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ANSYS, Inc. (NASDAQ: ANSS) is a fast growing software maker with generally strong fundamentals. Although adjustments to normalize EPS would result in a $0.02-$0.03 reduction to Q106 EPS, the company beat estimates in the quarter by $0.07, rendering the normalizations somewhat moot. The strong fundamentals appear well recognized, as consensus estimates for revenue and EPS are higher than management guidance, which may justify a cautious approach toward building positions.

Income statement analysis

Sales growth - sales grew 22.5 per cent sequentially (and 22.3 per cent year/year) in the first quarter. Growth was strongest in the US and grew in all territories with the exception of Japan. On page 22 of the 10Q, the company notes:

With respect to revenue, on average, for the first quarter of 2006, the U.S. Dollar was approximately 6.8% stronger, when measured against the Company’s primary foreign currencies, than for the first quarter of 2005. The U.S. Dollar strengthened against the British Pound, the Japanese Yen, the Indian Rupee and the Euro, while it weakened against the Canadian Dollar. The overall strengthening resulted in decreased revenue and operating income during the 2006 first quarter, as compared with the corresponding 2005 first quarter, of approximately $1.1 million and $600,000, respectively.

As we have discussed before, it is important to realize the impact of foreign currency and separate it from any underlying sales trends. In this case, currency is hurting and a weaker dollar would boost revenue even more.

On page 22, the company also notes a potential sign that the revenue growth was not sustainable:

The increase in revenue is primarily due to the following reasons:

• newly generated software license revenue of $6.3 million, including $3.3 million related to an order with a long-standing major customer

Such one-time large sales may not happen regularly. Given that it accounted for half of the increase in license revenue it is something to understand.

Sales quality

  • Revenue recognition – license revenue can be lumpy. Misallocation of revenue between license and maintenance could result in higher than warranted sales and margins in a given quarter.
  • Customer financing – the company does not offer customer financing but does have a high degree of sales concentration through a small number of distributors. The loss of a distributor or the inability of a distributor to pay receivables due could have a meaningful adverse impact.
  • Other - None

Seasonality – there is no apparent seasonality to revenues, but a look at past trading patterns suggests a high propensity for the stock to sell off in January. Investors considering selling should do so near year-end, and those considering a late-year buy may wish to wait until January.

Earnings quality

  • Capitalization of expenses – capitalized software balance declined from 642 to 528, which means that the company capitalized less than was amortized away. If all software costs were always expensed rather than a portion being capitalized, net income would actually have been higher than was reported. However, the difference was too small to impact EPS.
  • Operating margins were 46.3 per cent of revenue in Q12006, down from 48.3 per cent in Q12005 primarily because of the requirement to expense stock options.
  • Net margins were impacted by the requirement to expense stock options and a higher tax rate, partially offset by an increase in interest income.
  • Stock options – stock options were expensed for the first time in Q12006. This had the effect of reducing operating income by $1,224 and net income by $984. Despite the addition of stock option compensation to the income statement, reported operating margins increased year over year due to the dramatic increase in sales and related operating leverage.
  • The company also reissued treasury shares (shares that had previously been repurchased) to redeem stock options. Of 2 million shares that the company has bought back over time, 1 million have been reissued to option holders or used in acquisitions.
  • Pensions - None
  • Anomalous tax rates – the tax rate was 33.8 per cent in Q12006, compared with 31.0 per cent a year ago. 0.8 per cent was due to the change in accounting for stock options.
  • Other – “other income,” primarily interest income, rose sharply year/year. This difference explained $0.02 of EPS in Q12006 relative to the year-ago period. Further, since half of the cash on hand will be used in the Fluent acquisition investors can expect approximately a $0.02 headwind to EPS owing to the lower cash balances in future periods.
  • Other – the company listed a risk factor we have seldom seen, relating to the concentration of its deposits in a few banks and thus the lack of insurance on those deposits. The rarity of the risk factor caused us to wonder whether the company is concerned over the health of one of its banks, although presumably it would be easy enough for the company to switch banks if that were the case. (If anyone has followed up with the company about this or can otherwise explain it please give a response in the comment section.)

