ANSS: Market Pullback Presents Buying Opportunity in Ansys

This article was originally published at RealMoney on November 19, 2007.

With shares of Ansys (ANSS) up 100% over the last two years and more than 1,200% over the last seven, it hardly qualifies as undiscovered. However, with only four analysts covering the stock – and none from bulge bracket investment firms, the stock may remain under-appreciated.

Earnings have exceeded estimates by a wide margin for several consecutive quarters (including a significant earnings beat just two weeks ago), which is further evidence that the current consensus may not fully reflect the company’s earnings power. The shares soared on that news but have since come back down to their prior levels due to the overall stock market weakness. I think this baby is wrongfully being thrown out with the market’s bath water.

Ansys (ANSS) designs engineering simulation software used in such industries as aerospace, automotive, manufacturing, electronics, biomedical and defense. Simulation software reduces the time it takes to move products from the design stage into manufacturing because it allows for much of the necessary product testing to be simulated rather than tested on prototypes. Ansys licenses its technology to businesses, educational institutions, and governmental agencies.

On May 1, 2006 Ansys acquired one of its largest competitors, Fluent. The acquisition depressed trailing earnings and elevated trailing valuation multiples, possibly keeping Ansys off the radar screen of some investors.

Despite a fairly hefty multiple of 28x next year’s earnings, the company generates a strong free cash flow yield of 3.5%, which is nearly as high as the current yield on five-year treasuries. Unlike Treasuries, Ansys also offers significant growth that should more than compensate for accepting the related risk. Based on my calculations, the stock has an intrinsic value of $46 per share based on that ability to generate excess cash.

An Eye on the Risks

With the possibility of a recession rising, it is worth considering a possible demand slowdown. The company’s largest end markets are aerospace and autos. Aerospace is booming but major projects like the A-380 and Boeing Dreamliner are past the design stage, so arguably demand could slow until the next major product cycle is under way. Autos face the opposite risk – slowing demand due to the overall industry’s distress.

The long sales cycle and potential for large license sales can lead to lumpy sales patterns, a risk reduced by the Fluent acquisition since Fluent sells a higher proportion of lease-based licenses rather than perpetual licenses. Ansys has been a leader for many years, and even if it were to fall behind technologically its customers would be unwilling to migrate to a new platform immediately. This lag could allow them to catch up or buy the necessary technology.

The company could fail to successfully integrate a future acquisition. However, its acquisition of Fluent, and Dassault’s (DASTY) purchase of ABAQUS, has reduced the pool of potentially large acquisition candidates significantly.

Valuation

Ansys has generated more than $103 million of free cash flow in the last 12 months. Based on its current enterprise value of $2.9 billion, Ansys is generating a free cash flow yield of 3.5%, slightly less than the yield on five-year treasury securities.

According to Zacks Investment Research, the consensus five-year earnings growth estimate is 18% per year, which compares to 11% actual historic market growth and a 13% theoretical sustainable growth rate (equal to the average ROE since there is no dividend.)

I think sales can grow 15.7% in 2008 and 15% in 2009, which should generate nearly $130 million of free cash flow in 2008 ($1.60 per share) and $160 million in 2009 ($2.00 per share). At that time, assuming a 100% required return premium to treasuries and a 4% terminal growth rate the company could be worth $3.7 billion, or approximately $46 per share. I further believe they would have $4 per share in net cash by that time for a total potential value of $50 per share and total potential cash on cash return over the 2+ years of 30%. Discounting the cash flows to the present at a required return of 8.5% generates an estimated current intrinsic value of $46.00 per share, from which the current price represents a 20% discount.

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