Chit Chat Stocks - ANSYS (Ticker: ANSS) Not So Deep Dive

Episode Date: November 8, 2022

ANSYS designs engineering simulation software and services for a variety of industries. The company's software allows engineers to test whether or not ideas/products would be viable in the real world. At the end of the month, we will publish an Arch Capital episode that will cover the company: Autodesk. Listen closely as Brett and Ryan go through the history, financials, and future prospects of ANSYS. Enjoy the show! ****************************** Interested in becoming a member of 7investing? Subscribe with code “MONEY” and get $100 off your annual subscription for life: https://7investing.com/checkout/ ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (3:30) Industry | (11:28) Management & Ownership | (14:09) Earnings | (17:56) Balance Sheet | (22:24) Valuation | (24:30) Our Analysis | (25:37) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Okay, welcome in. This is the Tuesday Not-So-Deep-Dive episode on Chit Chat Money. Today, we're hitting the second show in our November engineering software theme,

and we're covering Ansys, the premier simulation software company around the world. It's a very tough business to understand we're going to let ryan get into it first let's hit our uh round up stuff one remember to subscribe to the newsletter i've seen a big uptake in people doing that so thank you for everyone and it's really helpful for the not so deep shows it's free you get the charts and the show notes sent to your inbox along with this episode so you get the audio format our discussion. There's some of the metrics that may be harder to understand in the audio format. You kind of go back through those, understand this business more fully. Second, let's talk about our 7investing sponsor for the rest of 2022. Our presenting sponsor at 7investing who just

released their research reports and recommendations for November. They do seven each month. And I thought this month I would want to highlight, you know, we talk about how they're really strong in the innovative companies. And I don't think they've done a report on Ansys, but something like ansys is you know usually up their alley but for people that are more you know income oriented uh maybe more competitive advantage focused or more i don't want to call them boring companies but kind of boring compounders matt cochran who's been on the show before and i want to highlight who was on our show and it was actually just on the popular business brew podcast talking about his philosophy his recommendation this one month was a low-risk industrial we don't want to spoil

it any further. But this business is one that kind of stares people right in the face. And it might seem like a really slow growth business. Not that exciting. You're like, okay, well, what's going to happen over the next few decades? But their long-term stock returns have been phenomenal. Since the 90s, they're up 3000%. And since before that, they've been around for 100 years, just crushing the market. And yeah, when you subscribe to 7investing, you not only get those innovative companies but you know mac covers stuff like this as well that can be a i don't know a great addition for some of the ones maybe less excited for their portfolio but something that sells a great chance for long-term returns and ryan do you want to talk about the promo code

that people can use yeah it's the the code is money you get a hundred dollars off the annual subscription uh and that's for every year that you uh subscribe and to kind of touch to harp on Matt again, he would be, I think he would self-describe his companies as boring. But I believe one time he said his favorite thing about being an investor is that he can just sit on his butt and do nothing. And that's a good way to invest. And so, yeah, he's one of the reports that I definitely look forward to reading each month. But let's get started on Ansys. Let's talk about what they do. So Ansys develops and sells, as Brett kind of mentioned earlier, engineering simulation software to a variety of industries, but their products help engineers, and I pulled

this quote from their website, explore and predict how products will work or won't work in the real world. So with ANSYS, users can test designs or products by seeing how they would react when applied with different temperatures, different pressures, different fluid flows, or basically just how a product interacts in a real world environment. Is that kind of a good way to describe it? That's a great way to describe it. There's also plenty of other things that they use.

And when you look at their notes, their press releases, they'll talk about the multi-physics environment, which means that with all their plethora of products, they can have someone simulate multiple things. I guess I want to describe them as that at the same time. So you can do fluid plus heat. You can do electronics. You can do light and optics. You can do really small stuff with semiconductor electronics and all that good stuff at the atomic level, or you can do structures all at the same time.

And they have, as per Ryan, you're probably going through and looking at all their products, tons and tons of different simulation things that they acquire and add to their portfolio each year. Yeah, I believe it's 93 different products in total. So tons of different offerings. And some of those are probably bundled together. yeah and they all get the the key is that it's all under the same sort of they they want to eventually at least probably not all of them work together but they want to have them all work together so a company can simulate the real world as best as possible yeah let me use a uh let me highlight a good use case that their ceo mentioned on the most recent conference call so

in september nasa and i assume some people probably heard about this uh nasa launched an unmanned spacecraft which collided with an asteroid and altered its orbit basically it's the first time this has been done in human history um so that that the netflix movie not a great analogy anymore i think we solved that one yeah i think most people were just surprised that it was so easy we needed to do that i think most people didn't realize that was happening and maybe we didn't need to do it it's not the point but in preparing for that launch, the Johns Hopkins Applied Physics Lab, which NASA is sort of contracted to help prepare for this, used one of ANSYS's products to test the flight. Here's a quote from the CEO from the

conference. He says, the Johns Hopkins Applied Physics Lab extensively used ANSYS STK, and I'll talk about what STK is in a second, but throughout the mission planning process from formulating DART, which was the DART launch mission, DART's trajectory through the asteroid system, as well as to visualize relevant vectors and altitudes. The thermal team used STK's full mission environment when checking the location of the sun relative to the satellite during critical maneuvers. I think that hopefully paints a picture of the kind of complexity that ANSYS' software can simulate.

