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 271,533,614 shares of our common stock outstanding on February 4, 2005 and 270,489,104 shares of our common stock outstanding on January 1, 2005.

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 accounting principles generally accepted in the United States of America. 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. We have made a reclassification within cash flows from operating activities to the Consolidated Statement of Cash Flows for the first quarter of 2004 to conform to the 2005 presentation. 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, 2004.

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. Total maintenance-related customer receivables included in other current assets at January 1, 2005 and September 30, 2004 were $67.8 million and $33.3 million, respectively.

The results of operations for the three months ended January 1, 2005 are not necessarily indicative of the results expected for the remainder of the fiscal year.

In 2003, we announced and began implementing cost reduction initiatives designed to significantly reduce our operating cost structure. These restructuring initiatives were completed in the fourth quarter of 2004. In the first quarter of 2004, we recorded total restructuring and other charges of $21.6 million, comprised of $12.3 million for severance and termination benefits related to 274 employees terminated during that quarter and $9.3 million related to excess facilities and other costs. The charge for excess facilities was primarily related to gross lease commitments in excess of estimated sublease income for excess facilities. Of the $21.6 million in restructuring and other charges recorded in the first quarter of 2004, $0.9 million was non-cash for the write-off of leasehold improvements related to the excess facilities.

The following table summarizes restructuring accrual activity for the three months ended January 1, 2005:

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 benefits. As of January 1,

2005, of the $40.7 million remaining in accrued restructuring charges, $10.4 million was included in other current liabilities and $30.3 million was included in other long-term liabilities, principally for facility costs to be paid out through 2014.

As described in Note 6, Recent Accounting Pronouncements, in December 2004 the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R). SFAS No. 123R will require us to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award.

We currently have proposed amendments to our 2000 Equity Incentive Plan (“2000 EIP”) that 1) authorize us to grant restricted stock more broadly as equity awards, and 2) authorize the exchange and cancellation of certain outstanding underwater PTC non-executive employee stock options for either cash or shares of restricted stock (the Exchange Program). The amendments are designed to reduce the overall number of employee stock options outstanding and will allow us to issue restricted shares more broadly as a component of our equity incentive program. The amendments are described in detail in our Proxy Statement in connection with the 2005 Annual Meeting of stockholders and are subject to stockholder approval at our annual meeting to be held on March 10, 2005. If approved, we currently anticipate that the Exchange Program will be completed in the fourth quarter of 2005 concurrent with the adoption of SFAS No. 123R, as described in Note 6, Recent Accounting Pronouncements. If we decide to exchange outstanding stock options for cash, we estimate that the cash required to fund the option buy-back will be $15 million to $20 million. Under the current guidance of SFAS No. 123R, which will be effective at the expected time of the exchange, we would be required to record a charge to stockholders’ equity for the amount of cash paid per option up to the fair market value of the option on the date of exchange and record compensation expense for the excess, if any, of the cash payment per option in excess of the fair market value of the option on the date of exchange.

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. We historically have offered an employee stock purchase plan (ESPP) for all eligible employees. SFAS No. 123R also includes revised accounting rules for company-sponsored stock purchase plans. In light of these accounting changes, we have suspended offerings under the ESPP with the offering that was to commence on February 1, 2005. These stock plans are described more fully in Note I to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2004.

We currently 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 income (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.

There were no stock options granted or ESPP purchases during the first quarter of 2005. The fair value of options granted during the first quarter of 2004 was 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 37.7 million shares for the first quarter of 2005 had exercise prices per share that were greater than the average market price of our common stock for that period. 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 first quarter of 2004, the effect of outstanding stock options for the purchase of 67.7 million shares was excluded from the computation of diluted EPS as the effect would have been anti-dilutive. Of that amount, 52.2 million shares had exercise prices per share that were greater than the average market price of our common stock for that period.

We operate within a single industry segment—computer software and related services. Within this single industry segment as described in Note 9, Segment Information, we have two reportable segments: (1) software products and (2) services. All of our goodwill and other intangible assets are associated with our software products reportable segment. 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 reporting segment below its carrying value. We conduct our annual impairment test as of the end of the third quarter of each year. We completed our most recent annual impairment review as of the end of the third quarter of 2004 and concluded that, as of July 3, 2004, no impairment charge was required. 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 reporting segment below its carrying value. There have not been any events or changes in circumstances since July 3, 2004 that indicate that the carrying values of goodwill or other intangible assets may be impaired.

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

The changes in the carrying amounts of goodwill and intangible assets with indefinite lives at January 1, 2005 from September 30, 2004 is due primarily to 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 months ended January 1, 2005 and January 3, 2004 was $0.8 million and $2.0 million, respectively. Of those amounts, $0.2 million and $1.4 million for the three months ended January 1, 2005 and January 3, 2004, respectively, was recorded as amortization of other intangible assets and $0.6 million and $0.6 million for the three months ended January 1, 2005 and January 3, 2004, respectively, was recorded as cost of license revenue. The estimated aggregate future amortization expense for intangible assets with finite lives remaining as of January 1, 2005 is $2.0 million for the remainder of 2005, $2.6 million for 2006, $1.2 million for 2007, $0.4 million for 2008 and $0.2 million for 2009.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R). SFAS No. 123R addresses the accounting for transactions in which a company receives employee services in exchange for (a) equity instruments of the company or (b) liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. It eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require that such transactions be accounted for using a fair-value-based method. SFAS No. 123R is effective for periods beginning after June 15, 2005, which would be the fourth quarter of our fiscal 2005. We expect that the requirement to expense stock options and other equity interests that have been or will be granted pursuant to our equity incentive program will significantly increase our operating expenses and result in lower earnings per share. See Note 3, Valuation of Employee Stock Plans, for the effect on net income (loss) and earnings (loss) per share if we had applied the fair value recognition provisions to all stock-based awards to employees.

In October 2004, the American Jobs Creation Act of 2004 (“AJCA”) was signed into law. The AJCA contains a series of provisions, several of which are pertinent to us. The AJCA creates a temporary incentive for U.S. multinational corporations to repatriate accumulated income abroad by providing an 85% dividends received deduction for certain dividends from controlled foreign corporations. It has been our practice to permanently reinvest all foreign earnings into our foreign operations. Should we determine that we plan to repatriate any of our foreign earnings, we will be required to establish a deferred tax liability on such earnings through a charge to our income tax provision.

