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MSC Software (MSCS)
Q3 2007 Earnings Call
November 6, 2007 10 am ET

Executives

Bill Weyand - CEO and chairman
Sam Auriemma - CFO
John Mongelluzzo - Executive VP
Eric Sand - VP of Finance.
Joanne Keates - VP of Investor Relations

Analysts

WooJin Ho - Merrill Lynch
Mark Schappel - Benchmark
Barbara Coffey - Kaufman Bros.
Andy Blum - Delaware Street Capital
Eric Singer - Riley Investment Management
Philip Alling - Bear Stearns
Roger Chuchen - Morgan Stanley
Stan Mann - Mann Family Investments
D.J. Hynes - Needham & Company

Presentation

Operator

Good morning, my name is Lisa, and I’ll be your conference operator today. At this time, I’d like to welcome everyone to the MSC Software Third Quarter Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer session. (Operator Instructions)

I will now turn the call over to Joanne Keates, VP of Investor Relations. Thank you Ms. Keates, you may begin your conference.

Joanne Keates

Good morning, and thank you for joining us today for MSC Software’s third quarter financial results. On our call this morning from MSC, we have Bill Weyand, CEO and chairman; Sam Auriemma, CFO; John Mongelluzzo, Executive VP; and Eric Sand, the VP of Finance.

After opening comments from Bill and Sam, we will hold a Q & A session. I would also like to add at this point that the webcast slide presentation is available and downloadable on our website at www.mscsoftware.com/ir. Now I’d like to make our safe harbor statement.

This presentation and the Q & A session may include forward-looking statements regarding MSC’s products, future operations and financial performance. Those statements are based on the current assumptions of the company’s management and are subject to risks and uncertainties that could cause actual results to differ materially. Information concerning those risks and uncertainties is contained in our most recent Form 10-K and Form 10-Q filings with the SEC.

At this point, I’d like to turn the call over to Bill.

Bill Weyand

Thank you Joanne, and good morning, welcome to MSC’s third quarter financial results. We are seeing positive signs in our customer activities and ongoing SimEnterprise implementations. In particular, we just completed, worldwide, our annual VPD conferences, experiencing record attendance, up significantly year-over-year.

We also announced some key technology partnership, which I’ll give you some additional color on in the call. And we also announced a number of key latch customer transactions, particularly in the aerospace industry.

We are also seeing solid activities with our Enterprise Simulation Solution, as evidenced by the Airbus, Audi and Honda announcements.

Going to geographical performance, America’s was up year-over-year in Q3, showing signs of improvement. EMEA was down slightly year-over-year (inaudible) specific was flat with last year.

There are a number of important wins that will help us in positioning. In regard to key customer wins in Q3, obviously the most exciting was the Airbus announcements, which I’ll go into more detail, as well as Audi, those are SimEnterpise new technology adoptions. When you go to ASRC Aerospace and Northrop Grumman. These are our traditional engineering solutions opportunities, and then on the right side, Mahindra Engineering, consulting services company to the auto industry as well as Honda expanding theirs.

Several weeks ago, in contention with our European VPD conference, we announced that Airbus has selected SimXpert as their solution to drive improvement for all commercial aircraft development. As well as they are implementing this across all European sites by the end of (inaudible). This is the first major company to adopt SimXpert in addition to [Fin Contrarian] and Whirlpool earlier this year. This is a major opportunity for us, a major expansion, and a sign of good things to come.

In regards to Audi, we announced the implementing of our multi-discipline solution and SimManager for creating an integrated simulation environment, and this is both in the linear and non-linear areas.

The third important announcement was ASRC Aerospace, a partner with NASA, and this is a new business opportunity for us in the traditional engineering solutions business.

In regards to Northrop Grumman, they’ve been evolving over the last number of quarters, to our mast key solutions, and this was evidenced by orders virtually every quarter this year from Northrop Grumman.

(inaudible), Mahindra Engineering, is obviously the leading engineering service company in India, and they have moved to utilize our technology based upon our being de facto standard in the auto industry.

Last but not least in terms of major order opportunities in the quarter, is Honda R & D, and they have adopted our multi-disciplined stimulation environment with MD Nastran, as well as utilizing our ability to simulate non-linear aspects of structures and NBH. This order was both in Japan as well as the Americas.

Also, looking forward in terms of Q4, in terms of product evolution and new product releases, we are announcing four product releases this quarter: Patran ‘07 R1, Adams Engine ’07 R1, MD Nastran R3, and MD Adams R3. So we’re continuing to invest in our traditional engineering solutions, (inaudible) well as the robustness now of our multi-disciplined products and offerings is far wider and more capable, and should accelerate as option.

