Chit Chat Stocks - Dassault Systemes (Ticker: DASTY) Not So Deep Dive

Episode Date: November 1, 2022

Dassault Systemes provides software solutions and services worldwide. The company's most popular product is SOLIDWORKS, which is a 3D design software. 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 Dassault Systemes. 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 | (3:07)  Industry | (11:48)  Management & Ownership | (14:29)  Earnings | (20:28)  Balance Sheet | (24:21)  Valuation | (26:39)  Our Analysis | (27:52)  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, host 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 recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not So Deep Dive episode on ChipChat Money. If you're listening to this or watching, I guess for the few, the 10 to 20 on YouTube at this time being,

these are free again. We did the subscription experiment, hard to say that, for the Not So episodes for i think three or four months unfortunately didn't get the traction that we wanted and we think the free episodes are better just because we like to you know for various internal reasons but larger audience larger audience to talk to better to grow all that good stuff but that's not relevant to you as the listener today we're talking to so systems uh french company uh they're in the engineering software space and that kicks off our theme for november which is engineering software so if we have the companies i don't know if i remember them all but we're going to have ptc we're going to have bentley we're going to have ansys which is

next week and then for the arch capital fund episode we're becoming autodesk which we own in the investment partnership so we're going to cover that as well what pro core pro core yes thank you i forgot that um but yeah we're going to talk to so systems owner of solidworks metadata Data, and Katia. Ryan is going to get into it, but first, Ryan, do you want to talk about our sponsor through the end of 2022, the presenting sponsor of Chit Chat Money, 7investing? Yep. For those that don't know, 7investing provides seven stock recommendations each month. They span tons of different industries and they've now have cumulatively more than research on more than 200 different companies. So tons of back catalog that you can look into

the very thorough recommendations. And then on top of it, they also are very accessible. So if you read a write-up, you're intrigued by it, and you have any questions about the business, or you want to learn more about it, you can easily get in touch with a lot of them. They have their subscriber meetings monthly, and then you can also easily DM them. I believe they have a Discord channel, which is easy to ask questions in as well. So very collaborative, very accessible, and it's just a good group to be a part of. Use our code money and you get $100 off at checkout. It's $100 off your annual.

So I believe it's, is it $399? Yes. So 25% discount, $100 off. Link and information will be in the show notes wherever you are listed to this episode. All right. Well, I think that's it covers 7investing. So why don't we get into SoSystems.

If you're reading the title, it probably looks like Dassault Systems. uh it's just so is the proper pronunciation um and it's a little bit difficult to describe all that they offer in a concise manner because they have a lot of different products so i i'm just going to steal this quote from their annual report they say the purpose of to sew systems is to provide business and people businesses and people with 3d experience universes to imagine sustainable innovations capable of harmonizing product nature and life i know that's how you understand it fully now right yeah so basically they have a large portfolio of software applications

that can fit into three buckets but they're primary they're primarily built used for building different things although life sciences is kind of throwing a wrench and all that so it's it's a little more than that there's three buckets there's industrial innovation life sciences and mainstream innovation and so the industrial part is the leading product within that segment is Catia or Catia. It's the leading global solution for designing and modeling products in 3D and doing so in the context of its real life behavior. If you're looking, two of their big building or designing software applications are SolidWorks and Catia. You might be slightly confused in looking at both of them, how they differ. Now, Brett is an engineer,

So he's used SOLIDWORKS before. I talked to my brother, who is a current engineering student, and I wanted to get his take on the differences between the two. CATIA is similar to SOLIDWORKS as well, but it's better designed to apply certain stresses to a product. So you can kind of stress test the actual product a little more as opposed to just the actual design phase, if that kind of makes, is that a good way to encapsulate it? Yeah, there's more. Solidworks is better for assembling certain stuff, and it's more in the education, I guess, just because it's a little cheaper. And Cadia, I think, was started out as the joint venture. Maybe you're going to get into this in the history with Boeing, but yeah. Yeah, that was the first product they actually launched. Boeing is one of their big customers for it. It accounts for industrial innovation. That segment accounts for 53% of overall revenue. It also includes a number of other products, including Inovia, Simulia, which is like simulation applications. I'm not going to go through all of them, but they've got a whole host of different products in there. And then the second segment that I think is important to highlight is life sciences. So this is relatively new, and it's comprised primarily of metadata. And metadata is an all-in-one life sciences platform that helps companies like pharmaceutical manufacturers or medical device makers run clinical trials, engage with customers, and leverage swaths of data.

