AGB 2022.14 - ANSYS (ANSS)
Long Runway for Simulation Software
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“It's certainly fair to say that by using simulation, you are much more efficient in the processes. You don't have to build prototypes. You don't have to invest in wastage in that form. And certainly, a single engineer can be incredibly efficient because a single engineer… could consume an enormous amount of compute. I talk about simulation as being a superpower for engineers because simulation gives the ordinary engineer the ability to really understand exactly how a product is going to behave even if that product doesn't physically exist” - Chief Executive Officer, Ajei Gopal, at the Bernstein Strategic Decisions Conference in June 2022
ANSYS
Ansys is the leading provider of simulation software for customers across many technical industries. Customers use the company’s software to simulate the effects of physics during the design, validation and engineering phases of their products. Simulation software helps these customers test and optimize their products at much lower costs and often results in faster product cycle times. Physical testing typically makes up 70%-80% of validation costs for an engineering project.
To help conceptualize a use case for simulation software, Ansys likes to give the example of crash testing for new automobiles. Instead of building a prototype and crashing it into a wall with test dummies inside to figure out how the car responds and the extent of the injuries, automotive customers can run a simulation.
This not only saves the customer close to a $1M from not having to run the physical test, but it also saves the customer time. By using simulation software, there is no need to build multiple physical prototypes and any subsequent tweaks to the test can be done within the software. The customer has the ability to run the test again with variations to the speed of crash and the angle of impact to determine differences in the safety rating of the car. Furthermore, testing can be done earlier in the design process, which would allow the customer to build multiple concepts simultaneously.
Ansys can call most large industrial and technology companies their customers. Technology is the largest industry segment representing 31% of annual contract value (ACV), followed by aerospace and defense (21%), automotive (17%), industrial equipment (9%), and energy (9%). Airbus has been a customer of Ansys for over 20+ years, leveraging simulation software to develop flight controls for their aircrafts. The company claims that 85% of the code used in an Airbus aircraft was built and tested using Ansys software.
Early in its history, Ansys’ core offering was in structural simulation but the company has expanded to other areas like fluid dynamics, electromagnetics, semiconductors, safety and optics over the years through acquisitions and organic investment. While the technical aspects of the software can be better explained by someone with a deeper background in technology (and physics), the basic idea is that having multi-physics offerings in the arsenal helps customers meet their more complex simulation needs. Most simulations these days require multiple systems to work together and testing of these systems often requires multi-physics simulation software.
The company has also made a concerted effort to expand the use cases for its simulation software from mainly validation to (1) moving upstream to the design phase and (2) downstream to the manufacturing and operations phase. To get more design engineers to use the software, Ansys released Discovery Live in early 2018. Users can see real-time simulation results on screen while making changes to their designs. An example the company gave was for a large automotive supplier working on a set of customer RFQs. The bids were held up because there was a bottle neck during the validation process, which was run by a single simulation analyst. With Discovery Live, the design engineers were able to run validations themselves and reduce RFQ times by 75%.
Ansys’ new Twin Builder offering is for simulation during the operations phase. Even after a product is working in the field, customers can leverage the software to create a physics based replica of the product. The digital twin can simulate the performance changes of the product from any future design changes and validate the changes to meet any structural or performance requirements.
Ansys (24% market share) competes with other pure simulation software providers like Altair (6%) and MathWorks (15%) as well as larger multi-software solution providers like Dassault Systems (13%) and Siemens (12%). The company has win-rates against the largest competitors at above 80%. Win rates are high because of Ansys’ strength and breadth of its software as well as key integrations with products from other large software vendors. The company has joint solutions with over 350 partners like Microsoft, AWS, PTC, Autodesk, Synopsis, NVIDIA and Rockwell Automation.
The company has increased its revenues at a 10.7% CAGR over the past decade, but there was a period of decelerating growth from 2013-2016. From the company’s account, the slowdown was related to underinvesting in other simulation areas outside of the core, a stagnant sales and market strategy and weakness in the underlying economy. You can almost separate the past 10 years into two 5 year periods, 2012-2016 and 2017-2021. In the first half, revenue growth was 7.4% CAGR and EBITDA margins averaged 46.3%. In the second half, revenue growth was 14% CAGR and EBITDA margins averaged 37.7%.
