MSC Software Corporation Q3 2008 Earnings Call Transcript

Nov.24.08 | About: MSC Software (MSCS)

MSC Software Corporation (MSCS) Q3 2008 Earnings Call Transcript November 4, 2008 11:00 AM ET

Executives

Joanne Keates – VP, IR

William Weyand – CEO and Chairman

Sam Auriemma – CFO and EVP

Analysts

Woo Jin Ho

David Hines

Michael Coady

Barbara Coffey

Mark Schappel

Operator

Good morning. My name is Marcus and I will be your conference operator today. At this time I like to welcome everyone to the third quarter conference call. (Operator instructions) Thank you. Ms. Keates, you may begin your conference.

Joanne Keates

Thank you for joining us this morning to discuss MSC Software’s third quarter financial results. On the call today from MSC we have Bill Weyand, CEO and Chairman; Sam Auriemma, MSC’s CFO; and John Mongelluzzo, our Executive VP. I’d like to point out that slides for this call are available for download from our website at www.MSCSoftware.com/IR.

Before we begin let me make our Safe Harbor statement. This presentation contains forward-looking statements that involve risks and uncertainties. All forward-looking statements included in this web cast and presentation is based on information available to us at this time. These statements involve uncertainties which may cause our actual results to differ materially from those implied by the forward-looking statements. Important factors that may cause actual results to differ from expectations are discussed in risk factors in our quarterly 10-Qs and our 2007 Form 10-K filed with the SEC. We undertake no obligation to revise or update publicly any forward-looking statements for any reason or at any time.

At this point, I would like to turn the call over to Bill Weyand. Please go ahead Bill.

William Weyand

Thank you, Joanne. Good morning and thank you for dialing into MSC Software’s third quarter conference call. Our third quarter total revenue grew at 11%. Breaking that down software revenue grew at 8% to $21.5 million, maintenance grew at 9% to $34.6 million and our service business revenue grew 33% to $7.6 million. Our enterprise simulation standards based architecture represents now approximately $7.5 million or 35% of our total revenue in Q3.

Net income was $2.3 million and earnings per share were $0.05, which clearly demonstrates our improved income statement business model. Cash and investments were up 14% from the year end to $154 million. Net cash generated year-to-date is approximately $22.8 million.

Let me talk about the economic environment. We’re clearly mindful of the macroeconomic issues that are happening today, yet we believe we will weather the storm. And looking at our business from an engineering perspective, MSC Software has more than 43 years experience in the aerospace, automotive, and heavy manufacturing businesses. Our customers evaluate their internal product development and engineering processes for improvements and efficiencies, better products to market faster are clearly drivers in today’s world.

Companies now need to manage their IT, engineering process and all resources including the supply chain on a global basis. Continued emphasis on reduction of vendors is clearly taking place in the IT world as well. We believe that our customers will continue to invest in higher priority projects that reduce costs, improve global productivity, and accelerate better higher quality products to market faster.

Moving on to our product status, we’re in a more stable product cycle today with our

SimEnterprise releases. Initial pilots are now starting to move to phased deployments and provide a base of business and better visibility going forward. We’re the only enterprise simulation solution in the marketplace today. Our enterprise simulation solutions allow our customers to improve product innovation, be transformative, and collaborate globally.

Looking at our regional performance, Americas had the strongest quarterly performance with revenue growth of 15% in the quarter and 11% year-to-date.

Major customers included tier one automotive suppliers Timken, GKN as well as Northrop Grumman.

Software license revenue grew $1.3 million or more impressively 27% in the quarter. Europe remains and continues to be our largest geographical entity and produced revenue growth of 18% on a GAAP basis. The major customers in the quarter included Lloyd's Register, Airbus, and a major mobile phone manufacturer.

Asia Pacific had flat results in the quarter. Major customers included Nissan, Honda, Leyland, Nippon steel, and Airbus engineering in India.

In regard to our product development activities for Q3 new enhancements to our product suite now address specific functionality. Composites and advanced materials multi-discipline vehicle performance, new industries for packaging and electronics, consumer goods and we were very pleased to have one of our major automotive partners OEM announce that they have demonstrated in excess of a 75% engineering productivity improvement three months after deploying our enterprise through their operations as well as their entire supply chain worldwide. That is real ROI.

SimEnterprise solutions are now stable and have demonstrative ROI that will help drive markets.