basically it's on i would just look at it as a holistic life sciences platform for pharmaceutical or device manufacturers is that kind of the best way to put it yeah this one is tougher for me as well i have no industry experience here so i i watched a couple tutorials on seems understandable right though it's like there's yeah there's a couple of different products in there but it's more it's a lot of like reporting and workflow tools as well if you're working at like a lab or a pharmaceutical manufacturer. Right, right. Because the information people have to get

and transfer to other people is probably very, very hard to manage. Yeah. And then the third one, or I guess I should mention that accounted for in the most recent quarter, I believe 24% of overall revenue. And then mainstream innovation

is the third category. This is primarily comprised of SolidWorks. As I mentioned earlier, SolidWorks is the global leader in 3D computer-aided design. They also compete with some other ones as well. I think AutoCAD. And they compete with Katia.

I don't know why these aren't in the same segment. It's a bit confusing because they're very similar. Maybe it's so they can upsell. Maybe, maybe. We'll see. But it really helps engineers and designers build new shapes and products. It accounts for basically a quarter of revenue. Essentially, think about it like Katia accounts for half of revenue.

Life Sciences and SolidWorks both account for a quarter of revenue. And SolidWorks, I think Brett's going to talk about this. But these are software applications that take time to train and learn. And I almost think about it like Excel in that way. It's like Excel on steroids. It's like Excel times 10. Yeah. And carved out specifically for designers and engineers.

But they serve tons of different end markets, including, and I think the bulk of their revenue comes from the big manufacturing enterprises. So think Boeing, Tesla, NASA, Airbus, even companies that are like managing warehouses or like consumer goods companies like Procter & Gamble, Pepsi, they have tons of big customers. If you're building products, there's a good chance that you're using a Dassault system software. But I'll touch on the history real quick. They were created in 1981 to design products in 3D through a spinoff of a team of engineers from Dassault Aviation. So, Dassault Aviation was a part of the Dassault Group, and the Dassault Group, I believe, is basically a rich French family. Yeah, a big aerospace kind of family in France that's uber wealthy now because they've created all these really, really valuable businesses. Yeah. And the spinoff was initially to help design a platform to build 3D products. And they launched with their flagship software application, Katia, which is still their primary revenue driver today. And they signed a sales and marketing agreement with IBM initially to resell this to a bunch of IBM's customers, which really helped them kind of get their foot in the door with a lot of big enterprises. And then the software took off most among the large aerospace and automotive manufacturers during that time. And then kind of fast forward to 1996, the company had a successful IPO.

They raised a lot of money and they were able to use the proceeds to acquire SolidWorks and a couple of others. I mean, if you look through the history of Dassault systems, it's basically most of their products have been acquired and then bundled in or repackaged in a way that's easier to potentially sell to customers. And so SolidWorks was really one of those. And while Dassault has made tons of other acquisitions throughout the 90s and the 2000s, it was really the iterations and the growth of SOLIDWORKS and CATIA that drove the performance and the results for Dassault over the last four decades. And then in 2011, they began their shift to the cloud. So they were shifting to Amazon's Elastic Computing or EC2, making it available to their customers that way. I know a lot of other software providers have made this transition, so you might be familiar with it. Adobe is an example.

Look at Autodesk. Today, 80% of their revenue is cloud-based subscriptions, and the remaining 20% is that licensed model. But it's progressively going more and more towards cloud, which makes it easier to ship new product updates. It makes it more recurring in nature. and these aren't desktop or excuse me these aren't browser like sas products they're they're still downloaded on people's computers because they have the need for so much processing power however they now people can buy them through subscriptions and a lot of stuff can get connected to the cloud which can help just for transferring files which is very very important

for this type of stuff yeah and the most recent big shift came in 2019 when the so bought metadata for 5.8 billion dollars and they announced their intent to extend extend our focus from things to life so you're going to talk about the life sciences category uh in in your future growth opportunity but basically they're trying to move away from purely uh manufacturing like items things products to uh being 3d software for human beings yeah they are very bullish on the life sciences sector, which we will cover further later. Let's hit industry and competition. We're going to be talking mostly, I think a lot of, at least from the numbers I put down, will be in euros. I guess it's pretty one-to-one now, but they do report in euros. So some of the

