ANSYS: When Software Simulation Turns Into Real Value (NASDAQ:ANSS)

Investment Thesis

From a small fork to a giant aircraft, simulation software helps shape and improve the world we live in, and Ansys (NASDAQ:ANSS) sits at the top of the Computer-aided Engineering industry (‘CAE’). CAE software are used from the Aerospace to the Healthcare sector to design and simulate product behaviours reducing development costs and improving product quality and safety.

Over the years, Ansys’s business model delivered astonishing results, but that might be just the beginning. Starting in 2019 Ansys started to invest heavily in its growth drivers to benefit from the opportunities that the CAE industry can offer going into the future, as companies demand more precise tools to develop cutting-edge products able to transform the way we conceive our world.

However, a strong business model and bright future opportunities should not tempt investors to blindly jump into buying Ansys’s stocks. Currently, Ansys is trading well above its intrinsic value of $199 and does not represent the best investment opportunity, at least not yet.

In today’s analysis, we will find out why Ansys should be closely followed, waiting for its price to decline in order to buy a great company able to represent a good long-term investment opportunity.

Business Model

Ansys develops and sells simulation software used by engineers from different industries to design and test products before launching them into production. Ansys’s software is able to simulate real-world conditions and different types of physics, permitting engineers to test virtual prototypes and study their behaviours in every situation.

The biggest advantage of CAE is the considerable reduction of development costs. Instead of wasting resourcing and time in building prototypes to be tested, thanks to Ansys’s software, companies can simply design and test their products on their computers, improving the design, efficiency, and performance before starting to manufacture the final product.

Revenues are generated 49% from software licence sales and 51% from maintenance services. Software licences are sold both under fixed-term lease and perpetual licences, but in the last years, perpetual licences have almost been replaced by fixed-term lease ones, permitting Ansys to have more stable and predictable recurring revenues.

With every licence sold, customers have the right to purchase maintenance, support and upgrade services for the duration of one year, and the option to renew them every year. Starting in 2018, revenues generated by maintenance services surpassed revenues generated by the sales of software licenses.

With one product, Ansys is able to generate two different revenue streams, stabilizing the uncertain revenues generated by multi-year licence sales with the recurring revenues from maintenance services.

Operating Performance

Looking at Ansys’s operating performances, revenues grew at a compound annual growth rate (‘CAGR’) of 10.7% from 2011 to 2021 reaching $1.9 billion. Ansys doesn’t need to spend a lot to sell its products, and that is shown in an astonishing average gross margin of 89%.

Operating efficiency and profitability are also excellent, with a five-year median operating margin of 34% and a median return on invested capital (‘ROIC’) of 14%.

Ansys has generated sustainable and consistent free cash flows to the firm (‘FCFF’) in the past, but in 2019 FCFF turned negative. The main cause is the considerable increase in reinvestment done by the company to support future growth, particularly in acquisition and R&D expenses. Being FCFF obtained after subtracting the reinvestment needed to support growth from the after-tax operating income, it is easy to understand why FCFF turned negative by looking at Ansys’s reinvestment margin going from an average of 30% from 2011 to 2019 to an average of 60% in the last three years.

In the nine months ended in 2022, revenues grew 9.6% badly affected by macroeconomic headwinds, but both the gross margin and operating margin remained stable, at 90% and 24.4% respectively.

Financially, Ansys has a negative cash position of -$250 million due to a considerable increase of debt outstanding started in 2019, but the overall financial condition is healthy having a current ratio of 2.38, a debt-to-equity ratio of 0.19, and an interest coverage ratio of 41.8.

Growth Drivers

Ansys’s main growth drivers are represented by the investment made in R&D and Acquisitions. By developing new technologies, or acquiring technologies from already existing companies, Ansys is able to maintain its leading position in the CAE industry by attracting new customers from different fields and retaining existing ones adding new features to its already existing products.

