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Executives

Joanne Keates – VP, IR

Sam Auriemma – CFO and EVP

Ash Munshi – Interim CEO and President

Analysts

Kevin Liu – B. Riley & Company, Inc.

Barbara Coffey – Kaufman Bros.

Mark Schappel – Benchmark

Charles Frumberg – Emancipation Capital

MSC Software Corporation (MSCS) Q1 2009 Earnings Call Transcript May 7, 2009 4:30 PM ET

Operator

Good afternoon. My name is David and I will be your conference operator today. At this time, I would like to welcome everyone to the MSC Software Q1 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. (Operator instructions) Thank you. Ms. Keates, you may begin your conference.

Joanne Keates

Thank you for joining us this afternoon to discuss MSC's first quarter financial results. On the call today from MSC, we have Ash Munshi, CEO and President; Sam Auriemma, MSC’s CFO, as well as John Mongelluzzo, our Executive Vice President. I’d like to point out that the financial slides for this call are available for download from our website at www.mscsoftware.com/ir.

Before we begin the call, 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 conference call are 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-Q and our 2008 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.

Sam Auriemma will open the call today. Please go ahead Sam.

Sam Auriemma

Well, thank you, Joanne, and good afternoon to all of you MSC's first quarter call.

Before proceeding with this call, I will make some opening comments regarding our interim CEO and our CEO search. On March 12, 2009, Ash Munshi was named Interim CEO by our Board of Directors. Let me give you a little background on Ash. Ash has a unique history and knowledge of MSC and the software business in general. As a member of the Board of Directors of MSC since 2005, he has kept abreast of the company and its operations.

As a technologist, he has gained broad industry expertise and business experience at companies like Oracle and Silicon Graphics. Additionally, he has been the founder of a number of technology and Internet-based businesses; so he brings an entrepreneurial spirit to MSC. Ash clearly understands the assets of the company and our technology franchise and will work during his tenure to enable maximization of those assets and he will talk about his goals as Interim CEO in a moment.

I also want to review the status of the CEO search. The search firm of Hendrick & Struggles has been hired by the Board and the search is under way. The Board is making good progress going through the candidates and they are on schedule. So with that, I will turn the call over to Ash.

Ash Munshi

Thanks, Sam, for the introduction. I'm delighted to be on this call as a participant as opposed to a listener. I'm equally pleased that the Board had enough faith in me to ask me to step in as Interim CEO. Over the past roughly 60 days, I spent a lot of time speaking with employees and customers while assessing the needs of both. In addition to directly speaking with many employees and customers one to one, I have also commissioned an independent third-party customers survey to determine our strengths and weaknesses. It is my goal to make certain that the issues identified from this are addressed in a timely fashion.

I have been delighted to discover that our customers are very loyal in spite of the fact that we have made it occasionally difficult for them to work with us. Our core products, particularly MSC Nastran, are still considered to be market leading. However, we are being increasingly challenged by competitors even in our core strength areas. We as a company need to address this immediately. It is also true that our vision and strategy around making simulation and enterprise offerings resonates well with those customers who are sophisticated and that uses the simulation technology.

Switching for a moment to the employees, MSC possesses some of the world's experts in the areas of simulation, software development and simulation physics. Many of these employees have been with the company for a long period of time and continue to pour their heart and soul into the technology that constitutes the company's products. Indeed, they are eager and hungry to win and reestablish MSC as a leader in this space. Customers in fact often seek out our world-class experts in order to solve their toughest problem thus making MSC a unique asset.

Internally, there is significantly more cross-functional activity with the customer as his focal point. Quality and ease of use along with stringent requirements for both have been articulated and are being implemented. I have seen a marked improvement in employee engagement along with feedback, both positive and negative, in the last two months. Open communication is highly encouraged and every suggestion is evaluated on its own merit. Many of the actions that we have taken undertaken organizationally have been initiated by the employees themselves. We're rewarding talent, nurturing its growth, and supporting our staff across the world. There is a palpable improvement in the energy within the company.

Let me address competition. Our results over the last few years clearly indicate that we have been losing market share and performing sub optimally. It is imperative for us to reverse this trend. Competition has been fielding products, which has good quality and is easy to use. Additionally, they have consistently deployed more technical resources in the field to support customers. Both of these trends are easily reversible and we are aggressively taking steps to remedy the situation. I have put in place a number of initiatives which include re-examining our pricing, making QA and release a top-level function within product development, hiring additional application engineers and addressing product ease-of-use.