The AJCA also provides U.S. corporations with an income tax deduction equal to a stipulated percentage of qualified income from domestic production activities (“qualified activities”). The deduction, which cannot exceed 50% of annual wages paid, is phased in as follows: 3% of qualified activities in 2006 and 2007; 6% in 2008 through 2010; and 9% in 2011 and thereafter. We believe that we qualify for the deduction. The tax benefit of the deduction would generally be accounted for in the periods in which the qualifying activities occur, generally the years in which the deductions are taken on the tax returns. This benefit would be included in our annual effective tax rate, but would not result in a remeasurement of deferred income taxes. The AJCA may have an impact on our tax rate for future years. However, we have maintained a full deferred tax valuation allowance on U.S. deferred taxes and, as a result, we do not expect the AJCA to materially affect our financial position or results of operations.

As described more fully in Note K of our Annual Report on Form 10-K for the fiscal year ended September 30, 2004, we maintain defined benefit pension plans covering certain employees of Computervision Corporation, which we acquired in 1998. Benefits are based upon length of service and average compensation and generally vest after five years of service. The net periodic pension cost was actuarially computed using assumptions applicable to each subsidiary plan and economic environment.

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

We did not make any employer contributions to our pension plans in the first three months of 2005, and we do not have any minimum funding requirements for the remainder of 2005. However, we may, at our discretion, make voluntary contributions to the plans.

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 examination of our income tax returns for fiscal years 1998 through 2000, which resulted in a tax refund, including interest, to us of $39.5 million (which is included in income taxes receivable on the Consolidated Balance Sheet as of September 30, 2004). Notification of the refund amount was received in the fourth quarter of 2004, and the refund was received in the first quarter of 2005.

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

We currently offer a product development system package called “Flex 3C” for Create, Collaborate and Control. Because this 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 the second quarter of 2003 under which new Flex 3C revenue is allocated 90% to our design solutions and 10% to our collaboration and control solutions and 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 and product categories are summarized as follows:

Total long-lived assets by geographic region have not changed significantly from September 30, 2004.

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 one-year 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. Rand has recently quantified its claimed actual damages as being in excess of $50 million and Rand asserts that this amount should be trebled by the court. We believe Rand’s claims and its damages assessment associated with those 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 30.

We are encouraged by our performance in the first quarter of 2005. As discussed in detail below, during the quarter we experienced year-over-year revenue growth in license, service and maintenance revenue across all major product lines and geographies. We also continued to expand our indirect distribution channel, we made measured increases to our direct sales force and we increased services delivery capacity in regions with sufficient consulting and training business to support the infrastructure growth. While the increase in sales volumes that contributed to the year-over-year revenue increase in the first quarter of 2005 was modest, we believe it to be an indicator that our strategic initiatives for 2005 are beginning to gain traction.

Over the past few years, we have been focused on improving our products, our distribution model, our competitive position and our cost structure. With these initiatives now substantially complete, our focus in 2005 and beyond is to achieve further revenue and earnings growth. We believe that the discrete market for computer-aided design solutions has begun to show signs of modest growth and that the collaboration and control market continues to present an opportunity for more meaningful growth. We believe these markets have converged into an overall market for product lifecycle management (PLM) solutions as manufacturers look to improve their total product development processes instead of focusing on individual productivity in engineering or manufacturing. These product development processes have become increasingly complex as companies develop and manufacture products across geographic and corporate boundaries. Additionally, there is a growing opportunity in the small and medium business market as these manufacturers migrate from 2D design solutions to entry-level 3D design solutions. We also believe that these smaller manufacturers will begin to invest in collaboration and control solutions over the next several years.

To achieve our 2005 goals, while remaining focused on profitability, we will continue to (i) leverage and optimize our distribution model, including, when appropriate, making measured increases to our direct sales force and reseller channel; (ii) evaluate strategic investments in solutions for vertical market segments outside of our traditional market segments as demand for our products dictate; (iii) focus on growing strategic accounts; (iv) make strategic investments in the Asia-Pacific market; and (v) actively evaluate and pursue corporate development opportunities. Our enhanced suite of PLM software solutions provides the foundation for our future growth, as these solutions provide a basis for expanding our relationships with existing customers who have previously purchased our traditional high-end design products. We must accordingly focus on enhancing and marketing our product and service offerings so that our customers are able to understand and realize their advantages. During 2005, we are scheduled to release the next generation of our Windchill^® and Pro/ENGINEER Wildfire^™ products, including integration and interoperability enhancements.

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 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; (iii) our success at penetrating strategic emerging markets; (iv) our ability to differentiate our products and services from those of our competitors, including larger companies with established enterprise relationships with our customers; and (v) our ability to successfully execute corporate development initiatives.

Our success also will depend on other factors, including: (i) our ability to elevate PLM expenditures over other technology spending as a budgetary priority among our customers; (ii) our ability to further improve customer satisfaction and to build customer references; (iii) our effective management of our geographically dispersed development resources; (iv) 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 (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; but spending in our sector of the economy has been weak in the past few years. Although recent economic indicators suggest that technology spending has begun to increase modestly, our success will depend in part on further improvements in this area.

Additional factors affecting our revenues and operating results are identified under “Important Factors That May Affect Future Results” beginning on page 30.

Parametric Technology Corporation (PTC) was founded in 1985 and is headquartered in Needham, Massachusetts. PTC develops, markets and supports PLM software solutions and related services that help manufacturers improve the competitiveness of their products and product development processes. The PLM market encompasses the mechanical computer-aided design, manufacturing and engineering (CAD, CAM and CAE) markets as well as many previously isolated markets that address various phases of the product development and manufacturing lifecycle. Our software solutions, which include a suite of mechanical computer-aided design tools (our design solutions based on our flagship Pro/ENGINEER^® software) and a range of Internet-based collaboration technologies (our collaboration and control solutions based on our technology platform known as Windchill^®), 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. Our PLM software solutions are complemented by our experienced services and technical support organizations, as well as resellers and other strategic partners, who provide training, consulting, ancillary product offerings, implementation and support to customers worldwide.

The cornerstone of our design solutions software is Pro/ENGINEER^®, a three-dimensional product design solution based on a robust, parametric, feature-based solid modeler, enabling changes made during the design process to be associatively updated throughout the design. Pro/ENGINEER consists of capabilities for detailed design (CAD), manufacturing/production (CAM), and simulation/analysis (CAE), as well as facilities for exchanging CAD data with a multitude of sources and in varied standard formats, allowing companies to create more innovative, differentiated and functional products quickly and easily.