stuff we might be looking at will be in euros, but we might reference other stuff in dollars. Sometimes that's what they do. So they have a ton of different products, as Ryan mentioned, and it's all focused on software for engineering or life sciences. In its annual report, they estimate that their total addressable market is $42 billion in US dollars. And they also talk about a potential future total addressable market of $100 billion, which I think is kind of funny to hear that term. But I think they're saying is that their industries that they're in continue to grow and have general tailwinds of more adoption from companies and people. Now, for competition, I'm going to look at both the manufacturing side and then the life

sciences side. They have some small infrastructure products that we don't really need to look into, but I'm kind of grouping Katia and SolarWars into the same bucket here. And then we'll life sciences will be separate so for manufacturing and engineering uh not so excuse me not solidworks but just so in general is the leader in this space and then the other players are kind of second third or fourth you'd have autodesk with inventor fusion 360 and autocad autocad is not is somewhat of a competitor but the big competitors here inventor which is essentially a copy of solidworks that autodesk made or acquired um that hasn't really caught on some kind of second fiddle Then Fusion 360 is kind of the cloud-based subscription that is trying to weasel its way into the marketplace a bit different.

There's Siemens. I don't know their product name. Then there's PTC that has Onshape that's a competitor. And then there's Ansys that competes in the simulation technology. As you might have heard at the beginning, we're going to be coming to a lot of these this month. So once we flip over, we're going to see hopefully next week, the week after, how these businesses compete with each other, how large the companies are, all that good stuff. That's why we want to do the themes here.

Now, with the life sciences, it's a bit different. We're not going to be covering a lot of competitors, but it's also very different than the engineering software market. So there's a lot of competitors out there. There's Schrodinger, Benchling, Labware, Thermo Fisher Scientific, which is a large company, and then there's Viva. However, according to their annual report, the market is highly fragmented with the three largest players,

one of which is Dassault, having less than 30% market share. I think this is a very important point to make, and it is a big part of the bull case for the life sciences division as they're hoping there's going to be a general industry tailwind as more and more companies adopt the best-in-class products like Medidata that all the pharmaceutical companies are going through. Now, let's go through management and ownership. It's a pretty simple one, and it's very French and European because you have the family group, and they seem to have been in control for decades. It's a long-standing family control company. The CEO of this division is Bernard Charles. And I'm saying this division as kind of of the Dassault Group, and I'll get into the ownership briefly.

So Bernard Charles, he was essentially one of the founders of Dassault Systems when it was spun out in 1983 as its own company. And then in 1988, he was made president of strategy and R&D. And in 1995, he was named CEO, which he is still in the same position today. So really, really long tenure there. And then in 2016, he was actually named to the board of directors. I think that might have been a little bit late to name him to the board of directors, but I don't know if he cared.

He holds a PhD in mechanical engineering and is in his early 60s. So clearly, the man knows engineering software, and he's been working within the industry for a long, long time. Now, other important person would be Charles Edelston. I doubt that is the proper pronunciation for a French person but he is named the founder of the company he's also the chairman of the board today

and is the chairman of the Marcel Dassault group. This is important looking at his voting power and if you what he did, actually as a note here we should say, pause Substack is free now for all these show notes that we're doing with people if you are

only listening to the free, if you didn't subscribe to the CCM Plus experiment that we did um we started sending out the show notes and our charts and all the metrics and all the numbers that we go through through our free sub stack um so we'll have the link in the show notes subscribe to get all the numbers here that we may reference throughout the show we'll bring that up every episode but yeah for reference he has a voting power of charles edelston here has voting power of 8%. And that's important because the Marcel Dassault group, which is the Dassault family company has a voting power of 54.3%. So I really think you can combine those two numbers and say,

okay, he is definitely going to vote with the family because he's the chairman of that family company. If he didn't, that would be very crazy. And then lastly, for him, he is 84 years old. So there's going to be a transition here at some point. I mean, he could go for another decade, i guess or two but i bet you know he's getting up there in age no no need to beat around the bush um looking at the executive team big highlight was that there generally have been at the company for a while the coo has been there since 2001 the vp of rd has been there for 30 years that's two other examples the ceo as we mentioned has been the ceo since 1995 and has been at the company since the 80 80s uh the board has 12 members uh they it's pretty big which is likely because they have a

lot of the so group and family members on the board so the other members have been there to make sure they have the requirement number of independent directors other note that i think for management ownership is interesting and again this is very european they love esg so much so that it devoted 55 pages to it in its 2021 annual report if anyone wants to read that stuff by me i kind of just skim through it um i wonder how much of that it's required it's a lot of i think european requirements is for like lower cost of capital like whether they're able to like raise green like green type bonds if they like i mean 40 pages in the annual report i've seen lower cost capital i've seen a lot of other companies raise green bonds for without the esg coverage