And it's really, when you watch the tutorials, you'll get a grasp on how useful this can be and how critical it is to a lot of different businesses and organizations. But that's one specific example. As I mentioned, they got tons of different products. I think it was 93 in total, and they're intended to meet various needs. Brett kind of went through some of those. And they use both in terms of the actual operations, they use both the direct sales force and distribution partners in their go-to-market strategy.

Most of their sales are conducted through their direct sales force. And they generate revenue in two ways. So the first one is initial software licenses. So they sell the software licenses so that different organizations or companies can access the simulation or analysis programs that Ansys is so popular for. And then they also have maintenance and services revenue. These include like software license updates and product support fees and the account for the other half of the top line, roughly.

It's about a 50-50 split. It kind of varies depending on the time and the year. But those are the two main revenue drivers. Do you think I'm forgetting anything as far as business goes? I don't think so. I think the key people might look at that maintenance and not like how they're not almost fully subscription, like a lot of other software companies and say that as a low light, but a lot of people are using their simulations kind of in a one-off manner.

You might need it for a big project, um, that you don't kind of just subscribe, say compared to an Adobe or an Autodesk products, or even a solid works product that we talked about last week. It's a little bit different where you might need this super technologically capable simulation once, and you're not going to need it next month. You might need it a few times a year, and it varies case by case on these research projects. Right. As for the history, it's kind of an interesting story. The idea for ANSYS first came about thanks to an engineer named John Swanson.

It was kind of the mid-1960s, and Swanson, in reading about him, feels like really just a bright individual and someone who wasn't worried about taking credit, someone who really kind of found something he was passionate about and built a business out of it. So he had graduated Cornell with a master's in mechanical engineering. He also got a PhD in applied mechanics, I believe, later on. But at the time, he was working at Westinghouse Astronuclear Laboratory and was responsible for stress analysis. This was when engineers had to do the finite element analysis, which is basically what ANSYS does today by hand. Which is insane. That is. Yeah, it really is crazy to think about.

So, and John had the idea to automate the process through software and Weston House apparently rejected the idea to try to develop this software in-house. So in 1969, John left the company to start it on his own. It's reported that he founded the company, which at the time was called Swanson Analysis Systems. So analysis and systems is where they got that Ansys bridge. And he started out of his farmhouse in Pittsburgh. So this guy, I don't know, he seems just like your stereotypical, just really bright engineer without...

Engineer founder. Yeah. Doesn't care about the business model as much. Yeah. Just not a whole lot of pizzazz. He just really cared about the... He was really passionate about the work. And the initial software was developed on punch cards and it required Swanson to rent a mainframe computer by the hour.

His first customer was actually Westinghouse Astronuclear Laboratory. So... There you go. Full story. full circle yeah they basically hired him as a contractor i think it was an amicable departure where he said i really want to try to do this i'll work on it on my own and then if it it works out maybe i can do work for you and it sounds like that's kind of how it how it went and uh it was slowly adopted throughout the 70s and the 80s and kind of evolved and by 1991 it was a bit of a

success um it was called sassy s-a-s-i at the time it had 153 employees and 29 million dollars in annual revenue. And then a year later, SASE acquired a fluid dynamics software company called CompuFlow. And that really began their streak of acquisitions. And since then, well, I guess Ansys went public in 1996. They raised a good amount of money during that IPO. And they've made about 30 different acquisitions since, according to Wikipedia. I know that's not the most trustworthy source, but it's been just a two, three decades worth of acquisitions that they've bolted into their current offering. And some of it is sold independently, but a lot of it is also integrated into some of their existing offerings. But that's hopefully the basics of the

business. Yeah. But we'll address kind of how those bolt-on acquisitions can work. I'll have an example later in the show. I'll hit industry and competition. Again, we're talking engineering software this month uh but again ansys has that focus on simulation so if you're looking at say we're going to look at autodesk we just looked at solidworks and they were they were mainly in design uh ansys sort of competes with them but not really it's more of the more complicated multi-variable multi-physics environment so the majority of their addressable market is going to be that it's going to be you know whether it's fluid heats or electronics um and if we look at the The TAM, I guess, always take these research reports with a grain of salt, but there is

a research report out there that was published that says that the simulation market will grow to $40 billion in 2030 and grow at a 12% annual clip over that timeframe, looking at it and saying, okay, does this make sense? Ansys' revenue growth has been around there, and they're the dominant player within simulation software or one of the dominant players for the high-tech simulation software. And they've grown their revenue per share, which is actually going to be a little slower than overall revenue from 2017 to 2021 at 13.7%. So I think that checks out and wouldn't be surprised if that continues into the future.