The cornerstone of our collaboration and control solutions software is our suite of Windchill-based products, which is currently sold in two forms based on the common Windchill infrastructure: (1) Windchill Link solutions and (2) configurable Windchill modules. Our Windchill Link solutions consist of pre-configured, integral products designed to address specific business-critical manufacturing processes. Our Windchill modules architecture and toolsets enable manufacturers to extend the data models and user interface to support unique business processes, such as legacy system replacement and consolidation, and integration and rationalization of diverse systems following merger or acquisition.

With our suite of PLM software solutions, we see an opportunity to address several of the key challenges that manufacturing companies face in their product development processes: more frequent change, heterogeneity of systems, and increased communication inside and outside the manufacturing enterprise to support growing offshoring and outsourcing and increasingly transparent supply chains. Our PLM software solutions provide our customers a product development system that permits individuals—regardless of their roles in the commercialization of a product, the computer-based tools they use, or their location geographically or in the

supply chain—to participate in and impact the product development process across the digital product value chain. We believe that as we continue to implement our strategy for our products to become more tightly integrated and easier to deploy, we can create significant added value for our customers.

All of our software solutions continue to be distributed primarily through our direct sales force. In tandem with our direct sales force, we utilize an indirect distribution channel. Our indirect distribution channel has been broadened over the last several years through resellers and other strategic partners. Our resellers provide greater geographic and small-account coverage, primarily for our design solutions, while our other strategic partners help to expand the breadth of our PLM solutions by providing complementary product and/or service offerings.

The following is a summary of our results of operations for the first quarters of 2005 and 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 first quarters of 2005 and 2004:

Our revenue consists of software license revenue and service revenue, which includes software maintenance as well as consulting, implementation, education and other technical support revenue. We presently report our revenue in two product categories: (1) our collaboration and data management technologies (collaboration and control solutions), including our Windchill Internet-based software, and (2) our computer-aided design, manufacturing and engineering software (design solutions), including our flagship Pro/ENGINEER design software. The following table illustrates trends from the first quarter of 2004 to the first quarter of 2005 in our software license revenue and in our service revenue, as well as in our two product categories:

In the first quarter of 2005, we had year-over-year revenue growth in license, service and maintenance in both design solutions and collaboration and control solutions and in each major geographic region. Revenue in the first quarter of 2005, compared to the first quarter of 2004, reflects growth in sales of new seats of both design solutions and collaboration and control solutions. License and other service revenue recognized from deals greater than $1.0 million totaled $21.7 million in the first quarter of 2005 compared to $15.4 million in the first quarter of 2004. While we remain cautious about our customers’ willingness to consummate large, enterprise-wide software purchases, as well as the relative saturation and increased competitiveness of the North American and European markets for design solutions, this year-over-year growth provides us with initial indicators that our strategic initiatives for 2005 are beginning to gain traction.

We derived 66% and 64% of our total revenue from sales to customers outside of North America in the first quarter of 2005 and 2004, respectively. The improvements in our revenue in North America and Europe are indicators that the economy in those regions, where the manufacturing sector and related technology spending have been weak over the past several years, may be strengthening. Growth in European revenue in the first quarter of 2005 was due primarily to an increase in the number of large sales transactions compared to the year-ago period and favorable foreign currency exchange as set forth in the above table. Revenue performance in Asia-Pacific remains solid, particularly in Japan where revenue grew 14% year over year. We believe that Asia-Pacific continues to present an important growth opportunity because global manufacturing companies have continued to invest in that region and the market in that region for both our design solutions and collaboration and control solutions is relatively unsaturated.

License revenue accounted for 28% of total revenue in the first quarters of both 2005 and 2004. Service revenue, which has a lower gross profit margin than license revenue, accounted for 72% of total revenue in the first quarters of both 2005 and 2004. Maintenance revenue in the first quarter of 2005 was favorably impacted by operational improvements, strengthened product offerings and growth in license revenue. Our other service revenue (consulting, implementation, education and other support revenue) in the first quarter of 2005 reflects higher revenues from the delivery of training and assessment packages that follow on from orders of our software products from prior periods.

We have been building and diversifying our reseller channel to become less dependent on a small number of distributors and to provide the resources necessary for more effective distribution of our products. Although we typically receive lower revenue per seat for an indirect sale versus a direct sale, we believe that utilizing diverse and geographically dispersed distributors that focus on smaller businesses will provide an efficient and cost effective means to reach these customers, while allowing our direct sales force to focus on larger sales opportunities. Total sales from our reseller channel, which are primarily for design solutions, were $33.2 million (20% of total revenue) and $30.4 million (19% of total revenue) in the first quarters of 2005 and 2004, respectively. The growth in total channel revenue is due in part to our efforts to expand our reseller channel as mentioned above. We also attribute the increase in reseller channel revenue to the growing success of Pro/ENGINEER Wildfire in small and medium businesses both relative to our historic offerings as well as to competitive offerings in this market segment.

The following table illustrates trends from the first quarter of 2004 to the first quarter of 2005 in our collaboration and control solutions software license revenue and service revenue:

Total revenue from our collaboration and control solutions software and related services was 27% of our total revenue in the first quarters of both 2005 and 2004.

The increase in collaboration and control solutions revenue in the first quarter of 2005 compared to the year-ago period was driven by a higher number of new customers as well as increases in both transactions and new seats from existing customers, reflecting our success in driving incremental adoption of our solutions. 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 solutions targeted at specific business-critical PLM processes (our Windchill Link solutions). In the first quarter of 2005, Windchill Link solutions license revenue increased 32% over the first quarter of 2004, and represented 50% of overall collaboration and control solutions license revenue compared to 40% in the first quarter of 2004. This shift from sales of enterprise-level Windchill modules to our Windchill Link solutions is in line with our observations that customers are demanding PLM solutions that can be implemented in an incremental fashion with a clear return on investment. We feel that we have addressed this evolving customer demand with our Windchill Link solutions and related services packages, 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. We expect that our Windchill Link solutions will continue to gain acceptance with existing and new customers, and that they will comprise a large portion of our overall collaboration and control solutions license revenue. As the requirements of our customers and the general market change, we plan periodically to evaluate the need for additional solutions.

Maintenance revenue increases in our collaboration and control solutions have been driven primarily by an increase in the number of new users of our collaboration and control solutions as new customers are added and existing customers expand their implementation to additional users.