so i don't know if it's that they seem focused on it though and i'll get to why it seems like they're focusing on a lot is because the executive compensation uh 15 of the variable is based on esg initiatives so luckily it's not that big but that's something to watch out for if you're looking at this company and it just it's just a red flag or maybe not a red flag but a small it's it's a concern if executives are based on esg stuff when that is very hard to med like it's hard to directly measure that stuff and how it's generating shareholder value but they're exactly the compensation in general very standard 50 fixed 50 variable the other uh stuff for the variable compensation besides esg would be earnings for share growth revenue growth versus competitors

um non-ifrs which is basically non-gap uh operating margin and more seemed fine their total compensation was only 3.2 million euros for bernard charles uh so very standard no no concern there on a heavy pay again that's very european we've covered european companies they do not have the concern a lot of american companies do of overpaying their executives and then the other one the only yellow flag i had is that edelston again i know i'm probably mispronouncing his name he gets paid over 1 million euros a year as the chair of the board i think that's a little high once you agree for someone that already owns so much stock um yeah greedy he owns almost 80 million shares for context so yeah i mean he's the founder too and he's still getting paid that

it just that rubbed me slightly the wrong way only real concern again no one's going to not invest in this company because that guy's getting paid a million a year but didn't like it all right yeah if you put it in context of like how big the business is it's not that it's not it's manageable yeah exactly and their compensation was not egregious at all um a little low honestly a little low i saw yeah some of their executives don't get paid much kind of comes back a lot lot of stock yeah that's true that comes back to ubisoft too when we saw that um they're another european company i think french as well they didn't get paid that much and maybe that's just kind of the european thing compared to the united states all right uh i don't think there's anything

else important on the ownership there it's family control that's really all you need to know earnings though ryan how have they been doing recently yeah this is a pretty easy task honestly Typically, we get either complicated earnings or a complicated balance sheet, but this one was pretty easy. So for the last full year, so 2021, they did just under $5 billion in revenue. That was up 11% in constant currency. Now, are you USD or Euro? These are Euro, sorry.

And then, so 4.9 billion, but what's the conversion right now? Yeah, it's basically the same, but just in case anyone's wondering. And then a billion dollars in IFRS operating income, but a billion and a half in free cash flow. So about a 31% free cash flow margin. The discrepancy there between the IFRS, which for anyone that doesn't know, I believe it's just international reporting standards. It's the gap of international is the way I think about it. there's a few differences that you may have learned in your accounting 101 courses, but all intents and purposes, it's basically the same. And then, so the discrepancy there between

the operating income and the free cashflow is caused primarily by two factors. So billings versus revenue recognition, they've pivoted now to basically this billings model where people can pay upfront for their contracts now that it's cloud-based and you don't actually recognize the revenue during that time. I didn't go through the entire revenue recognition strategy, but basically you're getting the cash in the door,

but you can't quite recognize it as revenue. So your cashflow is gonna be potentially more elevated than your GAAP income. And then the other one is share-based compensation. They had about 250, I wanna say, million in share-based compensation. Not too crazy. It's been about 1% dilution annually over the last five years. So I would look at both, I guess, as metrics, but I mean, a billion and a half in free cash flows for a full year, that's 31% for cash flow margins, pretty healthy.

And then as for the most recent quarter, it's really just been more of the same. And this is when you look back through all the results and on that newsletter, you're going to see some of the charts. It's been a steady grower. Revenue was up 18% year over year in the most recent quarter. However, only 8% in constant currencies. So we've looked at a lot of companies lately where their revenue has been great in constant currency, but horrible in reported currency because they've had to translate it back to the dollar. because to so earns in the dollar converts it back to euros uh they're they're able to report higher revenue um but on on a category basis it was pretty strong across the board industrial was

up six percent year over year mainstream innovation was up five percent so both those grew at both steady cliffs and life sciences is growing much faster or about double the pace at 13 percent And then operating margins are relatively stable versus last year. They actually, it seemed like management intentionally brought the margins down a little bit, which we can talk about later. So 31.6% this quarter versus 33.8% last year. And then operating cash flow grew 8%. So it's really been a steady grower with basically constant top line and profit compounding. And it hasn't been rapid growth, but it's been really steady.