Now, if we look at, for reference, Ansys does around $2 billion in revenue. So I think I came away pretty positive from looking at the industry. We'll get into the specific ones that can be very exciting as well. But there should be, I think I'm pretty confident in saying this, a fantastic tailwind for Ansys products and simulation software products over the next decade and beyond. Boogie and competitors, their SOLIDWORKS simulation, which does the same sort of things as Ansys, but is not their core focus, will be a little less robust, a little less expensive, again, but not for the people that are in the heavy R&D departments, working at NASA, that type of stuff. Then there's Inventor and Fusion 360 from Autodesk, and there are a few other general simulation products. And then the other side of the competition equation, there are a ton of smaller niche

software programs for very specific simulations. This could be something like optics. This could be something like electronics that ANTS competes with, but their strategy has been to consistently find these companies and acquire them over the years and add them to their platform. For example, this is the one I wanted to talk about earlier. Its most recent acquisition is called CNR Technologies. I think it was last month or maybe in September.

They do thermal simulation specifically for space systems. So that's very niche, and they're going to get that added to the ANSYS software and hopefully have a more robust offering for the space economy companies that use ANSYS simulation. Now, let's move to management and ownership. Brian mentioned that they kind of had an engineering start. But right now, I think for an investing note, this is positive. They have an MBA software person who worked at Silverlake. He's been on a lot of boards in Ajay Gopal.

His name is A-J-E-I. Sorry if I'm pronouncing that incorrectly. He has many years of experience working in technology and software. Started at IBM in 1991. Interestingly, he was on the board of Ansys before taking the CEO role in 2017. So he has a relationship with the company for longer than then. If we look at ownership and share structure, it's very boilerplate. big index fund ownership, single class share structure, and one big growth fund owning more

than 5% of shares. And I kind of saw the typical growth funds in there as well, GEOD. I think I saw Massachusetts, MIT in there. And yeah, actually nothing really. I guess the big note is executives and directors only own 0.5% of the stock, which could be a downside given how we'll talk about their SBC, how heavy they are at SBC and stock-based compensation, but that's kind of what you expect with no founder influence. Yeah. I mean, it's been around for 60 plus years at this point. John Swanson is long gone.

They've kind of gone through a couple of different management teams. So unsurprising to see little insider ownership. Yeah. Do you want to talk a little bit about the proxy? Yeah. Well, let's look more into that stuff. If we look at compensation, total board of directors pay in 2021 was $2.7 million or 0.16% of gross profit.

Just kind of checks out that it's not a big deal there. And then if we look at executive compensation, it was $39.9 million, just under $40 million in 2021, or 2.4% of 2021 gross profit. A little high, but not crazy. I think it kind of worries me if it gets closer to that 5% range. It's something that could be meaningful and hurt shareholders in the long run. Now, if we look at the majority of their compensation, it is in the form of stock awards. They love the stock awards and it's a mismatch because they don't own that much stock, but

maybe they're trying to change that. Executives get paid in performance stock units, PSUs, based on annual contract value, which is basically revenue over time. Yeah, I'll explain that in earnings. Yeah, non-GAAP operating cash flow, which is kind of their key earnings metric that they look at. And then total shareholder return hurdles. The total shareholder return is cumulative or three years. So pretty solid hurdle there. And then their annual cash bonuses are based on non-GAAP revenue and non-GAAP income hurdles. The only yellow flag I saw is this. I think it

kind of combines into two. So the hurdles for the bonuses seemed a bit conservative and really easy for the executive team to hit. Maybe that was a one-time thing in 2021, but if you're tracking this company, I think it's very important to look at and track over time because it can be a big problem for outside shareholders when management teams are incentivized to maybe not grow as quickly as they could while also hitting those hurdles and getting paid fat bonuses. And then since they're based on non-gap operating income or operating cashflow, you're getting paid in a lot of stock. Those don't count to those. So that's the only yellow flag I saw. I'd also worry about the incentive to grow through acquisitions because the non-gap earning stuff,

they don't- They can exclude a lot of the- They exclude the acquisition costs. Yeah, exactly. They exclude the acquisition costs. However, I think the total shareholder return metrics can anchor them and help them mitigate this a bit. But again, those are the only small yellow flags. Besides that, I didn't find anything crazy in the proxy statement. All right, Ryan, do you want to hit earnings and how this business is doing as of late? Yeah. The other thing worth mentioning, and you kind of touched on this, but they could potentially,

if they've already hit their incentives or their hurdles and they could go quicker, they are incentivized potentially to defer some of that growth to the following year to make sure that they are- They're ready to hit their hurdles.