Key order wins in Q3, I mentioned earlier, Timken, which is the leading producer of bearings for the aircraft, aerospace, and automotive industries. Lloyd's made a shift (inaudible) moving to MD, Multidiscipline environment, from single discipline where we are doing linear and nonlinear simulation for them and GKN one of the tier one leading automotive suppliers as well.

Let me some give you some details. GKN, this is in regard to driveline components for major OEMs for driveshaft, the critical ROI business issues were to focus on product quality and innovation, provide critical insight into engineering and product development, streamline and standardize their engineering processes worldwide.

GKN is deploying SimManager for enterprise engineering automation and they are calling their project Viper [ph].

Timken again, another well known household tier one supplier in the automotive industry as well as the aerospace industry. Their critical ROI issues were to drive process improvement and automation to optimize knowledge reuse, improve product innovation, and do it for all their resources globally.

Timken selected MSC Software in Q3 for engineering automation and is called the Titan [ph] project. Phase I of a global multiphase deployment has begun and they’re going to leverage SimEnterprise to drive product innovation, automation as well as reduce costs.

I mentioned Lloyd’s earlier. Obviously they are in the marine business. The critical drivers for them to move to our multi-discipline environment from single discipline was to integrate their software simulation tools and they have expanded the capability of MD Nastran to nonlinear impact events including fully coupled fluid structured beds. Multiprocessor modules will run and drive a more efficient engineering operation and improve their quality and time to market.

In October, we conducted a number of number of European aerospace and automotive events. I would like to highlight an event in Rome that was cosponsored by Alenia and MSC Software, and it was for the Italian Aerospace and Defense Conference and it included the Italian Air Force and the Ministry Of Defense. The whole conference was focused on virtual testing engineering simulation. We had 160 attendees, significant number of CTOs and executive VPs of product development and the conference addressed the challenges facing aerospace manufacturer with strict environmental rules, time to market rules, and how they capitalize on their intellectual property and accelerate simulation as a strategic asset in commercial and defense sectors of aerospace.

Moving on, we also cohosted an aerospace event in Toulouse, France. Had attendees from 15 countries including Japan, Canada, US, Russia, about 110 people. The key note speakers in addition to MSC Software, were Airbus, EADS, and Alenia and the base of the (inaudible) clearly helped to drive moving from point solutions to standards-based architecture enterprise solutions allowing them to capitalize on engineering productivity on a global basis and through the supply chain. A few key quotes that I thought you would be interested in hearing from key aerospace messages. EADS

Virtual testing can save significant development time and cost. Airbus

VPD is the key enabler to meet our present and future challenges. Alenia

The reduction of the physical prototype tester to minimize development risks and costs is strategic to our company. Sogeti, the time is right for a new wave of optimization and innovation. We will see a new savings compared to today’s practice. Simulation Content Management will be the backbone.

Moving on to Q3 transaction metrics, we’re pleased that orders over $100,000 increased in Q3 08 versus ’07 from 79 to 100 and average transaction size increased from ’07 to ’08 from $193,000 to $228,000. Growth in both deals over $100,000 is affirming our market situation.

Summary comments. Before I turn it over to Sam to cover the financials, third quarter was a solid quarter. While we are cautiously optimistic about our business, a prolonged economic downturn could adversely impact our customers and therefore our sales and profits. We believe that our new SimEnterprise solutions are a transformation – transformative technology. Why is that, huge ROI. Reduce physical prototypes, save time and money, improve engineering efficiency, greatly improving engineering productivity as well as integrating collaborative globally through the entire OEMs as well as their supply chain efficient resources. Products and improved productivity can have a high ROI will be prioritized as much used during the periods of economic uncertainty.

We will focus on our operating expense structure while monitoring our customers buying decisions and purchasing patterns. Sam.

Sam Auriemma

Well thank you, Bill, and good morning to all of you on the third quarter call. Now let’s turn to the financial results for the quarter. Total revenue for the third quarter was $63.7 million and that’s up 11% or $6.5 million from the $57.2 million in the prior year. The increase was favorably impacted by changes in foreign currency of about $4.6 million. For the nine months, total revenue grew 8% or $13.8 million to $189.4 million and we had favorable FX impacts of about $15.7 million. So for completeness we have included a table now detailing the impact of FX in each of our revenue components.