Looking at individual product performance, again in Q3 we saw a nice improvement in our MD Solution adoption, with 54 individual orders, that’s up from 37 in Q2 to 54 in Q3. And I’ll think you’ll recognize a number of the important names here, not only in our traditional auto and airspace business, but also a number in high tech electronics.

With SimManager, we made progress also in Q3, with five orders of SimManager in Q3, that’s up from three in Q1, four in Q2 and five in Q3. This was technology, again that we introduced last year, and now with the breadth of release and functionality, and customers going through the evaluations process (inaudible) being a nice expansion here as well.

And last but not least, SimXpert, we went from four orders in Q2 to eight orders in Q3, of which the Airbus one is the most significant one, but each one of these orders is showing that this new technology just introduced, about 12 months ago, is beginning to gain better traction.

Looking at geographical and financial metrics. In terms of transactions over $100,000, was up from 70 to 79 year-over-year. Average order size was about the same at around $200,000. And new software transactions were up from 39 last year to 47 in Q3 of this year.

Moving on to our channels business, which has been a significant focus all year, we ended Q3 in terms of having 132 new channels partners, both premium resellers, which are the big major companies, as well as (inaudible), that’s up from 75 starting the year, and we’re on goal to reach and end this year with 150 resellers.

We are in the process of transferring a number of our accounts from direct model to channels model on a global basis, and as you are all aware, we have a direct sales force on auto, aero and what we call SMB in manufacturing.

Moving on in terms of important alliance partnerships announcements, we announced a partnership with T-Systems, they are the trusted systems integrator for a number of German companies including Daimler, Porsche and BEHR. This is in addition to our relationship with IBM, and this is because it is a systems integrator specifically associated with specific companies and specific accounts.

We also announced a very important architecture partnership with PROSTEP, in terms of open (inaudible) they are the leading provider of PLM integration, so this takes our technology and enterprise and easily integrates it with all product data management and CAB systems, etc. that are available on the marketplace.

The next major announcement we had for Q3, beginning of Q4, was forming an alliance with Vistagy. They are in the composites arena. This is basically taking, or moving from offline composite analysis to simulation driven design in the composite field.

And now talking about our partnership with IBM, we are very honored to receive the second award from them in one year, in April, the Beacon Award, and just earlier in October, we received from IBM the top award, the Information Management Award for solutions excellence. This is for product innovation, PLM infrastructure, and also drives business process automation.

So with that, let me turn it over to Sam to take a deeper dive into the financials.

Sam Auriemma

Thank you Bill, and good morning to all of you on the third quarter 2007 call.

Let’s talk about the financial results for the quarter. As we discussed in prior quarters, we continue to be in a product transition mode. The transition from selling predominately software tools, to emphasizing enterprise simulation solutions, requires recruiting, and in some cases retaining sales personnel throughout our regions, As well as making comprehensive presentations to our key customers that demonstrate the capabilities of these new software solutions.

Our expense to date is telling us that the selling enterprise solutions, is generally linked in the sales cycle, and that’s led to delays or caused our customers to rethink their purchases of our products for a variety of reasons, as previously discussed.

For the third quarter, total revenue for the three months ending September 30th, 2007, was $57 million and that’s a decrease of 2% when compared to $58.4 million for the same period in 2006.

For the nine months, total revenue was $175.6 million, and that’s a decrease of 9%, when compared to $196.7 million in the same period last year.

The decreases are primarily the result of lower software and services revenue.

Let’s talk about the individual components of our revenue.

Software revenue for the three months ended September 30th, 2007 decreased 12% to $19.9 million, and that compares to $22.7 million last year. The decreases are primarily attributable to lower sales of engineering products, and that’s resulting from the transition to selling enterprise solutions, some competitive pressures, and the impact of software products discontinued in 2006.

Foreign currency rates increased software revenue by approximately $400,000 in the third quarter. Enterprise solution revenue represented 14% of total software revenue, up (inaudible). And for the nine months, software revenue was $65.9 million, and that’s an increase of 21% when compared to $83.3 million in the same period last year.

The 2006 period includes $1.3 million of non-recurring PLM revenue. Foreign currency exchange rates increased software revenue by approximately $800,000 in the nine-month period. And during the nine months, total deferred software revenue decreased $2.1 million to $23 million.

Maintenance revenue for the three months ended September 30th, 2007 increased 9% to $31.6 million, and that compares to $28.9 million for the same period last year.

Foreign currency rates increased maintenance revenue by approximately $700,000 in the third quarter. For the nine months, maintenance revenue increased 8% to $92.3 million, when compared to $85.7 million last year. This increase is a result of incremental (inaudible) base in continued high renewal rates. Foreign currency rates increased revenue by approximately $1.8 million in the nine-month period. And during the nine months, deferred maintenance revenue decreased $1.2 million to $50 million.