Yeah. So I wish their hurdles were slightly higher because they seemed a bit low. Like it seemed like when I was looking at it, they easily hit kind of that 200%, whatever, you know, way above their median metric on that. Yeah.

I mean, that total shareholder return Hopefully, it helps alleviate some of that. So in talking about the full-year earnings, that figure to pay attention to that Brett mentioned, ACV or annual contract of value, they use that due to the upfront revenue recognition model on perpetual licenses. So over the long term, ACV and revenue are going to be equal, but they may lag one another depending on the year. Think about it a bit like billings or bookings for a video game company, very similar. But for the full year of 2021, they had $1.87 billion in annual contract value. That was up 16% year over year. $1.9 billion in revenue. Like I said, very similar figures. That was up 13%. So you're usually, sometimes you're going to have those two kind of intertwine or intertwine might not be the same word, but invert year after year. And then they had 86.5% gross margins. This is a very high gross margin business and $526 million in free cash flow. The bulk of their spending is going to be research and development. And then I believe the majority of their staff or their employees are in sales and marketing. And they tend to keep R&D expenses at about 20% of revenue. And I don't have sales and marketing in front of me, but I would imagine it's slightly higher. Well, maybe around the same because their margins have been strong.

The one thing I would add to the earnings is that operating cash flow margin, which essentially the same for free cash flow for this business, has trended downward since 2017. In 2017, it was 39%. And now, as Ryan mentioned, we're down below 30%. That has been a consistent drop since that time frame. Something to watch. I bet they may have hit on that on the conference calls or something like that.

But the business has shown he can get close to that 40% margin range. And I think a big question that investors are probably asking is, can it get back there in the future? Yeah. Just kind of looking at the operating expenses here, how they break it out. They've got SG&A at about, it is a little more, I don't have the percentage, but 715 million out of 1.9 billion and research development was 404 million. So it's slightly higher.

Yeah. And that's combined, that's sales and marketing for anyone that doesn't know. They don't break out the two. It's sales and marketing combined with general administrative, so corporate expenses. But anyway, 28% free cash flow margins for all of 2021. And then in the most recent quarter, their annual contract value continued to grow at a pretty healthy rate, 12% year over year. It was 20% in constant currency.

So they're seeing a lot of foreign exchange headwinds, but really strong growth if you look at it on a constant currency basis. And since we don't know what's going to happen with foreign exchange moving forward, I try to use constant currency growth. It's a better proxy for the demand that they're seeing. But the foreign exchange is a real expense that they have to incur. So the 12% growth is what they saw. Operating cashflow was $127.2 million. That's actually down slightly due to some timing on some investments is what they mentioned on the conference call. But overall, over the last nine months, it has grown. And then $1.1 billion in deferred revenue and backlog. And they have a

big chunk of stock-based compensation, but they offset almost all of it with buybacks, or they have at least in the last year or so. So share count, they use shares to make some acquisitions, but in terms of issuing SBC to employees, they tend to offset that with their buybacks. So not too big of a concern there. Ultimately, I think the two numbers you pay attention to here are basically operating cash flow and annual contract value. CapEx is pretty light. So your operating cash flow is a pretty good measure. Yeah. And that's what they're tracking too. So I think it makes sense. In terms of balance sheet and liquidity, pretty clean balance sheet, $633 million in cash and equivalents.

About five, I mean, they generate more than $500 million in free cash flow each year. So it's not, they have plenty of healthy, plenty of liquidity on the balance sheet, and then $753 million in long-term debt. So almost enterprise value is going to be roughly equivalent to the market cap here, more than enough cash to service that debt. But in terms of that specific long-term debt, a lot of it was acquired to, or they used it, they got the funding to finance their recent acquisitions and their variable rate term loan facilities that accrue interest at it's another one of those euro dollar rate plus some margin and it kind of differs each year um and all the debt is due in 2024 so it's going to come assuming that they don't use more debt to finance acquisitions