Let’s talk about those components. Software revenue for the third quarter increased 8% to $21.5 million and this increase was primarily the result of favorable FX impacts. Although the Americas software license grew, as Bill mentioned, by $1.3 million or 27% and that is a good result for that region. For the nine months software revenue totaled $64.6 million and that is a slight decrease of 2% when compared to the prior period. As many of you follow know that and follow MSC know that we continue be in a product transition period and that continues to impact the software license results for the nine month period.

The next slide sets forth for the last seven quarters to proportion of license revenue represented by SimEnterprise, MD, and engineering application product categories. For more clarification we are now presenting three product categories, engineering applications, MD, and SimEnterprise. So, enterprise solutions along with the MD product revenue represented 35% or $7.5 million of the total software revenue in the third quarter. Let us take a look at our maintenance revenue for the quarter. Maintenance revenue for Q3 increased 9% to $34.6 million and for the nine months ended September 30 ‘08 increased 12% to $103.6 million and this part of our business continues to perform well. The increase in maintenance for both periods is primarily the result of the timing of renewals, incremental increases in our installed base, FX, and continued high renewal rates.

For the third quarter services revenue increased 33% to $7.6 million and that is a strong result and this was primarily attributable to higher implementation, post deployment consultant services engagement as well as the conclusion of a multiyear service contract. For the six month period service revenues totaled $21.2 million and that’s up about 22% from the prior year.

Geographically for the third quarter the Americas contributed 31% of our revenues, EMEA contributed 39%, and Asia Pac contributed 30%. We continue to have a good balance of revenue across all three of our operating regions although with 69% of our revenue occurring outside the U.S. this does create significant foreign exchange impacts to our business. These effects impact revenues and operating expenses as well as other income.

Turning to expenses, gross margin for the third quarter was approximately 80%, and software gross margin was 88%. Maintenance and services margins were 76%. And for the nine months gross margin was 81% for both this year and last year. We expect these margins to be relatively stable in the near term.

As you may recall, during the second quarter we began a cost reduction initiative and that impacting employee headcount, outside consulting services, as well as reorganization of various departments. The workforce reduction impacted approximately 6% of the workforce and when complete charges associated with this cost reduction effort will total approximately $1.8 million, $700,000 of which we recognized here in the third quarter. We expect to drive additional cost reductions and operational improvements in the coming quarters.

OpEx totaled $48.1 million in the third quarter and $154.3 million for the nine month period in 2008. Increases in both periods are primarily the result of FX impacts. To give you some insight on the FX impact for our expense numbers we have again included a table. We have also had a number of charges associated with restructuring and other items that impacted operating expenses that we have summarized as well on the table on the next slide. So this slide details the three quarters sequential comparison of our operating expenses for the year (inaudible) R&D, SM, and G&A are all moving in an overall favorable direction.

Taking into account the aforementioned factors the company reported an operating income of $3 million versus $400,000 for the third quarter and for the nine months we recorded an operating loss of $1.8 million and that compares with a loss of $9.1 million in the same period in 2007. Other income expense was adversely impacted by unhedged foreign exchange losses associated with inter-company accounts. Volatility in financial markets particularly foreign exchange rates is a factor that impacts other expense income accounts in ways we cannot predict.

The company reported net income of $2.3 million or $0.05 a share and that compares to net income of $0.01 [ph] or breakeven on an EPS basis last year. For the nine months, net income totaled $1.2 million or $0.03 a share and that compares with a net loss of $4.9 million or $0.11.

In the third quarter, the company recognized tax benefits from uncertain tax benefits and changes in estimates from prior years totaling about $1.5 million. The relatively low pretax loss for the nine months magnified the effects of these benefits and has produced an unusually effective tax rate for the nine months. Our effective tax rate differ from US Federal rates primarily due to the impact of state taxes, earnings from foreign tax jurisdictions that are taxed at different rates, changes in estimates from prior years, nondeductible comp and the effects of uncertain tax positions.

Quickly some other financial metrics, overall deferred revenue stood at $77.2 million at September 30, 2008, and that is down slightly from year end and that is a typically seasonal pattern for us. Net cash provided by operating activities was $22.8 million in the nine months ended September 30th and that is up from $16 million in the nine months last year. Cash generated by operations is primarily attributable to cash earnings and higher collection of accounts receivable. Cash and investments at September 30, 2008, was $154.2 million in CapEx and nine months totaled $2.3 million.