As part of our growth initiatives, we are working toward expanding the technology footprint of our PLM solutions by adding functionality through internal development and strategic acquisitions. In April 2004, we completed the acquisition of OHIO Design Automation, Inc., a developer of collaboration solutions for electronics design. This acquisition will allow us to better serve the high technology and electronics industries by providing the technology necessary to offer an integrated solution, enabling the dynamic management of both mechanical and electrical design information. We are in the process of integrating OHIO Design Automation’s Intercomm technology into the Windchill product line for expected release in the third quarter of 2005, while continuing to offer the technology on a stand-alone basis. In addition, to expand our distribution of PLM solutions, we now offer a limited number of qualified resellers the ability to sell our Windchill Link solutions as well as related services.

The following table illustrates trends from the first quarter of 2004 to the first quarter of 2005 in our design solutions software license revenue and service revenue:

Total revenue from our design solutions and related services was 73% of our total revenue in the first quarters of both 2005 and 2004.

Compared to the first quarter of 2004, growth in design solutions license revenue in the first quarter of 2005 reflects a 34% increase in the total number of new seats added during the quarter compared to new seats added in the first quarter of 2004. Stronger sales of all packages of Pro/ENGINEER Wildfire resulted in year-over-year design solutions growth, with particular strength in the entry-level package for small and medium businesses. The increase in design solutions maintenance revenue reflects an improved trend in license sales and further customer adoption of Pro/ENGINEER Wildfire. The increase in design solutions other service revenue is due in large part to higher revenue from delivery of training services and assessment packages. While we have experienced fluctuations in our design solutions revenue quarter to quarter, we are cautiously optimistic that, as a result of strengthened product offerings and improving economic conditions, our design solutions revenue has begun to stabilize.

Despite recent signs of improvement, design solutions revenue continues to be adversely affected by: (i) the relative maturity and saturation of the North American and European markets, (ii) the difficulty associated with displacing incumbent product design systems in the discrete market for computer-aided design solutions, and (iii) increased competition and price pressure from products offering more limited functionality at lower cost.

To address our customers’ purchasing patterns as well as enable us to better compete in the small and medium sized business segment of our market, we now offer Pro/ENGINEER design solutions packages that have price points, functionality and ease-of-use features that appeal to a broad spectrum of design solutions users and that provide customers with the opportunity to integrate more readily traditional design solutions with collaboration and control solutions. Our design solutions are now 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. Further, our direct interface between Pro/ENGINEER and Windchill offers a differentiated solution to manufacturing companies looking for a complete product development system.

Operating expenses of $146.0 million for the first quarter of 2005 reflect modest increases over operating expenses in the fourth quarter of 2004 due to planned investments in our services organization (particularly in Asia-Pacific), sales infrastructure, research and development and strategic corporate development initiatives. In addition, we are making measured increases in our sales organization related to supporting our reseller program and adding direct sales representatives in our strategic accounts. We are also investing in research and development programs aimed at adding vertical functionality to our products. In the general and administrative functions, we are investing in corporate development initiatives and continuing our Sarbanes-Oxley compliance work. Looking forward, we anticipate that we will make measured increases to operating expenses to support our base business and to fund the revenue generating initiatives described above and in “Executive Overview” beginning on page 14. Furthermore, we anticipate that the requirement to expense stock options and other equity interests under SFAS No. 123R, as described in Notes 3 and 6 of “Notes to Consolidated Financial Statements,” will significantly increase our operating expenses and result in lower earnings per share.

The following table illustrates trends from the first quarter of 2004 to the first quarter of 2005 in our costs and expenses:

Over the past several years, we have made significant investments needed to transform our business from providing a single line of technical software with a direct distribution model to providing a family of enterprise solutions with an expanded channel and partner-involved distribution model. In 2003, after completing a significant portion of this transformation, we implemented a restructuring plan to reduce our cost structure. The restructuring plan was completed in the fourth quarter of 2004. Restructuring actions taken in 2003 and 2004 impacted all cost and expense categories in the first quarters of 2005 and 2004. Going forward, we believe we will be able to maintain product quality and customer satisfaction, even with our reduced cost structure.

Total costs and expenses decreased 18% to $146.0 million in the first quarter of 2005, compared to $177.9 million in the first quarter of 2004. The decrease in operating expenses in the first quarter of 2005 is primarily due to:

The restructuring and other charges of $21.6 million in the first quarter of 2004 were primarily a result of headcount reductions and lease costs related to excess facilities. There were no restructuring charges in the first quarter of 2005. See “Restructuring and Other Charges” below and Note 2 of “Notes to Consolidated Financial Statements” for further discussion. The reduction in salaries, benefits and travel costs was due primarily to reduced headcount, shifting research and development activities to our existing facilities in India where overall research and development costs are lower, and lower employer benefit costs due to several employee benefit plan changes that were effective January 1, 2004. Total employee headcount was 3,156 at the end of the first quarter of 2005, compared to 3,186 at the end of the first quarter of 2004.

Our cost of license revenue consists of fixed and variable costs associated with reproducing and distributing software and documentation as well as royalties owed to third parties for technology embedded in or licensed with our software products. Cost of license revenue as a percentage of license revenue was 3% and 5% for the first quarters of 2005 and 2004, respectively. The decrease in cost of license revenue in the first quarter of 2005 compared to the first quarter of 2004 was primarily due to lower royalty costs of approximately $0.6 million. 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. We have reduced royalty costs (for both license and maintenance royalties) through more favorable terms with our royalty software vendors.

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 38% and 44% in the first quarters of 2005 and 2004, respectively. The improved service margin in the first quarter of 2005 compared to the first quarter of 2004 was due to both increased service revenue, which was 8% higher in the first quarter of 2005 than in the first quarter of 2004, and lower expenses, primarily through headcount reductions resulting from cost-cutting initiatives. Total salaries, benefits and travel costs were $3.1 million lower in the first quarter of 2005 compared to the first quarter of 2004 due to service-related employee headcount, which was 8% lower, and reductions in employee benefits, partially offset by higher commissions due to the increase in revenue. In addition, royalty costs were lower by $1.1 million in the first quarter of 2005 compared to the first quarter of 2004.