Balance sheet analysis

  • Debt load and maturity schedule – Virtually no debt at the end of the quarter, but will issue $200 million of debt to complete the acquisition of Fluent.
  • Value of unexercised options - $137 million
  • Pension funding – N/A
  • Accruals
  • Returns and rebates – not disclosed
  • Warranty – not disclosed
  • Doubtful accounts – allowance for doubtful accounts fell slightly to $2,214 from $2,231 despite an increase in both sales and total accounts receivable. The table demonstrates that using the prior year’s allowance rate would have reduced quarterly EPS by a penny. However, since actual EPS were $0.07 higher than consensus estimates this difference is not as meaningful as it would be if the change in allowance accounted for the entire beat (or had helped the company make its number.)
  • Inventory obsolescence – N/A
  • Environmental reserves – none disclosed
  • Legal reserves – none disclosed
  • Deferred taxes and valuation allowances – long-term deferred income tax asset rose considerably, from $2,153 to $2,950.
  • Other – “Other long-term assets” increased significantly, from $467 to $3,864. These primarily consist of accounts receivable for the portion of annual lease licenses and software maintenance that has not yet been recognized as revenue. This may be similar to deferred revenue as a potential indicator of future revenue growth.
  • Inventory trends (DOH) – N/A
  • Receivables trends (DSO) – Receivables grew 17.5 per cent sequentially, slower than the 22.5 per cent increase in sales. DSO, therefore, declined.
  • Long-term or unbilled receivables – “Other assets” appears to represent unbilled receivables. This balance rose sharply in Q12006 and bears monitoring.
  • SPEs and other off-balance sheet items - None
  • Composition of marketable securities – Company had $200 million cash at the end of the quarter but will use half of that and issue $200 million in debt to complete the fluent acquisition. Will also issue 6 million new shares.

Cash flow analysis

Operating cash flow and net income trends – although net income was up by more than $3 million compared to the year-ago quarter, cash from operations declined by almost $3 million.

Of the $6 million change in the relative balance, $2 million is due to the change in accounting for the excess tax benefit from stock options, which is now included in financing rather than operating cash flows. The remainder is due to increased working capital, which appears reasonable given the dramatic increase in sales levels compared to the year-ago period. Although the cash-flow to net income relationship should be monitored closely over the next couple of quarters to see if the balance is restored, it does not seem cause for major concern at this time.

Free cash flow and net income trends – Free cash flow will be limited in 2006, particularly if the Fluent acquisition is considered as an alternative form of capex.

Capital investment relative to depreciation – capital expenditures were below depreciation in the first quarter of each year. In each of the last three years, depreciation has exceeded capex, which would normally indicate a trend toward falling depreciation expense in the future. However, in Ansys’ case depreciation has been rising because the company has increased its asset base by acquisition rather than capex. All in all, the trends do not suggest the company is under-spending or manipulating EPS through these line items.

Cash taxes paid relative to tax accrual – due to the change in accounting rules for stock options, the company is recording a higher tax rate than they pay. The difference is accounted for as an increase to paid-in capital.

Footnotes

  • Legal issues – none disclosed
  • Social concerns – none apparent

Growth indicators

Guidance - on their recent earnings release the company said:

The Company currently expects the following for the quarter ending March 31, 2006:

- Revenue of approximately $41 - $42 million

- GAAP earnings per share of $0.33 - $0.36

- Adjusted (non-GAAP) earnings per share of $0.35 - $0.36

Fiscal Year 2006 Guidance

The Company currently expects the following for the fiscal year ending December 31, 2006:

- Revenue in the range of $178 - $180 million

- GAAP earnings per share of $1.38 - $1.53

- Adjusted (non-GAAP) earnings per share of $1.51 - $1.53

The above guidance excludes the impact of the acquisition of Fluent, Inc.

Current consensus estimates call for $42.5 million in revenue next quarter and just over $180 million for the year. Consensus EPS estimates are for $0.35 in the quarter and $1.56 for the year. The fact that these are above management guidance suggests that investors are aware of the strong growth potential and may be pricing it in. Further, the company could disappoint investors if it merely meets guidance.

Backlogs – N/A

Deferred revenue – rose from $50 million to $58 million sequentially, or 15.7 per cent, which although strong was slower than the 22.5 per cent sequential increase in sales. However, this may partially be explained by the fact that license revenue grew sharply (nearly 30 per cent). License revenues are recognized up-front with no deferrals. In addition, strong license sales should be a leading indicator of future maintenance revenue growth.

Macro-economic factors – On page 20 of the 10Q, the company states:

The Company licenses its technology to businesses, educational institutions and governmental agencies. The growth in the Company’s revenue is affected by the strength of the global economies, general business conditions, customer budgetary constraints and the competitive position of the Company’s products. The Company believes that the features, functionality and integrated multiphysics capabilities of its software products are as strong as they have ever been. However, the software business is generally characterized by long sales cycles. These long sales cycles increase the difficulty of predicting sales for any particular quarter. As a result, the Company believes that its overall performance is best measured by fiscal year results rather than by quarterly results.

The proxy statement and other issues

  • Compensation of directors and officers – directors receive an annual option grant of 12,000 shares, or can elect to receive 3,600 restricted shares instead. Based on the recent share price and the option value used in the income statement, these benefits are worth approximately $200,000 per year to each director, which may discourage them from challenging management or other directors.
  • Hurdles for incentive pay – not disclosed
  • Related party transactions – none disclosed
  • Other - none
Source: ANSYS, Inc. -- In-Depth Fundamental Analysis (ANSS)