In 2017, Ansys replaced long-time CEO, Jim Cashman, with Ajei Gopal. The meaningful changes that were implemented after the new CEO came onboard include (1) a refocus on enterprise level accounts and investing more in sales and marketing, (2) an increase in the number of employees participating in equity based compensation (over 50% now), and (3) an increase in M&A activity, especially around new adjacencies and new technologies. This has resulted in higher revenue growth but at lower margins. Stock based compensation expense has increased as a percentage of revenues from 2%-4% revenues historically to 6%-9% over the past 4 years. And the company put debt on the balance sheet in 2019 for the first time since 2012.
Starting in 2018, ASC 606 also impacted revenue growth due to the changes in revenue recognition for the perpetual and lease licenses. Ansys started to give out the ACV metric in 2018, which is much more inline with operating cash flows. At the company’s 2019 analyst day, Ansys projected ACV to grow to $2B by 2022. The company is on track to meet that target. At the 2022 business update, Ansys targeted a 12% CAGR from 2022 to 2025 with M&A contributing 1%-2% of growth. The company generated $2B in operating cash from 2018 to 2021 and is expecting $3B of cash flow from 2022 to 2025.
Why is it a good business?
As the leading simulation software company, Ansys benefits from its customers’ increasing switching costs. Similar to other enterprise software companies, this is manifested in two ways. First, users of the software build upon their knowledge and expertise over many years. Companies would have a difficult time switching to another simulation software provider since it could potentially create inefficiencies and require time to ramp up technical expertise on the new software.
The company helps future simulation engineers gain proficiency early on Ansys software through partnerships with over 3.3k universities in over 95 countries. Students can download the software and online courses for free. So far, there have been over 2M downloads of the Ansys student software. The company also provides pre-revenue startups with access to their software for a large discount. There have been over 1.4k startups in this program and 230 of them have “graduated” to paying customers.
Second, past simulations run on Ansys software may need to be referenced or used in the future simulations. There is a large history of verification data in the software that is available to customers. Digital prototypes that have been created in the past using Ansys software are compared to a physical product to validate the effectiveness of the simulation. Thus, the verification data gives customers confidence that simulation using Ansys software has a high accuracy rate relative to the to a physical prototype.
Compared to other areas of enterprise software, customers of simulation software have a more accurate way of measuring their return on investment. Using the software can be compared against the cost of building a physical prototype and the resulting quicker design cycle times during development. The company states that upfront simulation reduces engineering labor costs by 26%, physical prototype costs by 30%, safety test costs by 19% and engineering change costs by 33%. Simulation software also increases ideation by 43% and iterative design changes by 60%.
Because of these effects and the fact that Ansys software is purchased through customers’ R&D budgets, the company has had better fundamental performance during economic downturns. During the ’08-’09 recession, Ansys was able to maintain higher organic growth rates vs. the peer group. The economic slowdown in ’15-’16 did reduce Ansys’ growth rate below the peer group but the company was able to come out of that period with higher growth.
The company’s refocus on enterprise customers has helped recently as well. Ansys made a change in 2017 to focus more on this subset of customers as they have the potential to drive the most incremental ACV growth. Enterprise customers typically sign larger long-term deals after using part of the company’s software. They are much more sticky, and when large deals get signed, usually adopt multi-physics offerings. Ansys’ top 100 customers contribute 40% of revenues (as of 2018), and this metric has moved higher from 30% in 2016.
Ansys’ renewal rates average around 90% on maintenance and lease licenses, with maintenance renewals even higher. Gross churn of ~10% on the recurring portion of revenues does seem a bit high for a company with software that is so embedded in the engineering process of its customers. But we have to remember that Ansys has many customers that are much smaller in size than enterprise customers. If you compare the company’s gross churn metric to other enterprise + SMB focused software companies, it’s more than Salesforce.com’s ~8% but less than Atlassian’s ~13%.