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 33% and 37% for the first quarters of 2005 and 2004, respectively. Total sales and marketing employee headcount decreased 3% at the end of the first quarter of 2005 compared to the end of the first quarter of 2004. As a result of reduced headcount and reductions in employee benefits, partially offset by higher commissions due to higher revenues, our salaries and benefit costs, sales commissions and travel expenses were lower by an aggregate of approximately $0.7 million in the first quarter of 2005, compared to the first quarter of 2004. Additionally, due to facility consolidations, depreciation and rent expenses decreased in the first quarter of 2005 by approximately $1.1 million, compared to the first quarter of 2004. At the end of the first quarter of 2005, sales and marketing headcount was 962, compared to 945 at September 30, 2004 and 989 at the end of the first quarter of 2004.

Our research and development expenses consist principally of salaries and benefits, costs of computer equipment and facility expenses. Major research and development activities include developing new releases of our software that work together in a more integrated fashion and that include functionality enhancements desired by our customers. During 2005, we are scheduled to release the next generation of our Windchill and Pro/ENGINEER Wildfire products, including integration and interoperability enhancements. Research and development expenses as a percentage of total revenue were 16% and 19% in the first quarters of 2005 and 2004, respectively. The decrease in costs in the first quarter of 2005 compared to the first quarter of 2004 is due primarily to a decrease in total salaries, benefits and travel costs of $2.3 million due in part to shifting certain development activities to our existing facilities in India, where overall research and development costs are lower. In addition, in the first quarter of 2005, depreciation and rent expenses were lower by $0.6 million compared to the first quarter of 2004. Total research and development employee headcount increased 5% at the end of the first quarter of 2005 compared to the end of the first quarter of 2004.

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% in the first quarters of both 2005 and 2004. The increase in costs in absolute dollars in the first quarter of 2005 compared to the first quarter of 2004 is due primarily to a $1.9 million increase in the cost of outside professional services, related to corporate development initiatives and Sarbanes-Oxley compliance. In addition to the increase in the cost of outside professional services, headcount increased by 7%. These increases were partially offset by a net decrease in total salaries, benefits and travel due to a reduction in employee benefits. In addition, depreciation was $0.6 million lower in the first quarter of 2005 compared to the first quarter of 2004.

These costs represent the amortization of acquired intangible assets. The decrease in the first quarter of 2005 compared to the first quarter of 2004 was due to certain intangible assets being fully amortized in 2004, partially offset by amortization of intangible assets resulting from the acquisition of OHIO Design Automation, Inc. in April 2004.

There were no restructuring and other charges in the first quarter of 2005. In the first quarter of 2004, in furtherance of cost reduction initiatives commenced in 2003 and completed in the fourth quarter of 2004, we recorded total restructuring and other charges of $21.6 million, comprised of $12.3 million for severance and termination benefits related to 274 employees terminated during the first quarter and $9.3 million related to excess facilities and other costs. The charge for excess facilities was primarily related to gross lease

commitments in excess of estimated sublease income for excess facilities. Of the $21.6 million in restructuring and other charges recorded in the first quarter of 2004, $0.9 million was non-cash for the write-off of leasehold improvements related to the excess facilities.

Cash disbursements related to restructuring and other charges totaled $2.8 million and $13.9 million in the first quarters of 2005 and 2004, respectively. Amounts accrued and not yet paid at January 1, 2005 related to all prior period restructuring initiatives totaled $40.7 million. We expect to make cash disbursements related to these accrued restructuring and other charges of approximately $10.4 million within the next twelve months. The remaining accruals of approximately $30.3 million primarily relate to excess facilities and are expected to be paid out through 2014.

Other expense, net includes interest income, costs of hedging contracts, certain realized and unrealized foreign currency transaction gains or losses, write-downs of investments, charges incurred in connection with obtaining corporate and customer contract financing 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 revenues and expenses are transacted in foreign currencies. To reduce our exposure to fluctuations in foreign exchange rates, we engage in hedging transactions involving the use of foreign currency forward contracts and, from time to time, foreign currency option contracts, primarily in the Euro and in Asian currencies. Other expense, net for the first quarters of both 2005 and 2004 was $0.5 million.

Our effective tax rate was 16% on pre-tax income of $22.7 million in the first quarter of 2005 compared to 23% on a pre-tax loss of $21.6 million in the first quarter of 2004. The differences between the statutory federal income tax rate of 35% and our effective tax rate are 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 a full valuation allowance in 2002 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 as of the end of the first quarters of 2005 and 2004.

Our future effective tax rate may be materially impacted by the amount of income taxes associated with our foreign earnings, which are taxed at rates different from the U.S. federal statutory rate, as well as the timing and extent of the realization of deferred tax assets and changes in the tax law. In connection with the American Jobs Creation Act of 2004 (the “Act”), enacted in the U.S. in October 2004, we may be able to repatriate certain of our foreign earnings in fiscal 2005 or 2006 with an 85% dividends-received deduction under the dividend reinvestment provisions of the Act. We are currently assessing the impact, if any, that the Act will have on our future income tax expense. Further, we believe that our tax rate may fluctuate within a fiscal year, including from quarter to quarter, due to potential items arising from discrete events, including settlements of tax audits and assessments, the resolution of tax position uncertainties, acquisitions of other companies, or other similar events.

The number of worldwide employees was 3,156 at January 1, 2005, compared to 3,186 at January 3, 2004.

We have prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our reported revenues, results 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 of “Notes to Consolidated Financial Statements” included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2004, the areas that are our most important critical accounting policies and estimates include revenue recognition, valuation of goodwill and intangible assets, accounting for income taxes, allowance for accounts and other receivables, restructuring charges and transfers of financial assets. 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. Critical accounting policies 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.

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

While we apply the guidance of Statement of Position (SOP) No. 97-2, Software Revenue Recognition, and Statement of Position No. 98-9, Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions, both issued by the American Institute of Certified Public Accountants, as well as SEC Staff Accounting Bulletin 104, Revenue Recognition, 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 first quarters of 2005 and 2004 is 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 fixed or determinable, and (4) collection is probable. Substantially all of our license revenues are recognized in this manner.

Our software is distributed primarily through our direct sales force. However, our indirect distribution channel continues to expand through alliances with resellers. Revenue arrangements with resellers are recognized on a sell-through basis; that is, when we receive persuasive evidence that the reseller has sold the products to an end-user customer. We do not offer contractual rights of return, stock balancing, or price protection to our resellers, and actual product returns from them have been insignificant to date. As a result, we do not maintain reserves for product returns and related allowances.

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

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

project, the nature and complexity of the work to be performed, and anticipated changes in salaries and other costs. When adjustments in estimated contract costs are determined, such revisions may have the effect of adjusting, in the current period, the earnings applicable to performance in prior periods.