Yeah. And SolidWorks and Katia seem to be very easy businesses to run. The renewals are not hard to get. Yeah, absolutely. And then as for the balance sheet, really straightforward. They've got $2.8 billion in cash and cash equivalents and about $3 billion in total borrowings. So enterprise value is not going to be too different from the market cap here. 95% of the $3 billion in borrowings is A-rated bonds.

So it's bonds that they've issued that are fixed rates, not variable debt. So here's kind of how it breaks down. And this was as of their 10K. So they've already paid some of this down. But they had $900 million due in 2022 at 0% interest, $700 million due in 2024 at 0% interest, $900 million at 0.125% due in 2026, and then just over a billion dollars at 0.375% due in 2029. I guess part of- Got to bless the European Central Bank. Yeah, that is a remarkably low debt.

And the remainder, which is a tiny percentage of their borrowings, is a term loan that bears interest at LIBOR. Well, it's going to be SOFR now, but plus 0.6%. Really, they've got really good, really cheap debt. And they've got steady cash flow, which I think enables them to have that cheap debt, but super clean balance sheets. And I think being in Europe, they were able to get maybe even cheaper debt than you would here in the US. Oh, not maybe, definitely. uh yeah the i'm so i'm kind of disappointed they don't have more of this cheap debt given how consistently they've generated cash flow but yeah yeah but they can't they raised a lot of this

in sort of an opportunistic period and now they're kind of paying it down and they are uh choosing i guess to either deal ever i saw them mention that potentially buying back if they they feel the need oh that would i would i would be very disappointed if they bought back these they're saying it as whichever they wherever they see the best place to return that capital whether that's the deleveraging or buying back they're buying back oh excuse me buying back uh the debt or buying back the stock either whichever they see yeah well hopefully they only buy back that it's not buy back pay back the debt on time because the interest rates are free um with inflation rate i mean come on it's like negative eight percent right now uh but either way we can talk

that maybe at the end for management but valuation pretty simple market cap 45 billion euros enterprise value like ryan mentioned 45.3 billion essentially the same two metrics i wanted to look at for this company as a multiple is just ev to sales and then ev the operating cash flow i don't like for these software businesses that have the upfront costs i like to look at the operating cash flow which to be fair with the sbc can make it seem a little bit higher than maybe their their you know real earnings power but i think it's even better than operating income if they're growing uh their billings because sometimes that operating income can just look way worse and really make the the multiples look higher than they actually are so if we look at ev to sales um which some

people might not care about but i think with these companies it can be interesting it's 9.3 so pretty high but as we looked earlier the margins are quite high now if we look at ev to operating cashflow is 28. So still an elevated multiple, just slightly above the market earning average of, what is it, about 20 right now? It honestly trades right about where I would have thought it would. Yeah. And we'll get to this later. Yeah. It seems like most people that own this understand that it's a high quality business. All right, let's move to anecdotal evidence. Ryan, what'd you find here? Yeah. So I spoke with my brother, as I mentioned, he's an engineer and he said he gave some fairly convincing a fairly convincing spiel for the

business honestly he said there's an entire semester long required course that's taught at a school specifically for solidworks and then once you've passed that you take he he mentioned the software at the time and i didn't think much of it but he said you take a class that's split for the semester between two different softwares but one of them was abacus which is he said it was simulation software and then i looked into it abacus is also owned by deso systems it's in the simulia or simulia i don't know best way to pronounce it but that package which is included in the industrial innovation segment basically this software is ingrained in engineering culture from everything i can tell and it starts as soon

as you begin to learn uh what you're going to be doing in the workplace um if you want to be an engineer you really got to know the software yeah right well uh yeah i can make an argument i can make well i'll make an argument later that there could be a way that fusion 360 is trying to gain market share and doing a good job of it but it'll be a very very very tough task i mean the same thing the mode for caddy s all works phenomenal i mean for example they have been the software provider for Boeing for decades. I mean, can you imagine trying to come in with a new software program and saying, look, you got to replace this. You not only have to be, you have to be, it has to be such a better value add just because of the switching costs are so high.