Returns on incremental capital?
Over the past 10 years, Ansys has invested 5% of its capital on capex, 46% on R&D and 49% on M&A. R&D expenses are mainly related to product development. R&D expenses steadily moved higher as a percentage of revenues from 16.6% in 2012 to 21.2% in 2021. The company has recently reinvested more in developing software for new adjacencies and emerging technologies. And Ansys continually reinvests in its core multi-physics software. Even though the laws of physics don’t change, understanding of physics evolves over time and incremental improvements in Ansys’ software are made over time as past simulations contribute to the library of verification data.
On the M&A front, Ansys has made a series of acquisitions that have increased the scope of its software offerings beyond structural simulation. The company acquired Fluent in 2006 for $565M (4.6x trailing revenues), Ansoft in 2008 for $832M (7x trailing revenues) and Apache in 2011 for $310M (7x trailing revenues). Fluent was the leader in fluid dynamics simulation, Ansoft was the leader in electro-magnetic simulation and Apache was the leader in chip level power simulation. These large acquisitions expanded Ansys’ core multi-physics offering.
Recently, the company has acquired more companies in adjacent technologies like digital twin and additive manufacturing as well as in emerging solutions like autonomous vehicles, 5G, IoT and electrification. Some of the recent acquisitions to mention are:
3DSIM (acquired in 2017) provided additive manufacturing simulation capabilities. Combined with Ansys’ solutions, the company launched the Additive Print simulation product.
Optis (acquired in 2018) provided lidar and camera simulation capabilities. This helps in the autonomous vehicle area where the company helps simulate miles driven tests.
LSTC (acquired in 2019) provided high-speed, short duration simulation capabilities. Examples use cases for this technology are to simulate a drop of a cellphone or a car crash.
Dynardo (acquired in 2019) provided process integration and design optimization capabilities. Customers use Dynardo to chain together many simulation elements and optimize it to a desired point in the simulation.
Granta (acquired in 2019) provided materials information management capabilities, which improves simulation accuracy.
Lumerical (acquired in 2020) provided light behavior simulation capabilities. This is additive to the company’s optical capabilities.
Analytical Graphs (acquired in 2020 for $700M) provided mission analysis simulation capabilities. This software is used for satellite launches and search and rescue operations.
Aside from the large deals, most financial metrics for the recent acquisitions were not released so we can’t estimate the returns on capital. However, given that most of the acquisitions were for the technology capabilities (not to add scale, or add customers, or expand into non-simulation software), it’s safe to say that the return calculations would have been misleading even if the earnings or EBITDA of the targets were disclosed.
We estimate that Ansys generated returns on incremental capital between 15%-25% over the past 5 years. Since the new CEO was hired, the company has been more acquisitive in areas outside of core multi-physics simulation. This has resulted in a lower return on capital even with the company’s recent higher growth rates, because most of these acquisitions were for the technological capabilities, which are likely expensive and margin dilutive.
As the largest simulation software company, Ansys can increase the distribution reach of these acquired assets and offer these new capabilities in conjunction with its core multi-physics simulation software. Looking ahead, while the it’s unlikely that the pace of acquisitions will slowdown any time soon, the company does expect operating cash flow to outgrow ACV and expenses, which should help improve returns on incremental capital in the future.
Reinvestment potential?
Ansys provides its estimate of the total addressable market from a top-down view. At the company’s 2019 Analyst Day, Ansys estimated that the simulation software TAM was $6.6B growing at a 9% CAGR until 2026. The addressable market was expected to be $15.8B-$20.6B by 2026. Most of the growth is expected to come from new adjacencies ($2.7B-$5.5B in 2026) and emerging high-growth technologies ($3.8B-$5.4B). Of new adjacencies, digital exploration, digital twins and additive manufacturing are the largest segments. And of emerging high-growth technologies, electrification, autonomy, 5G and Industrial IoT are predicted to be the largest segments.