In order to ensure plentiful supply of engineers trained on our product, we have instituted a University Advisory Board comprising leading universities across the globe. Additionally, we are leveraging this Advisory Board to inject new and disruptive technologies into our product development organization. From a sales perspective, we have removed layers of sales management in order to fund more customer touching resources and create cross functional attack teams to ensure improved sales performance in this quarter and beyond. These changes are intended to be cost neutral. The organization, and I mean the entire organization, has received these changes willingly and is energized by them. While changes can be painful, employees have embraced them wholeheartedly.

The current economic climate to state the obvious is challenging for everyone. There's no question that customers are hesitant to place large orders and are evaluating orders on a very near term return on investment. While license revenue has declined as expected and consistent with the rest of the market, our maintenance revenue continues to hold. Sam will address this shortly. The remainder of this year will likely be challenging but we are cognizant of making certain that our costs are in line with our business performance. It is likely that many of the actions being taken will positively impact our ability to close more business. Putting the customer in the center of everything we do I believe is the winning strategy.

My goal during this period as Interim CEO is to leave a lasting fingerprint on the culture of this company and to assure that my successor will have my guidance and feedback ongoing as a board member. Sam?

Sam Auriemma

Thanks Ash and welcome.

Ash Munshi

Thank you.

Sam Auriemma

Let's talk about our financial results for the first quarter, March 31, 2009. Total revenue for the quarter was about 53.6 million and that is down 12% from 61.2 million in Q1 2009 and that is in line with our guidance. It is clear however that the global economic downturn continued to impact our revenue in the first quarter, actually fairly equally across the three global regions in which we operate. I will start by individual categories of revenue.

Software revenue from the first quarter was 17.4 million and that is down about 4.6 million compared to last year. We believe this decline is due to customers reevaluating all levels of expenditures including software budget and IT spending and general cost reductions in their department. The next slide sets forth for the last five quarters proportionate license revenue represented by our products. SimExpert and SimManager products together with MD product revenue represented about 37% or 6.4 million of total revenue in the first quarter.

Let us take a look at maintenance revenue for the quarter. Maintenance revenue for Q1 was 31 million and that compares to 33 million last year. Every quarter we have customers that reinstate their maintenance revenue and that resulted in increasing maintenance for that quarter. We did have customers reinstate their maintenance revenue in both Q1 09 and Q1 08. However, the net effect was maintenance revenue was increased last year by about 1.5 million more in Q1 than this year. So (inaudible) maintenance was essentially flat year-over-year. This part of our business continues to perform well and our renewal rates are holding. But we are monitoring closely our customer's renewal rates. I'll talk a little bit more about what we're doing to sustain our m maintenance renewal shortly.

For the first quarter, service revenue was 5.2 million and that compares to 6.2 million in Q1 2008. The decrease here is attributable to lower process implementation and post deployment service activities and that is tied to lower software license revenue in the quarter. Geographically for Q1, the Americas revenue decreased 9% to 17 million. In EMEA, we saw business contract by about 22% to 18.3 million. Changes in the euro there unfavorably impacted revenue by 2.7 and that contributed to the decline. In Asia, we saw revenue decrease 3% to 8.5 million and we had a favorable FX there by about 2.1 million. So in constant dollars, you have Americas down 9%, EMEA down 11, and Asia down 14%.

Let's look at the expenses. Gross margin for the first quarter was approximately 80%, software gross margin 87 and maintenance and service margin was 77. If you look forward, we expect gross margin to be relatively stable in the near term, assuming no significant structural changes in our business that is. We have ongoing cost reduction initiatives designed to align our operations and business model with the realities of the current economic situation. These initiatives include among other things headcount reductions, reductions in contract and services and reorganization of various departments. When complete, we believe restructuring charges associated with cost reduction efforts will be about 2.8 million. To date we have recorded about 2.3 million of those costs and we expect to recognize the remaining cost in the current year.