Future growth can be determined by looking at how much and how well a company has invested in its growth drivers. The Reinvestment Margin shows what percentage of revenues has been reinvested into the company, while the Sales to Invested Capital ratio, shows how much revenues have been generated for each dollar invested by the company. If we multiply these two values and take the median value over the years, we obtain the expected growth rate in revenues based on how much and how well a company has invested in its growth drivers.

In our case, Ansys’s expected growth rate is 20.6%.

Market Risk & Opportunities

Simulation software has become indispensable for companies in industries like Aerospace and Automotive to develop cutting-edge products and cut development costs at the same time. It is not a surprise that the simulation software market is expected to almost triple by 2030, growing at a CAGR of 11.83%.

However, looking at Ansys’s main customers, respectively companies in the Semiconductor, Aerospace, and Automotive industries, some concerns should arise in investors’ minds. Ansys’s future performance might be impacted by the performance of these highly cyclical companies.

Automotive, Aerospace and Semiconductor companies, are heavily exposed to economic cycles, thriving when the economy is doing well, and suffering during economic downturns. In case of a prolonged economic downturn, those companies will be forced to stop investing in R&D to cut costs, and therefore there will be less demand for Ansys products, badly affecting its operating performance.

DCF Model

I use the discounted cash flow analysis method to value companies. The aim of a DCF analysis is to determine the present value of expected cash flows generated by the company in the future. The first step is to project the growth rate at which revenues will grow in the future. Secondly, we will need to assume the degree of efficiency and profitability at which the company will turn revenues into cash flows.

Efficiency is represented by the operating margin, and profitability by the ROIC. Having the revenue projections and future operating margins, we obtain the EBIT and, after subtracting taxes, we get the net operating profit after taxes. The ROIC is used to determine the reinvestments needed to support future growth, determining how much profit the company generates from every dollar reinvested into the company. Future cash flows are calculated by subtracting the reinvestments from the net operating profit after taxes. The higher the growth rate, the higher the reinvestments needed to support it, hence the lower future cash flows will be.

The last step of a DCF analysis is to apply the discount rate to future cash flows, usually calculated using the weighted average cost of capital (‘WACC’).

Projection

Trying to project Ansys’s future performances, the story we are telling here sees Ansys benefiting from the investments made to support future growth, with revenues growing at a sustained rate in the coming years, at the expense of short-term efficiency and cash flows generation, that will remain low in the foreseeable future, only to rebound considerably once Ansys reaches maturity.

Starting with revenues, as reported by the management in 2022 they expect revenues to grow around 7%. In the coming two years, we can start by applying the expected growth rate of 20.6%, based on how much and how well Ansys has reinvested in its growth drivers, and then let it slowly decline as the company approaches the steady state. With these assumptions, revenues are expected to more than double at a CAGR of 10.6%, reaching $5 billion by 2031.

Moving on to efficiency and profitability, in the coming years, as the company will have to reinvest heavily to support future growth, we can assume both the operating margin and the ROIC to remain lower than their median values, of 34% and 14% respectively. But as soon as the investments start to pay off, and Ansys reduce its reinvestment activity entering the steady state, assuming Ansys remains the market leader, we can expect both the operating margin and ROIC to improve considerably, surpassing their historical values, to 40% and 20% respectively by 2031.

With all of these assumptions, FCFF are expected to be around $1.3 billion by 2031.

Valuation

Applying a discount rate of 7.73%, calculated using the WACC, the present value of these cash flows is equal to an equity value of $17.3 billion or $199 per share.

Conclusion

Given my assumptions, Ansys’s stocks result to be overvalued at today’s prices. Despite assuming strong growth, high margins, and high profitability, Ansys cannot represent a good investment opportunity at these prices. If any of our assumptions will not be met, Ansys’s intrinsic value will certainly decline considerably, and buying Ansys’s stock now will only increase the risks.

However, Ansys should be carefully kept on our watchlist waiting for a considerable price correction that will make the company a good investment opportunity.