For the third quarter, services revenues decreased 16% to $5.7 million, and decreased 29% to $17.4 million for the nine months, compared to the same period last year. This decrease in services revenues is primarily due to changes in our strategy in regards to services engagements. We have discontinued certain low margin services in 2006, as an overall management strategy, to engage in only those services that profitably support our software license activities.

Foreign exchange rates increased services revenues by approximately $200,000 in the third quarter. And additionally, the nine-month period in 2006 included $1.1 million in services revenue from PLN, and that’s an operation we sold in March 2006. (inaudible) Foreign exchange rates increased services revenue by approximately half a million dollars in the nine-month period. And during the nine-month period, total of deferred services revenue increased $400,000 to $2.2 million.

Geographically, during the Q3, the Americans contributed to 31% of our revenue, EMEA contributed 37% and Asia-Pacific contributed 32%.

As we have experienced in the past, there is a good balance of our revenue amongst our region, and this speaks to the global nature of our customer base and broad use of our products.

Turning to the deferred revenues, as we experienced last year from Q2 to Q3 2006, deferred revenues decreased modestly during the nine-month period by approximately $2.9 million to $75.2 million.

And let’s take a look at our expenses. Gross margin for the quarter improved to approximately 82% from 80% in Q3 last year. And our performance here continues (inaudible) due to operational improvements in the maintenance services part of our business. The company continues to concentrate on higher margin businesses in the service area and increases in maintenance revenues combined with cost controls.

Gross margins are generally comparable for the two periods at approximately 89%.

Let’s talk about our operating expense. Research and development for the three months ended September 30th, 2007 increased to $12.4 million and that is compared to $9.9 million for the same quarter last year due to higher employee related expenses.

Overall, the R & D expense as a percentage of revenue is a high level of more than 20% as the company continues to invest in a broad suite of products that Bill mentioned earlier and still not generating significant revenue from all those areas.

Average head count for R & D was 266 compared 253 in the Q3 last year. Significant to note here that R & D expenses (inaudible) outside consultants which are not included in the head count numbers presented in the slides.

Selling general and administrative expenses for the three months ended September 30th, 2007 were $32.9 million, and that’s a decrease of $5.9 million when compared to $38.8 million for the same period in 2006.

For that 2006 Q3, the company hit a series of special charges, a total of approximately $2.4 million, so excluding these charges the year over year decrease is approximately $3.5 million.

As we mentioned in the past, we will continue to focus our efforts on cost containment as we go forward, and look at many internal processes to see if further efficiencies can be made or sustained. Average head count for SG & A personal was 636, and that’s down from last year’s comparison of 702.

Operating income for the Q3 totaled $78,000 and that’s compared to a loss of $2.3 million last year. Net loss for continued operation totaled $122,000, are break even per diluted share. This compares to a net loss of $1.8 million of $0.04 loss from last year, so there’s an improvement there.

Operating loss for the nine-month period was $9.5 million, compared to operating income of $5.6 million last year. The restructuring charge of $8.9 million contributed significantly to the loss for the nine months.

Loss from continuing operation from this period totaled $5.1 million or $0.12 cents per share and that compares to income from continued operations at $2.1 million or about $0.06 cents a share.

Our effective income tax rate and continuing operations for the nine months ended September 30th, 2007 was 35.5 and that compares to 65.3 for the same period last year.

For the three months ended September 30th, 2007 the tax rate is unusually high because of changes in the estimated annual tax rate (inaudible) added during the quarter. The combined effects, which are disproportionately larger compared to the small pretax income we had in the quarter.

Turning to some of the other financial metrics, net cash provided by operating activities was 16.1 million during the nine months ended September 30th, 2007. That’s a favorable comparison compared to the cash used last year in operations at $2.4 million during that same period in 2006.

Depreciation and amortization during this nine-month period totaled approximately $10.1 million and capital expenditures ended during the nine months ended September 30th, 2007 totaled approximately $6.3 million and that is consisted of $2.9 million of the purchase of software source code and about $2.1 million for purchase of computer equipment.

Our DSO’s stood at 79 days at September 30th, 2007, and that’s a nice comparison to the 98 days at December 31st, 2006.

Improvement (inaudible) be a major focus for management.

Cash and cash equivalents at September 30, 2007 stood at $134.3 million and that compares to $126 million at year-end and the $129.9 million at June 30th, 2007. So at this time, the company will not issue any guidance, we will evaluate our decision to provide guidance in the future as we continue to move through this transition period.

Some of the factors that will contribute to this will be our improved visibility in the overall business, in our business outlook, and the stability of our expense structure.

And with that I’ll turn the call over to Bill for closing comments.


Bill Weyand

Thanks Sam.