OpEx totaled 41.6 million in the first quarter and that is down from 53.7 million in the first quarter of last year. The next slide details the five quarter trends in our operating expenses. R&D, sales and marketing and G&A for the past five quarters are all moving in the right direction as a result of our cost containment initiatives. Taking into account the aforementioned factors, the company reported operating income of about $1.5 million compared to a loss of about 4.5 million in Q1 2008.

A quick look at income taxes, our effective tax rate in the first quarter was 62%, basically because of low pretax income. This resulted in net income of 147,000, just about break even on an EPS basis. EBITDA for the quarter was 3.9 million as detailed on the chart on this slide, and just a quick note, total comp in the quarter was 1.4 million, and that is down substantially during the quarter, primarily due to corporate credits or canceled invested equity awards.

Turning to some other financial metrics, deferred revenues stood at 75.5 million, down slightly from 75.8 at year-end, and that's basically due to lower bookings during the quarter. In the first quarter, we used cash in operating activities of about 1.7 million and that compares to cash provided by operations in the last first quarter of 16 million. Basically changes in cash generated by operations, lower cash earnings, collections of accounts receivables, changes in deferred revenue, all associated with lower bookings for the quarter, generally accounted for the decrease in cash flow. Our cash and investments at March 31 was 149.1 million. CapEx in Q1 totaled 200,000 and we expect CapEx to be no greater than 5 million in FY 2009.

Let's look forward and talk about our business outlook. The following assumes no further deterioration in the global economic outlook and relatively stable currency rates. As we look forward to the second quarter, we see revenue in the low $50 million range, which when taken together with Q1 revenue brings us in line with our guidance for the first half of 2009, down about 15% in terms of total revenue. For the back half year, we see revenue down 12% to 15%, plus or minus a couple of percentage points on either side from the prior year. We will continue to manage our cost structure closely weighing the needs of our business as we move through these difficult times. For Q2, we see our expense structure roughly comparable with Q1 in the operating expense categories, R&D, sales, marketing and G&A.

The issues that we will closely monitor given the current economic downturn, we are reviewing automotive industry issues, and for that matter, similar issues in other industries as well. We are laser focused on maintenance renewals and we have formed a task force to be sure we closely track key maintenance renewal transactions, to accommodate customers requirements in these tough times, and on an ongoing basis we're looking at our pricing and packaging. And lastly and most importantly, we have a continuing commitment to align our workforce and our business processes in order to make improvements in our cost structure in an effort to improve our results and turn inefficiencies against current business trends.

At this point in the call, we will take some Q&A. Operator?

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Kevin Liu.

Kevin Liu – B. Riley & Company, Inc.

I guess on the first question I was just wondering in terms of improving the customer experience, what sort of incremental expense would you expect to incur as we move throughout the year or would you expect some of the cost savings that you guys are about to realize just get pushed towards these initiatives?

Ash Munshi

As I said earlier, this is Ash – Kevin, thanks for asking. As I said very clearly, it is going to be cost neutral. We're going to remove cost from other parts of the organization in order to fund all of these efforts.

Kevin Liu – B. Riley & Company, Inc.

Okay great. And then in terms of some of the pricing actions you guys are contemplating at this moment, could you just talk a little bit about the competitive landscape in terms of where you feel your pricing stands relative to the competition and then perhaps in what areas you might need to take significant action?

Ash Munshi

You know I think that is a fairly complex question because it is not just pricing but it is also the licensing model that is out there. So this is a question I think that probably should defer because it is a very complex answer.

Kevin Liu – B. Riley & Company, Inc.

And then last quarter you highlighted or you guys highlighted a couple of different areas where you might be able to move outside of your core customer base, I think alternative energy, and specifically wind power was one area. So I was wondering what the update was there in terms of your ability to engage potential customers and whether you would expect that to have any sort of impact in the current year.

Ash Munshi

We have got extensive marketing efforts in sort of what I would call adjoining markets, particularly as you mentioned the wind energy market. The number of leads that we're generating continues to grow in all those markets and the customer engagement continues to increase in all those markets and in particular wind energy as you identified.

Kevin Liu – B. Riley & Company, Inc.

Great. Thanks a lot.

Operator

Thank you. Your next question comes from the line of Barbara Coffey.

Barbara Coffey – Kaufman Bros.

Yes. As you're talking about the customers and to salespeople, what are sort of the customer pin points that MSC historically has addressed and ones you have sort of left on the table that you can modify now with cheaper pricing like sort of – what are your plans specific, what are the pinpoints the customers are asking you to address and make better?