While we believe it is important to comment on recent financial markets we do not believe that financial markets disruptions will impact our liquidity or cash investments. We believe we’re positioned well because of a number of factors. We have an ongoing expense reduction program in place. We have minimal CapEx requirements and we do not have balance sheet debt or financing requirements to date to fund the business. We have $154 million in cash on our balance sheet and we can support the ongoing requirements of our business in a downturn. Although a prolonged economic downturn and more uncertainty will in turn adversely impact our customers and then obviously our sales.

While we don’t give guidance, we’re aware of Wall Street estimates and would like to make some following observations. We believe the current Wall Street consensus estimates for revenue for the fourth quarter were developed during a better global economic environment and at a time with more favorable foreign currency rates. Since then we believe the environment has become more uncertain and recently those rates have declined.

With that I’ll turn the call back over to Bill.

William Weyand

Thanks, Sam. Well in summary before we open it up to Q&A is we believe the underlining fundamentals of MSC remains solid. We cannot predict the movement of foreign currencies but we do expect that they will continue to volatile. A prolonged economic downturn could impact our customers IT spending and in turn impact our business. Although we should be well positioned to weather the macroeconomic environment and that is because technology providers like MSC with proven and transformative products will drive tangible cost savings that provide real engineering gains and productivity that will be favored in uncertain economic cycles. Joanne.

Joanne Keates

We will take questions now Marcus.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Your first question comes from the line of Woo Jin Ho.

Woo Jin Ho

Great, thanks. One question on the macro. Bill in your prepared remarks you discussed aero, auto, and heavy machinery focusing on virtual product development and virtual product development work force in periods of economic weakness. The auto industry is facing unprecedented times what can you say about simulation investment in the auto industry specifically. And number two, as you have expanded into nontraditional vertical markets, what can you say about their thoughts around simulation investment during challenging economic times?

William Weyand

Okay let me first comment on what the – basically the simulation market drivers are today. And I think that will give a flavor for why we are cautiously optimistic about where we are. And then the underlying fundamentals of our company are obviously very sound. IT needs today of global companies are to develop centers worldwide to leverage resources and intellectual assets to their companies as well as to the supply chains. IT organizations are moving to data from proprietary to standards-based architecture. And if you look at – refer to the Fortune August magazine article on high performance computing it basically stated that high performance computing and simulation is product developments’ new secret weapon. What does this mean. While modeling and simulation of the next game changing drivers for companies to innovate, drive new product innovation, faster, better, and cheaper in the marketplace. And that is what our SimEnterprise solutions are providing. So, as you look at our release 3 which was in Q2 and release 3.2 which was this quarter Q4, and release 4 in Q2 of next year, our SimEnterprise solutions are providing transformative and delivering a very high return on investment helping companies to collaborate global solutions. Major global automotive company in Australia publicly announced a few weeks ago that they have documented over a 75% engineering productivity improvement. That means that they are engineers and that the supply chain engineers can do 75% more simulation with the same number of engineers or they can reduce their organizations by a significant percentage and still deliver the same operations. And again this return on investment was 90 days after installing SimManager worldwide including their supply chain.

Moving onto to enterprise simulation again as our multi-discipline SimManager and SimXperts driver very high ROI. How do they do that. They greatly reduce physical prototype testing, greatly improving engineering productivity, integrate all global resources. So lower cost reductions worldwide can now operate 24 hours a day through SimEnterprise as well as engineers not only in the United States and Europe but China and India and then fully integrate their supply chain. Manufacturers are moving engineering from a single discipline to a multi-discipline environment. And whether it is the Lloyd’s press release or Alenia’s symposium that they held on multi-discipline environment for product development the real benefits are clear. So MSC is moving from – and evolving to become the systems integrator for all CAE.

And looking at industries and I hope this is not too long-winded for you. And looking at industries in our visibility, number one is as of today there is no demonstrable change in our pipeline visibility. Bigger deals have been in the cycle for approval and have high ROI. Our customers are moving to phased deployments which give us better funding and visibility. MSC’s SimEnterprise solution is now on the radar screens of CTOs, CIOs, and even CEOs to help drive virtual collaboration and innovation.

Americas and Europe tend to lead the new IT initiatives and Asia Pacific tends to follow. In the last two weeks or in the last two weeks I spent in Europe with our major customers in a number of countries. And obviously given the macroeconomic environment I asked all of them what they were planning on doing in ‘09 versus this year. And virtually all of our major customers are planning on investing more with MSC in 2009 and 2008 and is because the multi-discipline environment clearly drives product development whether it is aerospace, auto, major telecom company consumer products, wind generation. Every industry is focused on how to develop better products, faster, cheaper and get to market.