or they don't roll that debt in some way um it's going to be a clean balance sheet by the end of of 2024. Last year, their interest payments amounted to $12.4 million. So on $755 million in debt, that's 1.6%. However, it's been rising this year. They mentioned that it's going to continue to rise in the conference call, as you should expect with variable rate debt. They also have a $500 million revolving credit facility that they're not currently using. So it's more than enough liquidity to service the debt. Although I think they would have had an easy time raising or issuing bonds in 2019 2020 around this time fixed rate yeah yeah so it kind of to me it's a bit disappointing yeah it was a little disappointing to see that um

but i mean it's still not super high rate debt and it's going to be gone by 2024 and they have more than enough cash to pay it down early if they wanted to so um i want to be i want to think about it too much. Yeah, agreed. They don't seem to be the best at optimizing, but that's okay. All right, let's move to valuation. We'll keep this one quick. Market cap, $8.5 billion. Now, enterprise value is pretty much the same at about $18.6 billion. Excuse me, I said $8.5 billion. It's $18.5 billion market cap, $18.6 billion enterprise value. The two or excuse me, three metrics I like to look at for a software company like this are EV to sales, which is enterprise value divided by sales, EV to gross profit, and then EV to operating cash flow. Since we're

getting close to the end of the year, I kind of just took their revenue guidance, which is fairly reliable, and then they're just kind of at 87% gross margin and a 30% operating cash flow margin. And with those, we get an EV to sales of 9.2, EV to gross profit of 10.6, and EV to operating cash flow of 30.8, so basically 31. All of those fairly premium. Now, if operating cash flow margins get back to that 40% range. This could be around a market multiple, but without any growth, but it's not there today. So I still think it's quite the premium valuation. Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad. I get it. I'm Siaya and I live in Ice Cove.

I've made some questionable decisions that didn't end up the way I planned. and today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently, that's how I roll. So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. I don't think there's anything else to add on that, so let's move to anecdotal evidence, Ryan.

We're not users of the products because we are not PhDs at the R&D departments at Tesla or Boeing or somewhere like that, But what is your anecdotal evidence watching some YouTube clips? Yeah, that's exactly what my anecdotal evidence is, just product tutorials. And I recommend anyone that's interested in the business to certainly scroll through some of the product tutorials because you'll get a grasp on the complexity involved in the software. And I can't help but think in watching those, first of all, the question that comes to mind is like, how the hell did they build this? It must have took so long, so many years of iterations, and it's just, you kind of marvel at really the software and what it's capable of doing. And I would have to think that there's some serious barriers to entry here, not just in the complexity that it requires to build not only one of these softwares, but the whole portfolio that they've gathered, it would be quite the hurdle to get there.

And then on top of it, you're going to talk about this, but there's a bit of a reputational advantage that they've now garnered among the engineering community. Yeah, that's my actual evidence is that they not only have the best simulation technology on top of that, the best brand within that industry. So all you hear online or from anecdotes is that, you know, quote, quote, unquote, ANSI software is the best, which means that they have great mindshare among all these R&D departments. I think that gives them a really great competitive advantage and a comfortable position when selling the software to people. And likely additional pricing power, but how expensive the products are too. You sell something for, say, $5,000. If you bump that up for $6,000 to $6,000 for, what's a good example here? A space startup, Rocket Lab.

That's a mission-critical software for simulating the products that is going to make sure that they don't have to take all these real-world tests, save them a ton of money. You bump that up from $5,000 to $6,000 over a five-year period. i don't think anyone's going to blink an eye especially if it is the best and no one can compete with it yeah especially when you talk about like the all right the example i used earlier that johns hopkins applied physical lab they're probably in the end these these projects are getting financed likely by the federal government and some part of energy they got a big budget so yeah they they tend to pay their bills um and i imagine there's there's

There's certainly room for pricing power when you make your own money. Yep. All right. Let's move to future growth opportunities. There's a lot here, but Ryan, what are your thoughts? So, yeah, when it comes to the software, I'm not going to be able to provide any sort of insight, but they did make two recent acquisitions that were pretty large. So both of these were acquired since 2019 for more than $700 million a piece in a mix of cash and stock. i believe those are two of the largest acquisitions they've ever made and it was agi and lstc both just i'll talk about agi first this is it stands for analytical graphics inc it's kind of a theme

among pretty much all of their products is they're very hard to uh the names are bland yeah lots of uh terminology that mostly engineers would understand but exactly the engineers coming with of the name so yeah yeah so the agi provides analysis software for aerospace defense and intelligence applications this was the acquisition i believe that was made in 2019 um agi can track orbiting satellites and their connections to ground stations i believe this will just get implemented or integrated with their stk which was that system that johns hopkins was using um likely meant to be sort of an all-in-one aerospace uh or space system not aerospace but like uh like orbital stuff space stuff that's in space yeah anything that's taking missions

into space will likely use some form of the software um and then the second one was livermore software technology corporation like i said very boring names lstc it's the gold standard for predicting a vehicle's behavior and the effects on occupants during a collision. And it works great with the specificities involved with electric vehicles, according to the press release. When I look at these two acquisitions, it seems like both of them are going to be industries where there's increased spending over the next decade.