As Sam just covered we continue to see improvements in our internal cost structure as well as improvement in our DSO and cash collection. Our key positive business signs are high customer response to our VPD conferences, our SimEnterprise, as well as our CORE engineering product solutions.

We did experience record attendance worldwide (inaudible) and this is driven by the value proposition inherent in MSC’s new solutions.

Keynote addresses in Detroit by Proctor and Gamble, Whirlpool, IBM and General Motors all focused on the importance of simulation driven design, as well as in Europe by Daimler and Audi, as well as key customers in Japan as well.

As we look at expansion of our business, we clearly are making progress as well in our channels business. We have a strong cash position today or over $134 million, we are clearly focused on building shareholder value, and we also realize we are in a consolidating marker and will participate when appropriate as well as are considering the use of the cash for additional stock buy back.

Before I turn it over to Q & A, I’d like to thank all of our shareholders and analysts that attended our one day event in conjunction with the Detroit VPD conference and you all heard directly from our (inaudible) in terms of our vision, product releases, strategy, and their level of enthusiasm for where we’re going.

With that, Joanne, let’s open it up to Q & A.

Question and Answer Session

Operator

(Operator instructions). Your first question comes from WooJin Ho from Merrill Lynch.

WooJin Ho – Merrill Lynch


WooJin Ho from Merrill Lynch. Bill, the engineering tool business revenue were quite a bit lower than even our reduced numbers and lower than what we had anticipated how do you go about bringing stability in this business and at what point do you see stability in this business?

Bill Weyand

Well first of all, in terms of the engineering tools business the new releases, I think, will be one of the assets (inaudible) configuration. The second is expansion of our channels partners, and third is we have introduced new marking programs in terms of our master key deployment to our small and medium size business customers, so we anticipate without giving any forward guidance that we are making progress although looking backwards the numbers don’t reflect that.

WooJin Ho – Merrill Lynch

Right. And then just to further the enterprise tools business, part of it also had to do with the confusion between the MD tools and the MD and the tools transition. Some of it may have abated as part of the VDP conference this past October. Can we ever see the combination of the tools business and the MD business growing at industry rates? We’ve seen your peers at DESO and Antis growing at 20 plus rates.

Bill Weyand

That is our overall objective (inaudible).

WooJin Ho – Merrill Lynch

Okay. So Sam, turning to the financials fairly quickly, what is the long term correlation of MSC’s revenue growth and profitability, so for example, if revenues grew in the mid-teens what is your targeted operating margin?

Sam Auriemma

At this point we have a post of a target-operating margin. I will tell you though, that coming out of the restatement period, all the systems implementation that we did during that time, these expense structures starting to show at least on the SG & A lines a pretty favorable comparison. As soon as that stabilizes and as soon as we get to more normal top lying growth as you pointed out, somewhere closer to industry standards, we should start to take a look at where our targets out. I will tell you that structure here for an enterprise software company really doesn’t look too far field in terms of overall operating margins for a company our size, so I would generally out us in the $50 million range.

And as you know, WooJin, in your analysis, volume is everything in the software business; the higher up you go in terms of overall software revenue the larger your margin expansion is. You just continue to amortize you costs over a larger revenue base without significant increases in either capital expenditures or facilities or operating costs. So for now this looks to me pretty well standard for a business our size, head count in control, and personnel costs and real estate which we’ve continued to do a pretty good job on overall cost control continues to be a focus on management and when we get closer to stabilization in our software rates and when we get closer to more normalized expense structures we’ll look forward to providing our overall operating margin targets to the community.

WooJin Ho – Merrill Lynch

Thank you.

Bill Weyand

WooJin, this is Bill. Just let me add a couple of comments to Sam’s. Just that he presented in terms of R & D, you can see that about 40% of our R & D is now offshore, versus it used to be 100% in the USA, so as we are investing heavily in terms of head count in R & D, from a dollar standpoint we should be probably peaking at this stage. So that’s number one.

And number two is in terms of metrics, Sam and I have been discussing after Q4, meaning starting Q1 with giving a lot more what I would call traditional metrics in addition to financial metrics. And last but not least, one of Sam’s initiatives and you can see that the progress we’re making not only in DSOs but on the GNA side, we’re looking at improving those cost structures as well and obviously removing things from onshore to offshore is one the objectives. So I just wanted to say on the cost side it’s a continual work in progress.

WooJin Ho – Merrill Lynch

Great. Thanks

Bill Weyand

Thank you.

Operator

Your next question comes from Mark Schappel with Benchmark.

Mark Schappel – Benchmark

Hi, good morning. Bill you mentioned in your prepared remarks there were I believe 54 individual MD wins in the quarter, I was wondering if you could just let us know what percent of total revenue the MD solutions comprised this quarter. I believe it was 13% the past two periods.

Sam Auriemma

Mark, this is Sam. This quarter it’s about 14%, and we talked about that in the prepared comments, so 14% for the quarter.