And thinking of aerospace, which is our largest industry and aerospace is not only aircraft by it is satellites, (inaudible), helicopters et cetera. And this industry today has over a four year backlog in terms of making products. So what does that mean. The drivers in IT investments are clearly very high for the SimEnterprise solutions we deliver and we held conferences in Toulouse, Rome, Frankfurt, and Moscow over the last 2 weeks as well.

As regards to Americas, I received feedback and that was from a number of a major customers in the Americas. Quoting one of our major customers in their recent quarterly announcement, the Boeing Company Jim McNerney stated that they have heightened their focus on improving productivity and competitiveness throughout all their businesses worldwide. Auto and aero tier one suppliers are now beginning to move in this direction as well as evidenced by some of our order announcements for Q3.

In regard to new industries, we haven’t – our press releases are in the process of getting improved but we won a major mobile phone company for SimEnterprise. We also won a number of packaging and consumer products and though we’re gaining traction in alternate energy sources as well. And in fact alternate energy is going to be one of the hot markets moving forward and some of our special solutions like Rotodynamics specifically relate to alternate energy production. Next question.

Woo Jin Ho

So, Bill, so bottom-line your traditional and nontraditional vertical markets have not curtailed their interest in desktop simulation tools as well as data management is that right? Is that what you are seeing?

William Weyand

What we are seeing Woo Jin is because of the stage we are at with multi-discipline day simulation and with the stage we are at with SimManager and SimXpert and that the 375 companies doing pilots and using MD are now moving to deployment because of the richness of the functionality and the proven ROI. And then if you look at the SimManager and the SimXpert or the whole suite like Boeing or Alenia or Audi’s press releases or other we’re seeing a high degree of urgency in our primary industries to not necessarily licensing the software but clearly more towards capitalizing on resources not only in Germany and France but Poland and Russia and China and India where there are very talented but less expensive people and doing that through their cooperation as well as the supply chain. So, we’re solving a big IT issue and again with the release 3.2 this quarter and release 4 we think we will see – we’re cautiously optimistic that we will see continued investment because of the return on investment versus by (inaudible) software.

Like the Lloyd's announcement too. That is where we’re doing linear and nonlinear multi-discipline.

Woo Jin Ho

Right. Okay. Just an overlarge industry question, I believe we saw some share shift among the major PLM vendors. So, UGS and PTC, what would be the implications to your tools and desktop applications if there was such a shift.

William Weyand

Well we reported this quarter what our multiple products in SimEnterprise was we reported the traditional tools business and what that was as a percentage of the quarter. We are CAD neutral in terms of how we interface and support all those products. So we really don’t care whether they are using ProE or (inaudible). In fact if you look at our customer list you know, they are using all of those technologies.

Woo Jin Ho

Okay, and one last one from me. So I don’t know if you are starting your planning process for ’09, but what can you share in terms of some of the strategy in stabilizing the tools business even if your combine your MD and your tools you are still down 11% year-over-year in the third quarter. So is there anything that you could share with us in terms of the strategies, sales strategies, pricing or licensing strategy that you plan on implementing in ‘09?

William Weyand

So what you need to think about and I know you do and like any company we are reassessing our business plans as you see you know Q4 happens. We’re laser focused on our operating structure and as we announced in previous quarters we’re focused on continuous improvement. So if you look at the tools business and we mentioned this on my earlier – is that actually we saw some softening in Japan in Q3. That is number one. Number two the rest of Asia Pacific (inaudible). So the impacts of orders are over time. And three is that we have been over a number of quarters and number of years shifting part of our business from direct to channels partners. So when you do that what happens is you move from getting the gross value of the order meaning the retail price minus whatever the discount is to getting a channels’ price for the order. So what happens is as you go through that change you almost take a little bit of a step down even though the units are attractive but the step out. We’re continuing to add and drive our channels business on a worldwide basis. And what our customers are really doing is starting to move more aggressively from standalone tools to our MD solutions, both in the department or division or the whole company worldwide. So we’re moving from our tools to MDs and upgrade. So it is really – if you put MD together with our traditional engineering software tools that is a similar market. One is just a more robust, more better ROI solution.

Woo Jin Ho

Okay, thank you.

William Weyand

You are welcome.

Operator

Your next question comes from the line of David Hines.

David Hines

Thanks. Sam just one housekeeping. What was stock-based compensation in the quarter?