And yeah, I mean, the education stuff is also very, helps with the competitive advantage. The other thing you mentioned was in, and I always kind of thought of them as different softwares but he said once you've kind of learned one of the systems so say solidworks it becomes much easier to learn a new system so fusion 360 or katia and they're copycats yeah so potentially the switching costs aren't quite as high as maybe some might well that's the thing for an individual i don't think it's as high but if you have the cross connections across a larger manufacturing company it is extremely high because you have to send the files across we don't need into the details of that but you kind of see it's almost like microsoft excel with in that regard

in a giant company you wouldn't be able to dislodge it because everything is based on that and the connectivity you can't take out one node you're just screwing yourself if you move to the other one just because of the small intricacies um then on the life sciences front anecdotal evidence there i mean it's harder to judge but it feels like and i guess everyone has this take that the tailwind should be very strong for the next few decades they paint a good picture too for what they want to do with it yeah i'll get to that my future growth opportunity funny quote very very big brain quote but let's move to future growth opportunities ryan uh why don't you start and because that then you're going up on life sciences i mean yeah it is the big one all

right life sciences software is my big future growth opportunity i mean last quarter division grew 14 year-over-year on top of 19 growth in 2021 um there's been strong execution at MediData, that 5.8 billion euro acquisition they made in 2019. The long-term goal is to make the life science industry as virtual as the engineering industry as they have done with SolidWorks and CATIA. Here is a quote from the acquisition. Again, this is the big brain quote I just mentioned. The virtual world will push the bounds of possibilities to transform not only research and science, but also the entire pharmaceutical and medical device industry and medicine in general we made virtual twins of cars and airplanes possible we will do the same for the

human body now that sounds a bit like an evil uh genius or evil villain quote but that's their long-term goal is to kind of virtualize a lot of this stuff the simulation within the industry engineering industry has really helped for efficiency and product build-outs and just not wasting resources they're trying to do the same with life sciences i will say i read that quote first and then i watched the tutorial and i was a little underwhelmed with what the software looks like it's not as good as the solidworks type simulation or you know the simulations not not quite yet uh but yeah you you mentioned it the life sciences segment is sort of the glaring opportunity for them right now so i'm not going to double down on that um i'll kind

of talk about maybe external tailwinds that they could benefit from so i think there's a pretty good chance that this next decade, there's maybe heightened focus on infrastructure or an increased focus on infrastructure. I think the two reasons I say that is there's needed investments in energy production right now. I think everyone's kind of seeing that there's sort of a rejuvenated focus on bringing energy costs back down. And then the other one is there seems to be a bit of a reversion and globalization trends so potentially reshoring a lot of manufacturing those seem like two big tailwinds that would drive increased spend in engineering software which they're going to be right there to capitalize on if those two come to fruition they'll benefit yeah that is

definitely a way they can better all right highlights lowlights ryan what did you like dislike about so systems i don't know should should we say is it systemic i think there's an between the it's s-y-s-t-e-m-e-s our french pronunciations as west coasters in the united states is probably very very poor yeah we're going with systems uh so highlights for me katia and solid works i mean they've really been wonderful businesses just in general they're kind of i think there's a software bucket that could be classified as the you're stuck with it for life bucket um And I would say once you're an enterprise and you're on SolidWorks or Katia, you're probably going to stick with it for life just because it gets ingrained and it gets so hard to switch. It's such a pain.

The other one that I like is because I think the switching costs are pretty high for the enterprises. There's loads of pricing power, which now that they're majority cloud-based enterprise seems easier to implement those price increases. And then the last one is, it's just been a good business to own. They've shown a clear track record of growing free cash flow per share over the last decade, over the last two decades. So it's been, it's almost too easy to own in some ways. Uh, life sciences kind of complicates the mix now, but, um, it's just steadily compounded the free cashflow of the business at almost just like a very simple rate. Yeah. That's probably why that's why they have that high value, uh, multiple low lights for me though.

Um, I'm not sure why this is, but management scenes seems keen on limiting their margin expansion. they had 34 operating margins last year and then i was reading through the annual report and they said we were guiding for uh 30 it was like 31 to 32 so it seems like they want to grow their top line and this is the this is the non-ifrs um they seem like they want to grow their top line while limiting margin expansion too much i wonder if that's more a function of not wanting to piss off your customers and say, wow, look, look how much the price gouging us there. They keep increasing their profitability. It gets easier to point at that. If you maintain

margins and you grow your top line, it's not quite as bad. Um, but that's more speculation on my part. The second low light for me, I don't know the competitive landscape that well for most of their end markets, Brett, you might know it better. At the end of this month, you were hopefully going to know it a lot better probably um but maybe not on the life sciences side and just like i guess i don't know the nuances or the how big of a difference it would be between something like fusion 360 and something like solidworks yeah yeah that makes sense yeah life sciences that's a tough one to understand all right my highlights have been switching toss solidworks and katia uh are going to be high um same as adobe revit excel bloomberg i guess for