Right. Was there a trillion dollars going to EVs over the next, you know, commitments, right? I mean, some of that, all the automakers will probably be using software like this. Yeah, and then you think about the money that's sort of being poured into space missions as well. I think spending is going to continue to trend upward for them. So bolstering their offerings through acquisitions like this, I would think, makes sense.

Although you don't really have a sense on the price they're paying for these relative to the customers they already have. Right. Or I guess I just don't know how much they're paying for these acquisitions is kind of my concern. But it's a part of their growth strategy. It's been a huge part of their growth strategy. And you should probably expect more of these acquisitions moving forward. Yeah. All right.

I'll hit mine. And that is expanding their partnership with Amazon Web Services or AWS. They recently announced, and I think this was only a couple of days ago, Ansys Gateway, which allows customers to access Ansys simulations through the cloud. Now, they've already had a partnership, but this is a bit nuanced here. but I think it's important for more broadly to widen the funnel of who has access to ANSYS simulation software and basically how you want to spend your money on that.

The key thing here is that simulations take a ton of processing power, similar to a video game where I remember in college, we'd run these basic optimization simulations in the class where we're using SOLIDWORKS and it was on the SOLIDWORKS simulation. and you're on a, you know, not an old, old computer, but you're on just a regular computer. And when you run it, it would take like 40 minutes. So the time getting compressed there can be very vital. And a lot of this is just the need to, you know, do the more complex simulations while under a reasonable timeframe. Now, this partnership is not only going to help

improve the customer experience, but I think will also expand the potential customers who can use ANSYS simulation because they can kind of go on a one-time thing or they don't need this souped up hardware that can really you know process a ton of stuff uh on their uh yeah just to use the software now here are two quotes from the press release that i hope because i know it's a bit confusing um to have maybe help any listeners understand here's the quote customers can manage and control computer-aided design and computer-aided engineering cloud consumption and costs on AWS while taking advantage of the scalable hardware and compute capacity. So you're taking advantage of the giant computers that AWS has and the compute capacity there

to use the complex ANSYS software. Now, here's the second quote. With ANSYS Gateway powered by AWS, customers gain instant intuitive access to ANSYS applications. In addition to reducing time to market, customers can reduce costs by paying for cloud resources only when they are being used. So it's kind of instead of the subscription or the one-time cost model, they're going on the paper usage model, which we know a lot of these software companies, Autodesk as well, have been implementing to maybe get more flexibility for their customer bases.

Do you think if this becomes a larger chunk of their revenue, it's margin accretive? Oh, probably not. Probably not because AWS is definitely going to capture their share, but we'll see. I think these sort of investments are probably why margins are going down right now because there's this transition period where a lot of this stuff's going to the cloud. They made all these acquisitions for these new markets like autonomous vehicles, electric vehicles, the space system stuff.

So I think they could still go back to 40%, but it's hard to tell because AWS, they earn good margins as well. Highlights and lowlights though, Ryan, what'd you like, dislike about this business? Well, as I kind of mentioned before, I feel like there's pretty high barriers to entry for a couple of reasons.

So first is that technical complexity involved in building solutions like this. Second, it's the industry standard, which kind of gives them that reputational advantage. And then third, the holistic nature of their offering or the breadth of their offering, I imagine, deters a lot of competitors from trying to compete on the scale that ANSYS competes. So not specifically with one product, but the multi-physics offerings. And then it also probably provides better value to the customers. So I just have a hard time imagining that anyone, it's a mission critical market that they're serving or need that they're serving. And I don't think anyone can offer as much as they currently are. However, that maybe plays into my low light, which I'll talk about in a second. um the second one is the shift to cloud i thought that might bring about higher margins but it's

kind of hard to tell and then uh did they they say anything explicitly on that i mean no you've seen the transition with adobe and autodesk i would have thought that they would kind of fall in that direction these i think these are just a this is a little bit of a different of a business it's it's almost like and this is a weird comparison like adobe and autodesk and i guess they have different products but they're basic products or maybe like the say linear not linear um video consumption uh you know tv movies or whatever and the ansys products are like video games where it's just going to be a little tougher to move stuff to the cloud just because of how complex it is yeah it makes sense um i guess the the other highlight for me would be pricing power

As kind of mentioned, for most of their customers, what ANSYS provides is mission critical. You literally have to check that box in terms of, I don't think you can run a space mission without simulating it a couple of times first. Yeah, or it saves you a ton of money without having to crash a bunch of Virgin Galactic, whatchamacallit, whatever they call those things. Spacecrafts. So I have to imagine customers are willing to pay a big chunk for that. And if Ansys increases their prices, I think these customers aren't going to really bat an eye about it. Low lights for me, though. I'm not a fan of the variable rate debt.