Sam Auriemma

Stock-based comp in the quarter was $2.5 million and for the year-to-date it was $7.6 million.

David Hines

Got it. And then we saw a nice sequentially decline in sales and marketing expense I think as a percentage of revenue it is roughly 32%. Is this level sustainable going forward?

Sam Auriemma

All of our expenses continue to move in the right direction. You know there are a number of things that impact that. The Euro exchange rate and the yen exchange rate and all the foreign currencies we do business can also impact those expenses in absolute dollars. So it is difficult to look forward and say you know where are those going to trend without taking a look at and really taking into account the FX. Also our sales are heavily impacted by FX as you – as you might imagine. Over two-thirds of our revenue is coming from overseas locations. And we have had a nice tailwind here for the last three or four quarters with respect to the foreign currencies and you know if you go too far and see what has happened to the Euro over the last quarter. So as you look forward to that you can imagine we will have some declines in those expenses in the coming quarters as well as difficult comparisons on top line. So, we’re monitoring the business we continue to take a look at it and we continue to look at our expenses. Overall in constant currencies we continue to be focused on expense reductions wherever we go streamlining our occupations as we talked about in Q2 making our business more efficient.

David Hines

Got it. And you guys have done a nice job with the expense controls. And Bill, I guess can you just update us what you have seen since the close the quarter. We heard commentaries in the industry and I guess as recently as this morning from Autodesk that business really dropped off in October as customers were unable to secure credit and you know projects were delayed. I guess, can you just help me reconcile kind of the conservative commentary we have heard with your fairly bullish outlook going forward.

William Weyand

Well, obviously we’re very focused on the macroeconomic environment and the significant uncertainties that are out there. And we understand that the business is kind of tough right now in a lot of areas. When the cycles happen is that it tends to be that the enterprise side of the company and the high ROI projects that drive cost reductions and improve productivity tend to move ahead and that is why we have a very productive Q3 and that is why we are cautiously optimistic of it going forward. Having said that you know, you don’t know whether a project gets funded until it gets totally funded. So our software truly enables a reduction of again physical prototypes. It truly integrates and this was a quote by one of our major automotive companies that said, MSC is now our systems integrator for all CAE and what does that do. It drives having it all integrated, more efficient globally but it starts them in the process of reducing all these standalone proprietary tools and having less suppliers, saving multiples of maintenance and moving to a multi-discipline environment. It is tough out there. If you look at Whirlpool’s announcement spend recently 5000 more employees are departing because of the lack of sales I can tell you that they are accelerating the deployment of our SimEnterprise because it is cost improvement as well as efficiency improvement on their products and it directly affects, which they have said in their previous press releases, it directly affects and improves their warranty expenses.

So I think that it is clearly uncertain at the low end of the market and I think that is probably a little bit of what Autodesk had to announce. What we don’t have great visibility on is the sales of (inaudible) software. What we do have great visibility on is through our Salesforce.com system is all orders over 50,000 but while we’re seeing real consistency there is no change in the pipeline of orders over $100,000, $200,000, $500,000 and a lot of million dollar projects. So we’re not there until we are there in terms of Q4 but we think that because of the demonstrated ROA and the successes in the installed base that we have that in our 45 years of history in this industry and being with the major players that they will invest in good times and possibly even be a little countercyclical to the business in their industries because they’re driving to improve costs and improve productivity.

Sam Auriemma

But our model this is Sam, our model is a little different as well. We tend to be the very back-end loaded and a lot of our business will occur in the December period. And that is just the nature of our business. I think we discussed that a number of times. So like Bill says, you don’t know until you know where we’re at and what projects will get funded and what projects won’t get funded.

David Hines

Got it now that is helpful. And I guess just one last housekeeping, where are we in terms of core carrying sales reps?

William Weyand

It is down as we transition and we transition a number of countries into an indirect model in Q3. Those people either left our company and or joined our new channels partners. And secondly, we do like any other company based upon performance you transition and change people. So, we’re down approximately 20 to 25 people end of Q3 versus end of Q2. And again we transition three countries to a channels model versus a direct model. And again it is part of our continued improvement of infrastructure restructure and the cost structure.

David Hines

Great. Thanks a lot guys.

William Weyand

Thank you.

Operator

Your next question comes from the line of Michael Coady.