finance maybe um there's also a very strong moat for the education institutions that they're in for reference uh they say this in the annual report they are at 80 percent of the top engineering schools around the world so they have the majority market share there and that is going to help them because if the kids are learning it then they're gonna like i guess another example of the education mode is if you put this sort of skill on your resume then you know that the mode is strong adobe uh excel yeah revit solidworks aws uh some of the database stuff like oracle i mean that's when you know the mode is extremely strong now second highlight that i think even can increase the mode among enterprises is bundling the products

through this 3d experiences brand which the branding on that is atrocious but it is extremely hard to understand because the names are i mean ryan you're trying to go through it i mean it's just it's really i don't want to call it dumb but confusing uh but either way by having it under all these 3d experience stuff you can sell say all the software an engineering company would need as a bundle this includes their soft you know like communications product life cycle management and when you have that you can keep out the smaller companies from winning contracts because they cannot bundle and then third one metadata seems to have really good you know strength in life sciences and pharmaceuticals the top 20 pharmaceutical companies by revenue all use

metadata which i think is a very great stat um i think similar to how katia and solidworks grew with boeing and other manufacturers over the last few decades metadata and so is other software products for life sciences should be able to grow with these large customers as well um i would imagine they have really great net retention rate numbers and then third our fourth one long-term tenure with management team i like how that guy what is it bernard charles has been there for a long time it seems like he just wants to be there for like now low lights uh ryan already mentioned the lack of margin expansion since 2017 operating margin has hovered around 20 that's their ifrs one so it's not ifrs it's kind of a little above 30 um i think you could argue maybe that they've gone

through the subscription transition and then they're heavy they're investing heavily into life sciences but i think this business should be able to achieve 30 or even 40 ifrs margins we've seen adobe autodesk kind of push and say guide for that 40 number i i'm kind of confused and why just so can't get there as well because the unit economics should be the same uh third second one on lowlights they need to grow through acquisitions they have acquired a ton of companies over the years i worry about too much diversification on these and a lack of a coherent strategy the blow that can come with this this is a downside for a lot of the other companies i think we'll look at ansys and autodesk is kind of two downsides for them as well it is kind of the

upside because they acquire companies like metadata but there's a lot of them where it's most likely they wasted a lot of money um and then fourth there's our excuse me third on the lowlights is the competition from Autodesk Fusion 360. That product is growing really, really quickly at a very cheap price compared to SOLIDWORKS. And yes, it's not nearly the size of SOLIDWORKS or CATIA in the market today, but at the current growth rate, you're seeing a very, very large adoption. And the way Autodesk is pricing it, it could threaten some of what's going on in some of the moat there just because the price is so much uh lower um and they're willing to they're willing to go at that low price all right let's move to bull and bear case ryan

what do you think has to go right here for this to be a good investment well 28 times enterprise value to operating cash flow i think any way you look at that that's a bit of a premium i think you have to have for this to be better than a lot of the other opportunities out there today or even potentially the index, I think there has to be some combination of margin expansion as well as near 10% top-line growth. I think both of those seem doable, although we didn't mention the lack of margin expansion so far.

But if they get some combination there where you've got operating profits in the low to mid teens, percentage growth then i i think you're looking at potentially a market beating investment but i think you really have to have both yeah they should be able to expand margins that's kind of the big question here and uh will they is another one is is also there um yeah i think i'm in kind of the same boat investors with the operating cash flow multiple where it is i think they understand that to sow systems is a very high quality business so if you're going to invest today i think you need to be very optimistic about being more optimistic and uh we all understand the

mo but you got to be very optimistic about the future growth and the margin expansion like ryan mentioned um for this to do well over the next three to five years you have a market cap or excuse me enterprise value of uh 45 billion euros so you need i think you need to see a path where cash flow reaches kind of that four to five billion dollar range not dollar euro range uh which I guess is equivalent. If it does, you'll likely do quite well as an investor, but that's a big leap from the one and a half billion. There probably gets two very soon. They got to double it from there. I think it is possible considering all the growth factors we outlined earlier. We talked about the tailwind for manufacturing reshoring in America,

the pricing power that they have, the life sciences division growing very, very quickly. We didn't even mention the outscale cybersecurity and cloud division that they just spun out of, which probably wasn't important for us to cover on the show, but that seems to be having a lot of promise and there's, you know, signing up with these, uh, good. It's, it's, it can, it was a confusing product to go over, but it's, it seems like it's some sort of cybersecurity thing with, uh, governments or institutions that want information to be very, very secure.