I don't see why they couldn't have issued fixed rate bonds in that time period. The second one, I don't like when companies have to constantly acquire smaller competitors. And maybe you could say they don't have to. They're doing it opportunistically. But it feels to me like you've got a whole bunch of smaller competitors kind of eating away at your moat and you're having to go out and spend money and likely buy them at a premium to get rid of them or integrate them, however you want to think about it. I just don't like acquisitive strategies like this. Yeah. They have acquired a lot. They've used a lot of their cash flow and stock to acquire businesses and debt. Just a lot of the money. A lot of the money. My highlights? Yeah, similar to yours. I mean, the lack of competition is great. Sure, there's basic simulation tools on SOLIDWORKS Fusion 360. You can send some air through a tube. And they can do more than that. But that's just to exaggerate things. But nobody has been able to match the technological capabilities unless they focus on the hyper-specific niche, which ANSYS typically requires, as Ryan was just talking about.

Now, the second one is the breadth of the simulation software on the multi-physics platform. Multi-physics, I'll say it again, means the ability to simulate multiple properties at once. Think the combination of stress load, heat, and electricity all at the same time. ANSYS has this on steroids. Oops, said one there. let's type it up for the let's correct that uh it makes it extremely hard for someone to replicate that maybe you can do the heat stuff and it takes it takes you multiple years to get that to the same levels and it's just one they're going to get that even better over time but two you don't

have the combination of doing electricity and stress at the same time third and i think this is my favorite part here is the tailwinds in multiple industries i mean you have electric circuit boards and semiconductors which are going really really quickly i just saw them release some validation for TSMC's four nanometer architecture, where they're using ANSYS to validate that the chips will work in a real world environment where they can simulate, again, stuff like heat, electricity, and other properties all at the same time. And they're using ANSYS for that. You also have the space economy, which I think could go through a capital cycle where not many companies are making money because it's such a hard business to get into. But ANSYS,

I think will benefit from all the people trying. You also have autonomous vehicles, which could be the same sort of thing that they're big in. You have 5G stuff that people are trying to simulate and work to make sure all the technology works there. And there's others that we're forgetting. There's just tons of tailwinds here for all these industries. I think we both probably have our doubts

about certain players in those industries succeeding, but I think overall spending towards those industries will likely go up and you're basically buying the picks and shovels provider in sort of that gold rush classic picks and shovel uh i think thesis if you're kind of looking at answers from a positive light now if we look at low lights for me um i think the operating cash flow margin deterioration over the past five years has just not been a great thing from my point of view it's led to operating cash flow per share only growing by five percent over that time frame is this temporary maybe but i don't like it in line with kind of the suspect competition strategy for the

executive team uh the heavy acquisitions that may have been paid for at some extreme multiples um so yeah and then i think second there's some geopolitical risk here that we haven't talked about yet it's a little bit underrated their technology is so good that it could be deemed a security risk uh five percent of the revenue is in china and they also have major exposure to korea uh from samsung and the automakers you have japan automakers plus electronics and then taiwan with you know taiwan semiconductor semiconductor companies that aren't taiwan semiconductor and then other electronics i would worry about that a bit with that asia exposure you also have germany with the automakers that is going through some tough times from the energy markets

a lot of stuff there but they mentioned in their 10k that the china and u.s trade where trade war has been a headwind for them. Yeah, they mentioned on the conference calls, well, there isn't any direct revenue or there's barely any revenue risk right now from the new rules that just got put in place. But they said that I think 5% of the revenue comes from China,

which I don't know if I'd write that down to zero, like maybe I would for a semiconductor equipment company, but it seems risky. And I guess that kind of plays into all the talks about margin deterioration, And the acquisitions kind of plays into the revenue per employee. It's stagnated. It's actually down since 2017.

So getting that efficiency hasn't helped. I think if you're looking at the company, you want to see that revenue growth kind of even accelerate or keep up in that low double-digit rate to get back to growing that revenue per employee. All right. Bull case? Bull case. I'm going to go first here? Yeah. I think we have pretty simple ones here.

It's not too hard to understand. But yeah, go ahead. Yeah, it is. It's really quite a simple bull case. So they traded about, if I'm not mistaken, 32, 33 times. 31 after today's drop, but close. Yeah. 31 times operating cashflow.