We generally use the residual method to recognize revenues from arrangements that include one or more elements to be delivered at a future date, when evidence of the fair value of all undelivered elements exists. Under the residual method, the fair value of the undelivered elements (e.g., maintenance, consulting and education services) based on vendor-specific objective evidence (VSOE) is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements (i.e., software 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 $56.5 million as of January 1, 2005 and September 30, 2004. We assess the impairment of goodwill and identifiable 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.

The goodwill impairment test prescribed by SFAS No. 142, Goodwill and Other Intangible Assets, 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. As described in Note 9 of “Notes to Consolidated Financial Statements,” we have two reporting units: (1) our software products reportable segment; and (2) our services reportable segment. All goodwill is attributable to our software products reportable 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 exceeded its fair value, we would record an impairment loss equal to the difference between the carrying value of goodwill and 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 conduct our annual impairment test of goodwill and indefinite lived assets as of the end of the third quarter of each fiscal year. We completed our annual impairment review as of the end of the third quarter of 2004 and concluded that, as of July 3, 2004, no impairment charge was required. There have not been any events or changes in circumstances since July 3, 2004 that indicate that the carrying values of goodwill or other intangible assets may not be recoverable. 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 reportable 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,

determined using projected discounted future cash flows 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. If a foreign jurisdiction were to determine that our cost reimbursement arrangements need revision, that determination could affect our tax liability.

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. In 2002, we increased our deferred tax valuation allowance and recorded a corresponding $48.0 million charge to income tax expense and, in 2005, 2004 and 2003, we have fully reserved for additional deferred tax assets, primarily related to net operating loss carryforwards generated. 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.

Management judgment is required in assessing the collectibility 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 conditions, accounts receivable aging trends and changes in our customer payment terms. The following table summarizes our accounts receivable and related reserve balances as of January 1, 2005 and September 30, 2004:

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. Our customer base consists of large numbers of geographically diverse customers dispersed across many industries, and no individual customer comprised more than 10% of our net trade accounts receivable for any period presented.

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 estimates of 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 are reviewed 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 $40.1 million as of January 1, 2005 (compared to $41.7 million at September 30, 2004) related to excess facilities, representing gross lease commitments with agreements expiring at various dates through 2014 of approximately $77.4 million, net of committed and estimated sublease income of approximately $35.4 million and a present value factor of $1.9 million. We have entered into signed sublease arrangements for approximately $25.3 million, with the remaining $10.1 million based on future estimated sublease arrangements, including $8.0 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.

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

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

As of January 1, 2005, cash and cash equivalents totaled $334.1 million, up from $294.9 million at September 30, 2004. At January 1, 2005, we had $219.7 million, $94.1 million, $14.1 million and $6.2 million of cash and cash equivalents in the United States, Europe, Japan and other international countries, principally in Asia-Pacific, respectively. 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 three months of 2005 consisted primarily of $28.7 million provided by operations (including a federal income tax refund of $39.5 million), a $10.3 million effect of exchange rate changes on cash and cash equivalents, and $3.0 million provided by financing activities, partially offset by $2.8

million used for investing activities. Our largest source of operating cash flows is cash collections from sales of new software licenses, sales of initial and renewal software maintenance contracts and sales of other services to our customers. Maintenance contracts typically are sold and billed one year in advance at the beginning of each contract period, although we recognize the associated revenue ratably over the annual contract period. Because the majority of our maintenance contracts are on calendar-year terms, payments from customers for maintenance generally are received in the second quarter of our fiscal year . Our primary uses of cash from operating activities are for personnel related expenditures, facilities and technology costs.

Cash provided by operations was $28.7 million in the first three months of 2005, compared to $16.0 million of cash used by operations in the first three months of 2004. The higher cash provided by operations in 2005 compared to 2004 was due primarily to (1) improved profitability in 2005 versus 2004 (net income increased $45.7 million in the first three months of 2005 to $19.2 million from a net loss of $26.5 million in the first three months of 2004), (2) a federal income tax refund of $39.5 million received in the first quarter of 2005 and (3) lower cash disbursements for restructuring and other charges in the first three months of 2005, partially offset by a $13.3 million increase in net maintenance revenue recognized in excess of related cash collections in the first quarter of 2005 compared to the first quarter of 2004. Days sales outstanding in accounts receivable was 71 days at January 1, 2005 compared to 69 days at September 30, 2004 and 80 days at January 3, 2004.

Cash used by investing activities was $2.8 million in the first three months of 2005, compared to $2.9 million in the first three months of 2004. Cash used by investing activities for the first three months of 2005 and 2004 was 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 $3.0 million in the first three months of 2005 and $0.3 million in the first three months of 2004, primarily from the issuance of common stock under our employee stock option plans. In December 2004, the Financial Accounting Standard Board (FASB) issued SFAS No. 123R, Share-Based Payment, regarding revised accounting rules for company-sponsored stock purchase plans. In light of these accounting changes we have suspended offerings under our employee stock purchase plan (ESPP) with the offering that was to commence on February 1, 2005.

We currently have proposed amendments to our 2000 Equity Incentive Plan (“2000 EIP”) that 1) authorize us to grant restricted stock more broadly as equity awards, and 2) authorize the exchange and cancellation of certain outstanding underwater non-executive employee stock options for either cash or shares of restricted stock (the Exchange Program). The amendments are designed to reduce the overall number of employee stock options outstanding and will allow us to issue restricted shares more broadly as a key component of our equity incentive program. The amendments are described in detail in our Proxy Statement in connection with the 2005 Annual Meeting of stockholders and are subject to stockholder approval at our annual meeting to be held on March 10, 2005. If approved, we currently anticipate that the Exchange Program will be completed in the fourth quarter of 2005 concurrent with the adoption of SFAS No. 123R, as described in Notes 3 and 6 of Notes to Consolidated Financial Statements. We estimate that the cash required to fund the option buy-back will be $15 million to $20 million. Going forward, if the plan amendments are approved, we anticipate that we will make more use of restricted stock grants, which require fewer shares than stock options to deliver comparable value. The use of restricted shares, coupled with suspension of the ESPP, would result in lower cash proceeds. The ESPP and exercise of employee stock options generated cash proceeds of $3.0 million and $9.7 million in the first quarter of 2005 and the year ended September 30, 2004, respectively.