Mark Schappel – Benchmark

Thanks. And next question, during the past year, the company saw a meaningful increase in the government business and I was wondering if that trend continues into the September quarter?

Bill Weyand

Yes it did.

Mark Schappel – Benchmark

Ok great. Any particular industries you saw any special interest or special growth from in the quarter?

Bill Weyand

I think I mentioned this in my prepared script, but in regard to the aerospace industry or aerospace and defense, I think that everyone realizes that’s a (inaudible) market and growth industry for significant investment in commercial and defense, etc etc and we are well positioned to gain a lot of traction with our customer partners in the aerospace industry. So we see that as being incredibly robust of a long time to come. If you look at the auto industry, most of our announcements of orders happened to be in Germany and Japan, and some in Korea. Detroit has Detroit’s issues; however they clearly realize they have to invest in simulation if they are going to accelerate their product quality and product innovation.

And then last but not least, originally the company focused on just six industries and I think you’ll see continual progress as we move into not only ship building and consumer products and telecommunications and so on that our objective was to basically establish a model site this year for SIM enterprise and these new industries like [Fin Contrarian] ship builders (inaudible) Whirlpool and Kimberly Clark and I think hat we’re hopeful to have model sites in virtually every industry for SimEnterprise by the end of this year or Q1, therefore having high rev…proven results to take to them a broader market.

Mark Schappel – Benchmark

Thank you

Bill Weyand

Thank You.

Operator

Your next question comes from Barbara Coffey with Kaufman.

Barbara Coffey - Kaufman Bros.

Yes, good morning as you look at your pipeline of companies that are piloting your software can you sort of talk about how long the sales cycles you receive for companies across the board that sort of how long it gets from pilot to acceptance and how does that differ?

Bill Weyand

Barbara this is Bill I would be happy to comment on that. You know one of the challenges in our industry and the challenges of particularly moving into new markets is the ability to predict exactly when orders took place. Having said that--starting in Q2 of this year we have implemented salesforce.com worldwide and we are basically managing the selling process and the pipelines with salesforce.com and we are getting much better internal visibility on that.

Having said that your question is absolutely appropriate. The sale cycle for us in terms of SimEnterprises, SimManagers and SimXperts and MD has been longer than we first thought and its because they not only loved the ROI side of it which is the good news, but they have to change how they do simulation internally in order to capitalize on that.

So we originally thought the sale cycle for SimEnterprises was going to be anywhere from six to 12 months and the reality for the earlier doctor stage, which we’re close from moving from the early adoptive to the early majority is that the sale cycles have been as long as a year and a half. But I would say that looking forward and going into ’08 is that those sale cycles could be half of that meaning six to nine months.

Barbara Coffey - Kaufman Bros.

Does it change based on industry?

Bill Weyand

It actually doesn’t change upon industry, no that’s not true, let me correct it, the auto and aero industries are fairly structured either by vehicle programs or aircraft projects or military programs.

As you move out of those industries into appliances or hi-tech the cell cycles I think are going to be shorter as evidence by the whirlpool order in Q4 of last year and Whirlpool now talking in the Wall Street Journal and other publications about the significant return of investments they have received. And Whirlpool has announced to us that they’re going from just applying SimEnterprise in the US to deploying it worldwide in eight countries. So the industries that have lower margin and high vulnerability on warranty and packaging costs I think will be a significant opportunity in going forward.

For those that were at our VPD conference in Detroit, one of our key speakers European G announced that they were moving a manager form SimEnterprises later this year.

Barbara Coffey - Kaufman Bros.

Thank You.

Bill Weyand

You’re welcome.

Operator

Your next question comes from David (inaudible) with Delaware Street Capital

Andy Blum - Delaware Street Capital

Hey Bill, it’s actually Andy Blum.

Bill Weyand

Hi Andy

Andy Blum - Delaware Street Capital

I guess I keep coming back to the tools someone earlier alluded to your competitors seemed to be growing rather nicely, it just doesn’t totally add up to me. I still don’t understand where the growth is there and you’re relationship with INCAT really started how long ago, was it a year ago?

Bill Weyand

A year and a half ago in Europe and then it expanded to the Americas this year and then Asia Pacific at the end of this year, beginning of next year.

Andy Blum - Delaware Street Capital

I mean hey, did you see acceleration in Europe with the tools with them.

Bill Weyand

Yes.

Andy Blum - Delaware Street Capital

And so it just expanded into Americas, when?

Bill Weyand

This year.

Andy Blum - Delaware Street Capital

When this year?

Bill Weyand

We started the training in Q1 and the evolution of accounts in Q2 and Q3.

Andy Blum - Delaware Street Capital

And I’m sorry I missed that on Asia? When’s Asia supposed to be?