I think at that multiple investors need double digit growth, double digit percentage growth in the ACV or revenue. And then some gradual margin expansion. I feel like we say this for every software company or every engineering software company that we've looked at. This is obviously a high quality, durable business that has pricing power, but it trades at 32 times. Premium to what it has been historically too, right?

Yeah. Yeah. Certainly a premium. And I'll talk about that in the bear case. If you get double digit ACV growth and margins do expand and the multiple doesn't contract too much, then I think you're going to have good returns here as an investor. But I think you can say that for like every business. Yeah.

But here's the thing with Ansys. i kind of have high confidence they will at least for five years i think that i don't have any concern about them growing acv but i they revenue share operating cash flow per share yeah they love to spend i mean they've they've made they've increased their rd budget as a percentage of revenue over the last three years theoretically as these businesses reach higher and higher scale that should compress and you're just not seeing that yeah they've invested a ton and they specifically mentioned they want the kind of expensive phd level engineers within their organization which i think gives them an advantage because they're really hard to get and it seems

like they have that you know people want to work they're kind of like a spacex or something like that and that's great but they're expensive and you need to get that output um over time and maybe it'll show up but yeah it's because i think you know my book is similar yeah i think you gotta you got to expect 10% plus revenue growth and that operating cashflow margin to return to 40%. And remember that operating cashflow margin, they have some heavy SBC. It's not terrible, but that's going to eat into that. I think if that happens, it'd be pretty tough to lose money on the stock unless they go down to 10 times earnings, which that could happen. Seems doubtful for a high quality company like this, but I think the positive is in the past, you'll look at the

of the charts here that we'll give out and their share count has grown over the last five years. But if you look before that, that five-year period, their valuation was cheaper and they bought back a lot of stock and started reducing share count. So I don't think that is a huge concern with the multiple contracts, if you get that revenue growth plus the margin expansion. Better case though, Ryan, I think this probably comes down to valuation for us and maybe some geopolitical risk. Yeah, you can throw the geopolitical risk in there. I don't think it's huge. I mean, 5% of revenue in China. This is still largely domestic. I think 45% of revenue is from the US. Do you want me to get the number here for everyone? Yeah. It's actually grown

in America. It's 47% EMEA, Europe, and basically Middle East. 27% Asia, 25%. And America has grown over the last five years in this percentage. All right. I guess the better case for me, From 2012 to 2019, ANSYS's average EV to EBIT multiple was about 22 times. Today, it sits at 33.8 times. Now, maybe the argument could be made that margins are a little depressed, so earnings are lower than they could be. And it's potentially a higher – I think you can certainly say it's a higher quality business today than it was in 2012 just because the offering is more holistic, more comprehensive. if they provide more value to their customers. But that doesn't mean, I guess-

Everyone might already know this. Yeah, they're going to grow ACV, but I don't know where margins will go. And I don't know if this trades at 33 times in five years. I think there's, if you're, you want some margin of safety on this. And if you're underwriting the investment here, you probably should price in a little bit of multiple contraction,

which is going to be a bit of a headwind. Yeah. I just think you got to get at least probably teens percentage operating cashflow growth at this multiple. Yeah. Operating cashflow per share too, which they've grown their share count and it's tougher to reduce the share account where your earnings multiple is this high.

Yeah. I have the same bear case. So I don't think we really, let's just move to more or less interested. Ryan, let's close things out. God on the fence. It's a,

I feel like we said the same thing last week with Dassault Systems. Really high quality business. Yeah. Okay. I was more interested last week. Really high quality business. Not at this price. I'll just leave it there.

Yeah. I'm more interested. Again, valuation will keep me away today, but this is something I could definitely see myself owning if it got closer to a market multiple where they have the history of buying back stocks. You kind of have that, you know, 10% growth, maybe stable or growing margins and kind of reducing share count by a few percentage points a year. That could lead to some, you know, really, really great returns.

But a lot of that goes away at a 30 times multiple compared to 15 to 20. Yeah, that's the big deal. All right. Stock for next week. We're keeping the engineering software theme and we're doing Bentley systems, which is infrastructure. So they're more focused on and we'll get into it. but railways uh and those type of projects like subways uh infrastructure projects i guess

i feel like we're looking at the same company over and over no there's these there's nuances there's nuances but they all the all the software looks the same when you look at the screenshot right it's the 3d stuff that you have to click a bunch of buttons and it's not uh it's definitely not an apple product that looks good for the user that wants to click a bunch of buttons it's not all right well that's going to do it thank you all for listening remember we are not financial advisors anything we say on the show is not formal advice or a recommendation we are general partners at arch capital and clients may hold securities discussed in this podcast thank you all for listening we'll see you next

week.