In September 1998, our Board of Directors authorized the repurchase of up to 20.0 million shares of our common stock, and in July 2000 increased the shares authorized for repurchase to 40.0 million. Through January 1, 2005, we had repurchased a total of 31.2 million shares. There were no repurchases during the first quarter of 2005 or 2004.

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, 2004, 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 $227.6 million ($50.5 million due in less than one year, $59.6 million due in one to three years, $46.6 million due in three to five years, and $70.9 million due thereafter). Total contractual obligations have not changed significantly from September 30, 2004. For further information on these obligations, refer to “Contractual Obligations” beginning on page 23 of our Annual Report on Form 10-K for the year ended September 30, 2004.

We believe that existing cash and cash equivalents together with cash generated from operations will be sufficient to meet our working capital, stock option buy-back and capital expenditure requirements through at least the next twelve months. During 2005, we expect to make cash disbursements estimated at $12 million for restructuring charges incurred in 2004 and prior periods. Capital expenditures for 2005 are currently anticipated to be approximately $15 million. Our cash position could be adversely affected if we are not able to continue to generate operating profits.

We have evaluated, and expect to continue to evaluate, possible acquisition transactions and possible dispositions of certain businesses on an ongoing basis and at any given time may be engaged in discussions or negotiations with respect to possible acquisitions or dispositions. Our cash position could be reduced and we may incur debt obligations to the extent we complete any significant acquisitions.

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 Annual Report on Form 10-K and otherwise made by us or on our behalf, because these factors 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, a high percentage of our revenue has historically been generated 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 and other strategic partners and our shift in business emphasis to offering a product development system comprised of components that can be purchased in stages 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 has been adversely affected by unfavorable economic conditions, as customers have reduced, or are deferring, spending on information technology improvements, which in turn has affected our operating results. Although we recently have seen modest improvements in information technology spending, a return to unfavorable economic conditions has the potential to materially and adversely affect us.

Political/social events in recent years, including concerns regarding terrorism, have the potential 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. The impact of such conditions may have a materially adverse impact on our business, operating results, and financial position.

We utilize third parties, such as resellers 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 other strategic partners to promote, sell and/or 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, including new product introductions, technology acquisitions, and organizational changes. 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. This competition is even greater in offshore regions where we have shifted certain research and development resources in which concerted efforts to solicit employees are not uncommon. 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 is denominated in foreign currencies that fluctuate in value. Although we may from time to time enter into foreign exchange forward contracts and/or 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 of which emphasize lower price points and ease of use compared to the more robust functionality of our solutions. This increased competition makes attracting new customers more difficult. In addition, 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 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.

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, we cannot be certain as to the size of this market, whether it will grow, or whether companies will elect to utilize our products or acquire them from other sources, or 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 our solutions, or if our solutions are not well accepted within our customers’ organizations by their users after deployment, 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 Internet-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 solutions may crowd out service revenue and our initiatives to utilize select resellers to distribute these solutions may put pressure on license margins

Our introduction of our Windchill Link solutions, which have been developed to permit quick installation and provide customers more autonomy over solving their problems, may have an adverse effect on our service revenue. Additionally, we also have begun to offer a limited number of qualified resellers the ability to offer our Windchill Link solutions. We believe that entering into these relationships will best serve to expand the coverage of our PLM software solutions, generate sufficient additional license revenue to compensate for reduced margins, and provide the necessary regional coverage 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. In certain cases, we utilize third-party technologies to facilitate these integrations. As many of our 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:

To compete effectively in this evolving industry, we must successfully develop solutions that are technologically superior to those of our competitors, effectively demonstrate the value proposition offered by our solutions, including return on investment and value creation, and overcome the perception, based on our historical roots, that we are solely a mechanical computer aided design (MCAD) company.

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 superiority of our offerings as well as a high level of customer satisfaction.

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 the infrastructure for the Internet does not efficiently support enterprises and their supply chain partners or concerns over the secure transmission of confidential information over public networks inhibit the growth of the Internet as a means of collaborating across enterprises and/or conducting commercial transactions.

We are required to report on, and obtain the attestation of our independent auditors, relating to our internal controls over financial reporting

Section 404 of the Sarbanes-Oxley Act of 2002 requires that we must include in our fiscal 2005 annual report on Form 10-K our assessment, as well as an attestation from our independent auditors, of the effectiveness of our internal controls over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934 as amended (the “Exchange Act”)). While we believe our internal controls over financial reporting are adequate and have been well documented, there can be no assurances that we will not receive an adverse opinion from our independent auditors or that unforeseen circumstances will result in one or more of our controls becoming ineffective. If we are not able to implement the requirements of Section 404 in a timely manner or if we, or our auditors, report material weaknesses in our internal controls, the market price of our stock may be adversely affected, as investor confidence in the accuracy of our financial reports may be negatively impacted, and we would potentially be subject to sanctions or investigation by regulatory authorities, including the Securities and Exchange Commission or the Nasdaq National Market.

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 or the PLM market generally, could depress our stock price regardless of our results.

We currently anticipate that we will adopt SFAS No. 123R in the fourth quarter of 2005 and it will result in incremental expense on our consolidated statement of operations. There can be no assurance that there will not be a negative market reaction to the effect of this incremental expense on our results of operations, which could adversely affect our stock price and market capitalization.

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 have reported net income and operating profits for the last four quarters, after several quarters of operating losses, our liquidity position may be adversely affected if we are unable to sustain operating profitability or in the event we undertake larger corporate development initiatives, which may lead to a diminished ability to implement strategic initiatives and/or make investments in our operational infrastructure.

We are currently defending a lawsuit seeking substantial damages in which we could be liable

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 2004 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 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.