Ash Munshi

Well I think we touched a little bit on pricing and general issues around price, that is clearly one issue. But I think more fundamentally, ease of use of some of the products is a concern. You know that we have not potentially been tracking as well as some of our competition relative to that. GUIs in particular is the three letter acronym that I would like to throw out there as being an issue for us. We are aggressively going after and fixing that problem and I would expect that we would be able to field a competitive solution not too long in the future.

Barbara Coffey – Kaufman Bros.

And when you're talking about working with universities, can you talk a bit about how you're approaching them?

Ash Munshi

A number of different ways. One, as I mentioned, we formed a University Advisory Board. The intent is, the Advisory Board meets roughly twice a year in order for us to be able to get feedback from them, not only in terms of the courseware and materials that will need in order to teach using our products, but also to talk about new technologies and new application domains for our products. You know I believe universities are always the vanguard of some of these leading industries. Being involved with them, being able to give them our software and working with them closely enables us to address emerging markets very, very effectively, and that is clearly one goal. The second part frankly is to create as much as possible a set of engineers that are trained on our products and the only way that is going to happen is that we have courseware and courses that teach usage of our products.

Barbara Coffey – Kaufman Bros.

Thank you.

Sam Auriemma

Hi, Barbara, this is Sam. Before we leave this, had a couple of questions, pricing from two different people. So I didn't want to make this a total pricing story. I mentioned in the prepared part that it was packaging and pricing, so we're looking at not only pricing but we're looking at the way we package some of the offerings for customers in more logical bundles that will enhance our experience going forward, rather than just a pure pricing exercise. So I just want to leave you with just the thought that we are cutting prices. There is more – there is really more to it, and as Ash said, it's a complicated story, but it is not only pricing, it is packaging and licensing as well.

Barbara Coffey – Kaufman Bros.

Thank you.

Operator

And our next question comes from the line of Mark Schappel.

Mark Schappel – Benchmark

Good evening. Sam, starting off with you, if I heard you correctly in your prepared remarks, you said that foreign exchange was favorable 2.7 million from Europe and it was offset by – unfavorable 2.7 million, offset by 2.1 million in favorable foreign exchange from Asia, is that correct?

Sam Auriemma

That is right. So let me give you it again. The euro unfavorably impacted revenue by 2.7 million, Mark. So the euro went down. In Asia, we saw revenue decrease 3% to 18.5 million, but we had favorable impact to revenue of 2.1. When you net those together, overall it is 600,000, and I didn't mention it because it isn't an immaterial amount. But when you look at the components of that, you need to be careful, because Europe is down 22 and Asia was down – excuse me, Europe was down 2.7 and Asia was up 2.1.

Mark Schappel – Benchmark

Okay thanks. And Sam could you revisit your prepared remarks once again about maintenance revenues? Your thoughts on maintenance revenues in the quarter?

Sam Auriemma

Yes. So maintenance revenues were down a couple of million year-over-year. In every quarter we have some level of customers that catch up to us. So in other words they will pay – they will be off maintenance for a period of time and then they were on – and then they come back on maintenance. When they do that, they have got to pay the maintenance in arrears, okay. So we have a little bit of that every quarter, customers may come back into the fold. Year over year, we had $1.5 million less of that catch up revenue in Q1 2009 than we did in Q1 2008. So when you net that out, you are just about flat year-over-year in overall maintenance revenue. Did I clear that up, Mark?

Mark Schappel – Benchmark

Yes. We can talk further off-line. And Ash, could you just provide – with automotive being a significant sector for MSC historically, I was wondering if you would provide some additional details on what you're seeing in that sector given the turmoil that has been through there?

Ash Munshi

Sure Mark. In the US, clearly the automakers are more challenged than in other places. We're definitely seeing deal sizes become smaller, and as I mentioned in my prepared remarks, they want to see sort of near term ROI when they make the purchases. In Europe, there are a number of automakers that are still doing reasonably well, and they are investing in what I would call much more strategic programs and the size of the deal there are larger. In Asia, we're seeing a mixture of both. There is both some long-term investments and there is some cautious short term investments.

Mark Schappel – Benchmark

Thank you.