Bill Weyand

Asia is this quarter or next quarter.

Andy Blum - Delaware Street Capital

So we should expect things to pick up in the tools area presumably in the fourth quarter in Americas and sometime next year in Asia.

Bill Weyand

That’s correct as well as the new product we (inaudible) SimOffice which was just introduced literally at the end of ’06, 100% a channels product, MSC software is known as a high end, simulation companies just like a high end CAT companies, SimOffices specifically designed, manufactured in conjunction with Microsoft this is basically for the low-end mid-range markets. So, this is the first product we’ve had that directly goes into the 100% channels business and two, its designed to compete with mid-range low-end simulation technology.

Andy Blum - Delaware Street Capital

And you’ve really never had that before until now?

Bill Weyand

Correct.

Andy Blum - Delaware Street Capital

Well you historically have been a tools business, like everyone else, correct?

Bill Weyand

We’ve been a simulation tools company and (inaudible) non –(inaudible), etc. Correct.

Andy Blum - Delaware Street Capital

Well I’m not sure, I get confused between tools and channels, but historically you’ve sold through your sales channels?

Bill Weyand

That’s correct.

Andy Blum - Delaware Street Capital

And I guess the enterprise solutions is obviously a longer sales process, but I think there’s frustration out there that these smaller tools business has really not picked up when your competitors are and it doesn’t seem just a product issue I don’t know what (inaudible) are doing on their tools products, but I assume they’re always tweaking them and changing them a little bit, but it just seems like we’re either trying to high or the attaching ourselves to vistas is problematic. Is it any of those things?

Bill Weyand

As I mentioned earlier we have not had a low-end or mid-range product like some of the other simulation companies. SimOffices at first introduction and it is focused on the channels market and is focused on the mid-ranged (inaudible) like an auto-desk or solid works consolidation market place and that’s the market that is that is from the growing faster in the (inaudible) markets.

Andy Blum - Delaware Street Capital

Are you seeing any push through of the ten to one when you sign an Airbus and some of their suppliers follow? Are you seeing any of that start to kick in with the lower priced product, I assume that’s what they want, the lower priced product? And I would think you would see that really pick up in Europe, given you’ve been there for a while?

Bill Weyand

We are seeing it in the pipeline, taking it from the pipeline into the order revenue picture.

Andy Blum - Delaware Street Capital

So, all right, well thank you.

Bill Weyand

Thank you.

Operator

Your next question comes from Philip Alling with Bear Stearns.

Philip Alling - Bear Stearns

Thanks very much. I just wanted to get a little more color with respect to the modest decline in deferred revenue overall that you had in the quarter. Was that in line with your expectations? That also has sort of more specifically than the deferred maintenance revenue, there was a decline there a little more than a million dollars. If you could give a little more color on that and then just as sort of a final part of the question as to sort of expectations can be for normal seasonality maintenance renewal in the fourth quarter of the year and perhaps we’ll just start with those things here.

Bill Weyand

Phillip, there’s a number of parts to your questions I’ll try and take them in a general order. If you see last year and I think we mentioned it the last quarter conference call you know the software business in general tends to have lower activity during Q3 so we experienced that in 2006 when you saw a modest decline from the deferred balance in Q2 for the deferred balance in Q3. We saw the exact same thing this year from Q2 to Q3.

With respect to maintenance revenue you know over the long haul that’s really a question of timing and when those renewals come in and in some cases they come in more rapidly and they come in slower and that can have a significant influence on your deferred maintenance balance. So, as you book the businesses you record the deferred maintenances the (inaudible) over 12 months so its critical and what drives that number is the timing of those renewals so that could affect it significantly. I would call the decline in deferred revenues a pretty modest and very much in line with what we’ve seen in the past.

Philip Alling - Bear Stearns

And is there anything you could say with respect to trend and maintenance renewal rates?

Bill Weyand

Yeah, I think we’ve said in the past that we could. To experience high renewal rates, if you look at the overall maintenance revenue year over year it’s grown nicely. Customers clearly see value in those services we provide. They’re pretty active in the questions they ask, and the ways they use our business. That business gross also every time we sign new software license that adds incremental people onto the maintenance (inaudible) to increase that business, so that business has grown from the three months from 28.9 to 31.6 and for the nine months ended September 30th.

We’re up about $7 million so that’s a good business for us and companies like this really do well when you get to a mature software model or you’ve been around for a while you tend to have some nice maintenance streams.

Philip Alling - Bear Stearns

Okay, so what it is that you are trying to do to get to a point of increased comfort with respect to guiding investor expectations about the company’s financial performance, presumable you’re pretty comfortable about how things are going as far as the maintenance revenue streams. What can you share with us in terms of your comfort level as far as predicting the license revenue components of the business and are you where you thought you would be at this point?