Michael Coady

Hi thanks. Good morning. You have talked a lot about the macro economy and you are improving products and I believe on the point, but just curious what specific impacts you are seeing as a result of the increased uncertainty in the economy. Whether that is delays or elongated sales cycles or just whatever.

William Weyand

Well there is no question that there is a high degree of uncertainty particularly as you move into this stage of Q4 and what the stock market and the market’s experience in October. So that is one. Two is that most of our customers that I have met with over the last 30 days, and this is a high percentage of them, are it is not business as usual but they need to continue to invest. As an example, Airbus, they are now moving had on the new 350 aircraft. They are investing very heavily in their infrastructure with MSC software to accelerate product innovation on the 350. That also have a special project that a lot of you are aware of called the EADS Phoenix project and that is to correct their IT infrastructure. They selected PTC for data management and they’re moving to select some other strategic partners as well. So and if I look at aerospace or satellite or helicopter business this is a high ROI solution that benefits their company not only in technology but significantly from a cash standpoint on physical prototype testing from a engineering testing standpoint globally and from knowledge capture and reuse. Part of a technology in SimXpert is basically this template, knowledge capture and reuse. Most of our customers see that as becoming their intellectual property. So what does that mean? Is that in the past in simulation they always were reinventing the wheel. Now they can have their best engineers design a solution and that solution moves into simulation solution, that moves into a template and are reused and it becomes intellectual property for the company. That is a huge asset and it allows for them to move much faster. So yes we are concerned about the global position. We’re concerned about the low-end of the market. I think on the enterprise side we’re a little bit more comfortable.

Michael Coady

Okay, thanks and given the change we have seen in the economy in the last call it last six weeks how has the M&A landscape changed, are you seeing any more opportunities with some of the smaller companies as well fortified to weather a downturn may be looking for an exit strategy. Can you just talk about that please?

William Weyand

Well in regard to the – again MSC’s fundamentals remain strong. In regard to our acquisition philosophy. We have done a number of technical tuck-ins. I think you will continue to see us do that. We’re also looking at acquisitions in today’s market at reasonable values that might add size and scale to MSC. We do have a very good cash position and you are also very correct in today’s market evaluations and expectations are a lot different than they were six months ago. And we continue to pursue again lots of opportunities there. This is a consolidating market and whether it is technical tuck in advantages or onto that size and scale industry-specific it would take us into new industries as well as make us the de facto standard in the industries where we are already very heavily in.

Michael Coady

Okay, thanks. And then just one last question for Sam. You mentioned that OpEx will fluctuate placed on FX, but you’re going to continue looking to lower OpEx on a constant currency – on a constant currency basis. Does that just continue one indefinitely. I mean you can’t lower OpEx forever, obviously is there some point you have targeted in early ‘09 for example or you think on a constant currency basis OpEx would be at a relative bottom.

Sam Auriemma

Yes that is a good question. We do – we’re through the heavy lifting on the product development cycle. And so we have made – we have trended up there. A lot of the sales force as Bill talked about in the past has been retooled and G&A, we’re looking for ways to cut costs. So more than ever we’re starting to look at Street numbers of other companies our size and shape and trying to model more closely to their operating model than we have in the past. So yes, we are looking at every cost inside the company mindful of the environment we are in and mindful of the volatility of the business. And we’re trying to move towards a much more normal operating structure. And you can continue to see the amount of severance charges and restructuring charge the business takes as we attempt to resize and come in line with our operating expenses.

Michael Coady

Thank you very much and good luck in Q4.

William Weyand

Thank you.

Operator

Your next question comes from the line of Barbara Coffey.

Barbara Coffey

Yes, as you are taking a look at the direct versus indirect sales, can you talk about the – are your resellers seeing a different environment than the large guys who are saying seeing. Enterprises don’t seem to be hit getting hit that much. Are your resellers seeing a different environment selling potentially interest into more smaller and medium sized businesses?

William Weyand

This is Bill. It is probably too early in the quarter for us to be able to assess that with any validity. Obviously October was wild period for all industries in the whole economic environment. We have been again moving to a whole more indirect partners model. We’re very strong in Europe and in a lot of countries and industries in an indirect model. We transitioned Brazil in Q3 to an indirect model, Malaysia and Australia to an indirect model in Q3. So what am I leading up to is that and these partners not only sell our traditional engineering tools but a number of them are sophisticated enough to sell our MD solutions as well. As Sam also mentioned our quarters to be more back-end loaded because of it. So we’re clearly focused on the uncertainties that are happening and monitoring it very closely. But we don’t have data yet to say that it is going to impact our business other than I did say earlier that Japan which is traditionally a tools market has been affected. One of the other questions people asked about, was the Americas in regard to the auto industry being down for several years, we have been focused on obviously supporting Detroit but also really the supply chain. And when you think of the major and non domestic OEMs like Honda, Toyota, Mitsubishi, Or Hyundai or whatever is that we are doing very well in the US marketplace for automotive just not as much spending taking place by the big three in Detroit.

