Description: MSC.Software Corporation (MSC)  is an early entrant and market leader in virtual product development tools, specifically Computer Aided Engineering (CAE) / simulation software and related services.  MSC's solutions allow manufactures to accurately predict how their designs will behave in their intended environments. This reduces the need to build and test multiple physical prototypes, thereby decreasing cost and improving time-to-market.  MSC’s major customers operate predominantly in the aerospace, automotive and heavy machine industries.  Sales are geographically diverse with roughly 27% of sales in the Americas, 41% in Europe and 32% in Asia.  Approximately 46% of sales are derived from software with the remainder from maintenance and other services.

The long thesis is that MSC is very cheap on an absolute basis given the growth characteristics of the market, the quality of their products and their leading market share.  Additionally, MSC trades at a significant discount relative to its closest competitor, ANSYS, Inc. (ANSS).  MSC expects to have its shares re-listed by the middle of September, which will attract new sell-side coverage and additional buy-side interest, both of which should help close the valuation gap.  Discounting ANSYS multiples still provides MSC with significant upside.  At 3.5x sales, MSC stock is worth $28, at 13x EBIT the stock is worth over $23 and at 21x non-GAAP earnings net of cash the stock is worth $22.50.  This averages a $24.50 stock price and still leaves the Company room for multiple expansion. 

Following a lengthy, but ultimately highly successful restructuring described later, MSC still trades at an enormous discount to ANSYS and is cheap on an absolute basis.  MSC trades at 1.7x 2007 sales, 7.9x EBIT and 16.3x GAAP earnings, net of almost $3 per share of cash. The 2007 estimates are based on Wall Street research, management guidance and my conservative assumptions.  These multiples represent a 68% discount to ANSYS on sales and approximately a 45% discount on both an EBIT and net income basis.  The P/E metric is actually understating the valuation gap because MSC has a significantly higher tax rate that they are working to bring down through a tax efficiency strategy focused on recognizing income in lower tax jurisdictions. 

ANSYS is a solid company with good management, a history of meeting or beating earnings expectations, and consistent, profitable sales growth.  With top-line industry growth in the teens and significantly faster EPS growth given the operating leverage, I would not recommend shorting ANSYS on its own.  However, the size of the valuation premium relative to MSC is unwarranted.  MSC has recently emerged as the competitor it should have been years ago, with a focused growth strategy and leaner cost structure, and has significantly more room to improve operating margins (ANSYS at 37% vs. MSC at 22% for 2007).  Although MSC does have execution risk with its sales growth and overhead reduction initiatives (discussed later), early signs are positive. Nonetheless, with most valuation metrics being half of ANSYS, there is plenty of room for error.  In fact, if over time MSC can approach ANSYS’s operating margins, and they already have a similar sales level, one would expect the enterprise values to converge, rather than ANSYS having an enterprise value almost 4x that of MSC as is the case today. 

Is ANSYS overvalued, MSC undervalued or a combination of the two?  Looking at a relevant transaction comp, ANSYS paid 4.6x LTM revenues for Fluent earlier this year.  Based upon this deal multiple and the positive momentum in MSC’s products, I believe MSC is likely undervalued as opposed to ANSYS being overvalued.

 

 

                                                                                                                        MSC

                                                MSC                            ANSS                         Discount

Price                                        $15.28                          $46.90

Fully Diluted Shares                   44                                41

Market Value                            673                              1,908

Net Debt / (Cash)                     (123)                              67

Enterprise Value                       $550                            $1,976                         (72%)

 

Sales                                          $315                             $360                           (13%)

EBIT                                             69                               133                            (48%)

EBIT Margin                               22%                             37%

GAAP EPS                                 $.76                              $1.65            

Non-GAAP EPS (2)                   $.94                              $1.90            

 

P/E                                             20.1x                              28.4x                         (29%)

Adj. P/E – net of cash                16.4x                              28.4x                         (42%)

Non-GAAP P/E                         16.3x                              24.7x                         (34%)

Non-GAAP P/E – net of cash    13.3x                              24.7x                         (46%)

EBIT Multiple                            7.9x                               14.9x                          (46%)

Sales Multiple                            1.7x                                5.5x                            (68%)

 

(1)   Based on Wall Street research, my estimates and company guidance.

(2)   Adds back stock-comp charges and amortization expense.

