Form of Executive Agreement with certain Executive Officers, together with schedule identifying each executive officer.

31.1		Certification of the Chief Executive Officer Pursuant to Exchange Act Rules 13(a)-14(a) and 15d-14(a).

31.2		Certification of the Chief Financial Officer Pursuant to Exchange Act Rules 13(a)-14(a) and 15d-14(a).

32 **		Certification of Periodic Financial Report Pursuant to 18 U.S.C. Section 1350.


* Identifies a management contract or compensatory plan or arrangement in which an executive officer or director of PTC participates. ** Indicates that the exhibit is being furnished with this report and is not filed as a part of it.


Report Date		Description of Matters Disclosed in Form 8-K

January 21, 2004**		Form 8-K furnishing to the SEC, under Item 12, our press release issued on January 21, 2004 announcing results for the fiscal quarter ended January 3, 2004.

January 29, 2004		Form 8-K disclosing that two executive officers had entered into Securities and Exchange Commission Rule 10b5-1 Trading Plans.