Operator

And your next question comes from the line of Charles Frumberg.

Charles Frumberg – Emancipation Capital

Thanks for taking my question. Ash, I just have a quick couple of questions. I didn't hear anything specific about or even general about what your plans are or thoughts are about operating margin profitability, operating margins profitability generally sort of where you want to take the direction and how you are going to get there?

Sam Auriemma

This is Sam. I will take this one.

Charles Frumberg – Emancipation Capital

I would like Ash to take it, Sam.

Sam Auriemma

Well, let me take it and then Ash can fill in the blanks, if you don't mind. So year-over-year, we reduced between 11 million and $12 million on the operating expense line which basically improved our operating margins in Q1 2008 – Q1 2009 from Q1 2008. We have made substantial progress in our quarterly operating expenses in a time when we've really seen some real tough product transition, and now we are seeing real tough economic times. As we go forward, we have not published what we would view as a long-time operating model in this business, until we get stabilized and we see where our operating margins could go inside of these operations. But a couple of things jump out. We continue to make good progress in all operating expenses each and every quarter. So Q1 2008, Q2, Q3, Q4 all show positive trends. So we are committed to keeping that laser focus on our margins, on our operating margins. When the business stabilize, I think where we go in terms of normal operating margins will come into play and be obvious to us, but right now I still think we are in a transition period. Ash?

Ash Munshi

I will just second that. I mean there is enough uncertainty both from a market perspective in terms of the turmoil that we're seeing, the uncertainty that we are seeing, that it is really hard to lock in on a set of numbers. Additionally, as we mentioned, we're going to continue to watch the expense line very carefully and make sure that it is in line with where the business is. So those are two focuses we are going keep on and we can't forecast the model at this point.

Charles Frumberg – Emancipation Capital

Well if you are multi hundred million dollar software company, there is lots of precedence out there; you have been on the Board from any number of years. I appreciate the fact you guys have done yeomen's work here in terms of realigning your expense structure and I applaud you for that. But reality is that couple few hundred million dollars in revenues in this business, which is essentially a people business, not even with, but especially because of the headwinds that you are taking because of your verticals and some of the revenue pressures, I mean maybe I am – maybe my assumptions are wrong here, but when you look at best practices companies even with trouble that are consistently delivering double-digit operating margin. You know so isn't this an issue of just basically setting out an operating margin goal and driving everyone up and down the organization towards the achievement of that. And to get there you actually have to state it? There is lots of precedence here. And Sam you and I have had this conversation before so and I don't mean to beat the dead horse but just the avoidance of discussion is telling.

Sam Auriemma

I don't think we are avoiding the issue nor do I think we are standing with our head in the sand. If you take a look at our operating structure, you have got to take a look at the improvement we have made, and you have got to take a look at the commitment the management has made to continue to improve that. There is still things we have got to do in this business, I mean there is still products we've got to bring to market, there's still salesmen that we've got to reach and markets still to attack. So we will continue to spend some money in those areas to achieve the long-term goals and objectives of the company and that is the best answer I've got at this particular moment in time.

Charles Frumberg – Emancipation Capital

Well I just look at recent sales as sort of a measure of new business and compare various operating expense categories against that and that has generally been historically a pretty good measures of productivity of expenses, so you're spending as much in sales, rough numbers off of this quarter albeit may be a depressed one, but you are spending as much in sales as you are generating in license sales. You are spending as much in sales and marketing as you are generating in license sales. And I just want to point that out. I don't want to initiate a public debate about it, but you know, it seems like you have a fair amount of latitude – fair amount of ways to go here to even drive your operating margin to what should be a more normative, competitive state.

Ash Munshi

Charles, I think we understand where you're headed. Perhaps maybe the best thing to do is for us to take a deep dive with you and take it off-line.

Charles Frumberg – Emancipation Capital

Love to do that.

Ash Munshi

But I hear you completely and I understand what you're pointing out. Suffice it to say that we also see the same numbers you do.

Charles Frumberg – Emancipation Capital

Okay. I appreciate you taking my call.

Sam Auriemma

No more questions, I'll turn it back to Ash for closing comments.

Ash Munshi

Thank you all very much for attending the call. Really appreciate the engagement here and we're looking forward to continuing to improve the operations of the company. Thank so much.

Operator

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

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