In 2022, Ansys gave a business update to its previous estimates. The TAM in 2021 was $8B, implying a 3 year CAGR of 6.6%. With revenues of $1.9B, Ansys had 24% market share in 2021. The company expects that the core simulation market will grow 2x+ over the next decade and future use cases to add another 1x+ on top of that.
Estimating TAM from a bottom-up view is typically accomplished by multiplying the number of simulation engineers and the average cost of a software license. Ansys mentioned having 350k customer seats in 2010 and RBC estimated that the company had roughly 500k seats in 2015. This implies an “ARPU” of ~$1.9K/year using 2011 and 2016 revenues. However, this method of estimating TAM isn’t as meaningful for the simulation market because there is a third variable to the equation which necessary for determining the TAM.
Ansys also generates revenues for incremental compute power that a customer may require to run a simulation. This ties in with Ansys’ cloud strategy. Because simulations can take hours to days and require a lot of compute power, companies need to either (1) spend money on building that requisite compute power in their own private clouds, or (2) leverage the public cloud vendors to run their simulations. Even the car crash simulation example is a very complicated one in that it requires structural analysis of the car and how it bends during a crash, fluid dynamics simulation of the airbag and how it deploys, and analysis of whether the airbag deploys in a way to prevent injury to the passengers of the car. This simulation could take days and require thousands of nodes of compute power.
Ansys provides flexible licensing agreements so that customers can run part of their simulation workloads in their own private cloud or use the compute power from Microsoft Azure or Amazon’s AWS.
With a reinvestment rate between 40%-60% and a return on incremental capital between 15%-25%, we estimate that Ansys has increased its intrinsic value between 9%-10% annually over the past 5 years. While the company has seen lower incremental capital returns in recent years, that was mainly due to the high reinvestment rate because of presumably margin dilutive and expensive M&A.
What else is important?
Sales and marketing changes
Recent changes in the sales organization for Ansys has a lot to do with the reacceleration to double digit percentage revenue growth starting in 2017. When the company was originally founded in the ‘70s, the sales channel was almost 100% indirect, meaning that the company relied on third party distributors to sell software to their clients. As a much smaller organization at the time, this benefited Ansys because the company could focus on product development and rely on others for distribution.
As the company acquired other multi-physics companies, many of the larger ones had a direct sales organization, which moved the overall company more towards direct sales. When Fluent was acquired in 2006, they had a 100% direct sales organization, which moved Ansys to a 50%/50% sales model, since Fluent was a similar size to Ansys at the time. Ansoft moved Ansys to 70%/30% direct/indirect after it was acquired in 2008. And Apache moved the company to 75%/25% after it was acquired in 2011. Since then Ansys has remained near those percentages.
Before the CEO change in 2017, most sales people covered 50 to 75 accounts. With the new CEO, priorities were changed so that sales people covered 10 to 15 strategic accounts, especially focusing on the larger accounts that had the potential to make multi-million purchase orders. As a result, there have been many 8 figure deals that have been announced over the past 5 years.
IT spending environment
While Ansys’ software is typically purchased through customers’ R&D budgets and R&D historically has been resilient during recessions, it’s uncertain if the current environment in ‘22-’23 will end up the same way. Ansys did much better than peers during the ‘08-’09 recession as well as the slowdown in ’14-’15 but it may be different this time around.
Ansys has expanded its product offerings through recent M&A for future use cases outside of its core multi-physics simulation software. These emerging technologies and new adjacencies may not be as resilient, especially since they may likely be used by newer start-ups that don’t have the financial strength to withstand a big slowdown in the global economy vs. an established company that is using Ansys’ core simulation software.
IT spending expectations have also been pushed out as we’ve progressed through 2022, resulting in a lower expected spending in 2022 and higher spending in 2023. However, if there is a prolonged slow down in the global economy (and we know that the correlation of IT spending to GDP growth is a decent one), the expectations for a reacceleration of IT spending growth in 2023 may be misguided.
Optionality
For the company, optionality will come from adoption of simulation technology during the design process and the manufacturing and operations phases of product cycles. Ansys software for these use cases (Discover Live and Twin Builder) are still relatively new.
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Interesting idea, well presented, thanks.