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)


Massachusetts		04-2866152
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)


		Page Number
Part I—FINANCIAL INFORMATION

Item 1.	Unaudited Financial Statements:

	Consolidated Balance Sheets as of January 1, 2005 and September 30, 2004	1

	Consolidated Statements of Operations for the three months ended January 1, 2005 and January 3, 2004	2

	Consolidated Statements of Cash Flows for the three months ended January 1, 2005 and January 3, 2004	3

	Consolidated Statements of Comprehensive Income (Loss) for the three months ended January 1, 2005 and January 3, 2004	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	38

Item 4.	Controls and Procedures	38

Part II—OTHER INFORMATION

Item 1.	Legal Proceedings	39

Item 6.	Exhibits	39

	Signature	40


	January 1, 2005			September 30, 2004
ASSETS
Current assets:
Cash and cash equivalents	$	334,064		$	294,887
Accounts receivable, net of allowance for doubtful accounts of $6,598 and $6,340 at January 1, 2005 and September 30, 2004, respectively		134,364			130,393
Prepaid expenses		24,845			21,675
Other current assets (Note 1)		69,964			36,262
Income taxes receivable (Note 8)		—			39,523

Total current assets		563,237			522,740
Property and equipment, net		53,590			55,780
Goodwill (Note 5)		45,823			45,221
Other intangible assets, net (Note 5)		10,636			11,322
Other assets		31,705			31,319

Total assets	$	704,991		$	666,382

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	18,929		$	19,067
Accrued expenses and other current liabilities		41,329			39,420
Accrued compensation and benefits		46,984			58,086
Accrued income taxes		37,867			39,428
Deferred revenue		200,388			176,664

Total current liabilities		345,497			332,665
Other liabilities		90,624			91,766
Commitments and contingencies (Note 10)
Stockholders’ equity:
Preferred stock, $0.01 par value; 5,000 shares authorized; none issued		—			—
Common stock, $0.01 par value; 500,000 shares authorized; 270,489 and 269,509 shares issued and outstanding at January 1, 2005 and September 30, 2004, respectively		2,705			2,695
Additional paid-in capital		1,665,567			1,662,421
Accumulated deficit		(1,367,991	)		(1,387,150	)
Accumulated other comprehensive loss		(31,411	)		(36,015	)

Total stockholders’ equity		268,870			241,951

Total liabilities and stockholders’ equity	$	704,991		$	666,382


	Three months ended
	January 1, 2005			January 3, 2004
Revenue:
License	$	46,929		$	43,517
Service		122,261			113,293

Total revenue		169,190			156,810


Costs and expenses:
Cost of license revenue		1,497			2,127
Cost of service revenue		46,160			50,020
Sales and marketing		56,045			58,185
Research and development		26,467			29,579
General and administrative		15,587			14,960
Amortization of intangible assets (Note 5)		222			1,409
Restructuring and other charges (Note 2)		—			21,620

Total costs and expenses		145,978			177,900

Operating income (loss)		23,212			(21,090	)
Other expense, net		(487	)		(490	)

Income (loss) before income taxes		22,725			(21,580	)
Provision for income taxes		3,566			4,957

Net income (loss)	$	19,159		$	(26,537	)


Earnings (loss) per share—Basic and Diluted (Note 4)	$	0.07		$	(0.10	)
Weighted average shares outstanding—Basic		270,036			266,422
Weighted average shares outstanding—Diluted		279,194			266,422


	Three months ended
	January 1, 2005			January 3, 2004
Cash flows from operating activities:
Net income (loss)	$	19,159		$	(26,537	)
Adjustments to reconcile net income (loss) to net cash flows from operating activities:
Depreciation and amortization		6,473			9,562
Other non-cash costs and expenses		637			1,793
Changes in operating assets and liabilities:
Accounts receivable		3,702			6,012
Accounts payable and accrued expenses		(1,379	)		(411	)
Accrued compensation and benefits		(13,317	)		(8,821	)
Deferred revenue		(19,346	)		(6,020	)
Income taxes receivable, net of income taxes payable		37,134			3,125
Other current assets and prepaid expenses		(1,518	)		524
Other noncurrent assets and liabilities		(2,861	)		4,760

Net cash provided (used) by operating activities		28,684			(16,013	)

Cash flows from investing activities:
Additions to property and equipment		(2,799	)		(2,094	)
Additions to other intangible assets		(5	)		(802	)

Net cash used by investing activities		(2,804	)		(2,896	)

Cash flows from financing activities:
Proceeds from issuance of common stock		3,045			341

Net cash provided by financing activities		3,045			341

Effect of exchange rate changes on cash and cash equivalents		10,252			3,311

Net increase (decrease) in cash and cash equivalents		39,177			(15,257	)
Cash and cash equivalents, beginning of period		294,887			205,312

Cash and cash equivalents, end of period	$	334,064		$	190,055


	Employee Severance and Related Benefits			Facility Closures and Other Costs			Total
	(in thousands)
Balance, September 30, 2004	$	388		$	42,933		$	43,321
Cash disbursements		(208	)		(2,622	)		(2,830	)
Foreign exchange impact		—			230			230

Balance, January 1, 2005	$	180		$	40,541		$	40,721


	Three months ended January 3, 2004
Expected life of options (years)	4.0
Expected life of ESPP shares (months)	6.0
Risk-free interest rates for options and ESPP shares	3.4	%
Volatility	75	%
Dividend yield	—


	January 1, 2005						September 30, 2004
	Gross Carrying Amount		Accumulated Amortization		Net Book Value		Gross Carrying Amount		Accumulated Amortization		Net Book Value
	(in thousands)
Goodwill and intangible assets with indefinite lives (not amortized):
Goodwill	$	152,439	$	106,616	$	45,823	$	150,223	$	105,002	$	45,221
Trademarks		10,413		6,185		4,228		10,232		6,078		4,154

Sub-total		162,852		112,801		50,051		160,455		111,080		49,375
Intangible assets with finite lives (amortized):
Purchased software		30,625		29,432		1,193		30,385		29,060		1,325
Capitalized software		22,877		19,192		3,685		22,877		18,654		4,223
Customer lists		10,845		9,315		1,530		10,665		9,045		1,620
Other		316		316		—		316		316		—

Sub-total		64,663		58,255		6,408		64,243		57,075		7,168

Total goodwill and other intangible assets	$	227,515	$	171,056	$	56,459	$	224,698	$	168,155	$	56,543


	Three months ended
	January 1, 2005		Percent Change		January 3, 2004
	(Dollar amounts in millions)
Total revenue	$	169.2	8	%	$	156.8
Total costs and expenses	$	146.0	(18	)%	$	177.9
Operating income (loss)	$	23.2			$	(21.1	)
Net income (loss)	$	19.2			$	(26.5	)


	January 1, 2005			September 30, 2004
	(Dollar amounts in thousands)
Gross accounts receivable	$	140,962		$	136,733
Allowances for doubtful accounts		(6,598	)		(6,340	)

Net accounts receivable	$	134,364		$	130,393

Accounts receivable reserves as a percentage of gross accounts receivable		4.7	%		4.6	%


10.1*		Fiscal 2005 Executive Incentive Performance Plan (filed as Exhibit 10.22 to our Annual Report on Form 10-K for the fiscal year ended September 30, 2004 and incorporated herein by reference).

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

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

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