Sam Auriemma

Yeah, we’ve mentioned it in the past. The software business when you’re in a transition (inaudible) is difficult to predict. The timing of new orders for this kind of product, there’s a number of variables that go on in the sales cycle hat make it tough to say when this type of business would close.

We’re relatively young in our enterprise software business and as we go through that we’ll gain more visibility and we’ve mentioned a couple of times we have salesforce.com deployed, which appears to be a good application for what we’re trying to get done here in terms of our visibility as we get longer sales cycles with our customers, excuse me, in longer time with our customers they become more experienced with our products, we’ll gain more visibility our sales force will come up to speed. Hopefully our process has come up to speed and we can begin to guide for the coming quarters.

Philip Alling - Bear Stearns

Sam, thank you very much

Sam Auriemma

Thank you Phillip.

Operator

Your next question comes from Eric Singer with Riley Investment Management

Eric Singer – Riley Investment Management

Hey guys. (inaudible) your buyback, you haven’t been in the market in a while and with the stock down at these levels what’s your view here?

Sam Auriemma

You know, Bill mentioned earlier about uses of cash. There are a couple of things you can do. We bought modest amounts during the quarter and we’ll continue to evaluate that as we go through. We have John Mongelluzzo with us, John do you have any other comments on that?

John Mongelluzzo

No, as we’re required we’ll continue to report those results in the 10-Q.

Eric Singer – Riley Investment Management

We can’t get a break out of what you bought now?

John Mongelluzzo

I can give you a break. It was about 50,000 shares during the current quarter, pretty modest amounts too.

Eric Singer – Riley Investment Management

And with your stock at these levels would you look to step that up or are you looking at other uses?

John Mongelluzzo

As Bill indicated we’ll continue to evaluate all capital requirements and all changes in our capital structure as we go forward. We’re in a consolidating market (inaudible) some opportunities we continue to look at overall expense structure and overall capital structure.

Eric Singer – Riley Investment Management

Okay thanks.

Operator

Your next question comes from Roger Chuchen with Morgan Stanley.

Roger Chuchen – Morgan Stanley

Hi Bill. I’ve just got a quick question for you. I just want to go back to your reference to potentially participating in MNA. I think it’s the first time you talked about it, at least in the prepared remarks. To that point, could you talk about what are the optimal conditions under which you would potentially participate in that scenario? Thank you.

Bill Weyand

As you recall in Q2, we did participate in terms of MNA in terms of acquiring pioneer systems. There are lots, secondly we are in a consolidating market, and third there’s a lot of interesting technology either industry specific or complimentary to our solutions, so therefore it’s much easier to buy than make in terms of that picture so all we are saying is that in terms of (inaudible) growing the company and not only organically but growing through acquisitions as well and then today’s stock price which you guys referred to earlier in the call we’d much rather use out cash to be inquisitive than using the stock at this stage.

Roger Chuchen – Morgan Stanley

All right, thank you.

Bill Weyand

You’re welcome.

Operator

Your next question comes from Stan Mann with Mann Family Investments.

Stan Mann - Mann Family Investments

(inaudible) you imply that you would start giving an outlook starting in 2008, somewhere in the call, is that accurate?

Sam Auriemma

I didn’t catch the first part of your call, but what I said there was that as visibility continues to improve, we are in a, what I would consider, a pretty difficult to predict top line revenue piece. And a couple people have pointed out here the maintenance revenue continues to grow, services business is stabilized, and now improving in margin. (inaudible) obviously the swing factor there. Any quarter’s going to be your software revenue, and that’s the piece that’s difficult to predict.

I’ll also point out we’ve got an 89% margin in that, so the leverage on those kind of sales is high. So as we go through this process, as we continue to make our way through this transition, we’ll take a look at our numbers and we’ll start seeing how our visibilities increase from quarter-over-quarter. And when we feel it’s appropriate, we’ll guide.

Stan Mann - Mann Family Investments

All right, Bill, I’d like you to answer this question. Are we set in our sales channel plan, and direct and channels. For an experienced company, we seem to be floating. Could you speak to that?

Bill Weyand

Sure, I’d be happy to. Starting this year, we made the decision, and it was the right decision, based upon products and market opportunities and industries, that we would focus our direct sales force on auto industry, (inaudible) manufacturing, and what we call SMB, and then we would take a high percentage of our customers, small customers, and turn those over to channels partners.

So this has been a direct initiative, we have a worldwide channels organization, meaning sales organization to drive that. Obviously, European has been leading this whole model. We’re deploying the same model in Europe, now in the Americas, and Asia Pacific is a higher channels model, and we intend to expand fairly significantly in Asia Pacific as well.