 

As in all cases of extreme undervaluation, the market has an easy to grasp bear case.  The CAE software industry experienced a difficult post-9/11 economic climate during 2002 and 2003.  As the industry recovered in 2004, MSC’s stock price, unlike those of its competitors, did not reflect the improving dynamics due to an accounting irregularity discovered by its auditors.  The most significant issue involved the allocation of sales revenue between license and maintenance fees: license revenues are recognized upon contract signing, whereas maintenance revenues are recognized ratably over the year. As a result, financial statements were delayed and the restatement process began. More importantly for the future, the restatement drew the attention of activist investors who called for a restructuring of the operations.  Over the last two years, a new management team was brought in, significant cost savings have been realized, the product portfolio has been rationalized, new products have been developed and sales momentum has returned. Finally, on August 10, 2006 MSC became current with its financial filings and expects to be listed on the Nasdaq by the middle of September. 

The CAE market is going through a period of accelerating growth.  According to the leading industry source, Daratech, the CAE market is expected to reach $2.6bn by the end of 2006 and should experience low to mid teens top line growth over the next several years.  Given the cost and time savings derived from the products, CAE software is becoming a “must have” in its key end-markets in order to remain competitive. 

With approximately $315mm in sales, MSC boasts a 12% market share and is the 2^nd largest industry player behind ANSYS, who is expected to reach $360mm in sales pro forma for the Fluent acquisition.  MSC has focused more on direct sales to larger accounts, serving a blue chip customer base including Boeing, BMW, Toyota and Lockheed Martin.  Only 11% of MSC’s sales are to smaller accounts through indirect or reseller channels, although this number is expected to grow significantly.  ANSYS has dominated the middle market with over 40% of its sales through the indirect channel.  In terms of technology, based on my industry research MSC is considered as good if not better than ANSYS.  MSC recently launched Sim Enterprise, a “game changing” technology focusing on the sale of an enterprise solution rather than a basket of single tool solutions.  The early results of Sim Enterprise are excellent, with Boeing and BMW standardizing on the technology within 90 days of launch, and IBM signing a joint marketing agreement for the products.   MSC closed 21 Sim Enterprise deals in the 2^nd quarter versus only 3 in the 1^st quarter.  Additionally, 49 orders of over $100,000 were received in the 2^nd quarter, up from 45 in the 1^st quarter.  Bill Weyand, the CEO, provided some expert and customer quotes regarding the advantages of Sim Enterprise: 

[Why do we believe we truly have breakout strategy and this is unique disruptive technology?  Well, in regard to NASA, I have a quote “There are no other codes in the world that can perform this combination of analysis.”  And, you know all the industry analysts agree.  A quote from Daratech in regard to MD Nastran, “It is 50% faster than the competition”.  And Don Brown stated that “this obsoletes single point simulation tools, because multi-discipline solutions deliver a product greater value and improve simulation process time in excess of 50 percent.”] Bill Weyand, CEO MSC.Software

On the cost side, MSC’s margins are lower than those of ANSYS for a few main reasons.  ANSYS has a greater exposure to the indirect sales channel, which is a higher margin business.  MSC has recently hired a VP to focus on expanding their indirect channel, which should help their margins.  Additionally, the new IBM joint marketing agreement should significantly enhance this effort as IBM pushes the products to their existing customers. Not only will this accelerate growth, but IBM will be handling the lower margin service work.  Another reason for MSC’s lower margin is they are still not through with their cost rationalization effort despite substantial progress to date.  On the 2^nd quarter call, they announced an additional $7mm of infrastructure savings beginning in 2007.  Finally, MSC has used a portion of their already achieved cost savings to bring in some experienced industry executives.  Recent hires currently show up as a cost, but have not yet had time to improve the top-line of the Company.  MSC enjoys roughly a 90% contribution margin on incremental sales so these hires will be accretive to operating income going forward with only modest success at increasing sales.  

MSC is too cheap relative to its growth prospects, favorable industry dynamics and market position.  Therefore, I would recommend a naked long position.  However, if you want to protect against multiple contraction or the industry going through a downturn, I would hedge part of the long position by shorting shares of ANSYS.

-         Expected Nasdaq listing by the middle of September, when traditional software and technology holders will likely be buyers of the stock

-         Greater sell-side coverage

-         Potential sale of the Company

-         Revenue growth acceleration and consistency will improve multiple

-         Revenue growth is less than forecast

-         Customers slow purchases of simulation software

-         Additional cost savings don’t materialize

-         Nasdaq listing is delayed