Barbara Coffey

Thank you.

William Weyand

You are welcome.

Operator

Your next question comes from the line of Mark Schappel.

Mark Schappel

Hi, good morning, this is Mark Schappel. And first question for you Sam. Headcount at the end of the first quarter, do you have that handy.

Sam Auriemma

Let me look that one up. You have any question to follow up on that we will get to?

Mark Schappel

I do. Actually it goes to you again here. So with respect to your prepared remarks on the fourth quarter Wall Street estimates. Is it fair to assume that you think the Street estimates for both top and bottom line should come down?

Sam Auriemma

Well you need to look at it carefully from a number of aspects. You know again two thirds of our business does come from outside the US. And through the first three quarters we have really had a real nice tailwind from FX. I don’t know if you paid attention to what those rates have done but since September 30, Euro for example has had a difficult time. So, while we don’t give specific guidance we would push in the direction to look a look at those rates and see whether they’re at. For example, last Q4 ‘07 was impacted favorably by $4 million in FX from the prior year and that rate for Euro exchange rate is higher it is today. So let us be cautious here looking forward and what they do with the business and be mindful where our business comes from as we look at our results. And also clearly the macroeconomic picture is something that it is going to unfold for us here in the quarter and we get our businesses way backend loaded. So we won’t know until we know when we get there if what will get funded and what won’t get funded and you know, markets like this tend to make buyers and folks irrational and try to look at expense structures wherever they can.

William Weyand

Thanks, Mark.

Mark Schappel

Thank you. And final question for Bill. With respect to the North American sales force, there has been a lot of turnover in that organization in the past and a lot of disruptions. I was wondering if you can just bring us up-to-date on what you are seeing as far as turnover trends go into North American sales organization?

William Weyand

First of all we are structured by – in the Europe and Americas by industry. So, we have a dedicated Aerospace and defense organization and a dedicated automotive and a dedicated manufacturing, which also includes our channels business. So that is number one. And that is how we are organized in Europe and the Americas and parts of Japan are with over 50% of our Japanese revenue is automotive. It is focused on that. So, that is number one. Number two is that other than for performance reasons and or going indirect I would say that our turnover is relatively low at this stage and our cycle of training and changing to an ROI selling model versus a tools features and functions.

Sam Auriemma

Okay, Hi Mark let me get to you on the headcount question. We had a 1056 hefty average during Q3. What I got you on the phone there has been a question that was raised in here that I want to point out, our deferred revenue is up from a year ago, Q3 to Q3. It is down greater sequentially than it was a year ago. We went from 95 to 77 and that is a – that is greater trend than we have seen in the past. I will point out that deferred revenue increased $10 million from Q2 to Q2. And that was – and that is against a decrease in the prior year. So the message there is you know, deferred revenue is tied to the timing of renewals, when they come in and when they are booked and it tends not to trend on a business activity level, but it tends to trend on a renewal basis. So, most of that has occurred – has occurred in the deferred maintenance line. If software deferred revenue has continued to average between $21 million and $26 million in the quarter and so most of it, so most of that in this quarter in the deferred maintenance line.

Mark Schappel

Thank you.

Operator

At this Mr. William you have no further questions. Sir, do you have any closing remarks.

William Weyand

Thank you; yes, I do. Well let me summarize. And again thanks for all dialing in. The underlying fundamentals of MSC continue to remain to be strong. Our SimEnterprise products allow customers to collaborate and integrate globally. Companies with development centers in many places around the world can now leverage their intellectual assets across the global operations as well as the supply chain. We have a very solid balance sheet with healthy cash positions and we are clearly going forward looking at the opportunity for acquisitions and the consolidating market at reasonable values. We clearly remain mindful of the macroeconomic environment, yet we believe that the technology providers with proven and transformative products with tangible cost savings that provide real productivity gains will be favored in uncertain economic cycles. Thank you.

Operator

This concludes today’s conference. You may now disconnect.

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