We’ve even gone to some countries and changed it from a direct sales service model to a channels partner model. And then the last part I want to say about that is that we’re also moving into new industries, like electronics, consumer products and etc., we will focus on key global players where the value of proposition of our solution is good for them and good for us. (inaudible) work-in-progress, that’s one of the numbers we are debating and looking at breaking out in ’08 is revenue from channels versus direct.

Stan Mann - Mann Family Investments

Since I’m a long term participant and owner of the company, I’d like to know, when you think we’re going to get through this evolutionary, no time line process, and start running it as a predictable business. I think it’s a fair question to ask on this call. Everybody’s been pressing you in that direction.

Bill Weyand

I understand that, and we’re not giving forward guidance yet, and we’re vigorously implementing direct sales and channel business development to accelerate our license and services growth organically, as well as looking at being more inquisitive going forward. And that’s as far as we’re going to go on the subject.

Stan Mann - Mann Family Investments

Do you feel that your sales and your (inaudible) is set? That’s what I’m trying to get at.

Bill Weyand

Yes.

Stan Mann - Mann Family Investments

Well the next step is booking getting sales from those channels?

Bill Weyand

We’re set.

Stan Mann - Mann Family Investments

We’re not like Antis going back and forth. Or are they growing more than 20%?

Bill Weyand

I think that we are well set in terms of our direct sales, the major companies throughout the world, and that process is being managed and is very visible today through salesforce.com. And the same with the focus of growing our channels business, we’re just now implementing on salesforce.com as well.

Stan Mann - Mann Family Investments

Okay, and I’d like you to answer this last question, and that is, our stock is at a really low level, a tremendous investment. We’re sitting with $134 million in cash and growing. We’ve talked about acquisitions, why are we not buying back a stock at these levels, as a good investment?

Stan Mann - Mann Family Investments

Yeah, Stan this is Sam again. We addressed that in a couple of ways, and we did (inaudible) in the quarter, again about 50,000 shares. And we’ll continue to look at that as we move forward.

Stan Mann - Mann Family Investments

Do we have an open board buyback, Bill? I’d like you to answer this.

Bill Weyand

The board approved a stock buyback last year, and it was about 1.2 million shares, and depending on whether we’re in quiet periods or not, we have been buying back stocks.

Stan Mann - Mann Family Investments

And of the total of the 1.2 million, how much has been bought back?

Bill Weyand

About 75,000 shares total.

Stan Mann - Mann Family Investments

And is there a reason we haven’t bought any more? I’m just curious to understand the mechanics of the company.

Bill Weyand

Yeah, I’m sorry, about 260,000, 50,000 during the quarter and 260,000 total.

Stan Mann - Mann Family Investments

Okay, but is there any reason that that hasn’t accelerated, Bill? I’d like to understand, you know, I’m a large owner, and I’d like to understand what we’re doing in the logic.

Bill Weyand

Well, again, it’s a board driven, when we can (inaudible), that’s number one. And number two is that, because of being in a consolidating market, because cash is king right now, we want to keep as much of our powder dry so that we participate in that.

Stan Mann - Mann Family Investments

And you think we will be participating in a reasonable time period in that process?

Bill Weyand

Correct.

Stan Mann - Mann Family Investments

Okay, thank you.

Operator

Your last question comes from Richard Davis, with Needham & Company.

D.J. Hynes - Needham & Company

Hey, it’s actually D.J., hi. I just have a quick model question. What was Q3’s stock comp in the quarter?

Sam Auriemma

Sure, D.J., it was about $2.1 million, I’ll give you a little more color on that, about $120,000 in cost-to-revenue, $270,000 in R & D, and about $1.7 million in SG & A.

D.J. Hynes - Needham & Company

Thanks.

Operator

And I’d like to turn the call over to Bill Weyand for closing remarks.

Bill Weyand

Thank you. And again thank you for dialing in for MSC’s Q3 conference call. (inaudible) We are pleased with the record attendance of our VPD conferences just completed around he world, we had in excess of 3300 attendees.

We also were very pleased to receive a second award from IBM on product innovation in the IT arena for our SimEnterprise solutions.

We are evolving with our customers in a significant product transition. And we’re seeing positive signs with our key customer wins, that should turn into revenue growth over time.

We’re also making progress in expanding our channel’s partners, which will also drive license revenue growth in the future.

And then last but not least, we’re seeing an accomplishing continuous improvements in our cost structure, as well as DSO’s, and in regard to our cash position, which was obviously a topic on this call as well, is that we’re focused on maximizing shareholder value, and whether that’s through acquisitions and/or stock buyback, the board is seriously considering both avenues to increase shareholder (inaudible).

Thanks again for calling in.

Operator

Thank you for participating in today’s conference, you may now disconnect.

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Source: MSC Software Q3 2007 Earnings Call Transcript
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