I don't know how much potential that has, but again, they seem to be very optimistic about it. Uh, so yeah, I mean, the, There's not – I wouldn't be surprised to see this thing grow at 10% plus constant currency revenue and expand their margins, and you do well from there. Now, bear case, Ryan. Well, you kind of just mentioned it there. Let's say all the ancillary products, and you can throw metadata in there as well. So everything besides SolidWorks and Katia, maybe the simulation stuff, if that stuff doesn't grow and all your growth comes from SolidWorks and Katia, I don't see the top line revenue growth being where it needs to be to warrant the price. There's a chance that life sciences kind of had a little bit of a short term catalyst due to COVID that might not be repeatable.

so yeah they highlighted that people used it for that so yeah and maybe i'm i may the competitive landscape in life sciences might be more intense than i think or i like well we know how they paint we know because the market share stuff so it's not they're not locked into that position as they are with katia and solvers they don't even mention market share because i think it would seem too monopolistic um but yeah i mean with that market share is fragmented it's fragmented for a reason and they're going to have to win to become the dominant player. Yeah, I mean, the two, the industrial and the mainstream channels both seem bulletproof. But if those only grow 6% to 8% and your margins are steady,

the expectations are too high right now for that to be a really good returning investment. Yeah. Yeah, I mean, my bear case is similar. It's just slowing revenue growth for a variety of reasons. I think you could get market share losses from Fusion 360 if that continues on its toward growth. I don't know whether that is going to affect them or if it's going to be additive. We'll see to the industry where Fusion 360 might just be going for cheaper clients. I think we could see less growth in life sciences area, like the thing I mentioned with COVID might have given

them a short-term bump. You can have macroeconomic factors where if we go into a global recession, And I don't think they are, look, their existing customers might be recession-proof, or excuse me, the software payments might be recession-proof because you have to pay for them. But new customer add-ons will probably be way, way less in a recession. I know that the subscription stuff can be very, very reliable. But again, if there's less manufacturing going up, if there's less infrastructure going up, they are probably not going to be gaining that many more new customers, and they could lose some if people go out of business. Now, with a high starting valuation, I think these small little things could impact things because, excuse me, impact your returns because you don't need that big of a disappointment. You don't need growth to be that, like if they only go revenue of 5%, you're probably not going to do well here, which is what I'm worried about above all else. I don't think we need to be worried about their competitive position too much, but it's just that incremental growth that would be the big concern.

All right. More or less interested. I think the theme might change from last month to this month. It's kind of a big, not really a shock, but it was a nice transition to go from the home builders, which have all these sort of business model problems to the engineering software companies, which seem to have phenomenal business models. But Ryan, I don't want to spoil your answer here. Yeah, it was. Among all the home builders or the housing market, it was always some flawed characteristics in their businesses, but wonderful valuations potentially. And now it's basically the inverse where you're getting really good business models, but difficult valuations. And so I'm a little less interested, honestly. I think the next decade for Dassault is going to look a lot like the last decade, unless the life sciences might have some clear upside. Maybe that's like a big, maybe that provides some optionality here, but free cashflow per share over the last 10 years for Dassault systems was up 132%. It's fine, but it's not, I don't think you're getting great returns if they do that again

And over the next 10 years at 28 times operating cashflow. Yeah, you're probably right. Yeah. I mean, I was going to say the stock is up 218%. So if they grow, you'll add that rate. You'll probably do fine, but it is a high starting valuation. It's outpaced. I mean, the price, stock price gains have outpaced the cashflow growth.

Yeah, yeah, exactly. Exactly. I'm more interested. I am not interested at this valuation, giving the low growth plus the high multiple here. And again, we don't want to tease the Autodesk episode that much because it just is one of the episodes we're going to be doing. But comparatively, I think they have a lower valuation and higher growth potential. But I'm still more interested in DeSo system because I think it is one of these engineering software companies I think are very high quality. And at the right price, I'd be very interested in the stock at 28 times operating cash flow.

Probably not. Probably want something closer to a market multiple or lower. But yeah, still more interested. I think it's very, very exciting. All right. That's going to do it for this episode. Next week, we're going to be covering ANSYS, the high-tech simulation software that competes with companies like SolidWorks and CATIA. All right. That's going to do it. Remember, we are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and may hold securities discussed in this podcast. Thank you all for listening. We'll see you next week.

Thank you.