This article was originally published at RealMoney on November 6, 2007.

Parametric Technology (PMTC) develops software used for Product Lifecycle Management (PLM) and Enterprise Content Management (ECM). At a P/E of approximately 15x and a 5.3% free cash flow yield, Parametric appears cheap relative to other technical software developers. However, its earnings quality has historically been low and it faces more severe competition than some of its peers. With earnings quality improving and the valuation favorable, PMTC certainly bears watching. But for now I think Dassault Systemes (DASTY) and Ansys (ANSS) have sufficiently better prospects to justify their higher valuations.

Compared to companies like Ansys, which develops highly technical products and has relatively few competitors, Parametric has significant competition in each of its business segments.

PLM competitors include Dassault Systemes SA, Siemens (SI) subsidiary UGS, Autodesk (ADSK) and Agile Software (AGIL). They also compete with larger enterprise-solution companies such as SAP (SAP - Annual Report) that have entered the PLM market and offer solutions integrated with their other enterprise software applications.

ECM competitors include EMC (EMC - Annual Report) Documentum, IBM’s (IBM - Annual Report) FileNet, OpenText, Adobe (ADBE) Framemaker, and the Microsoft (MSFT - Annual Report) Office suite.

Parametric suffered mightily during the tech downturn, but since 2004 the company has been engineering a turnaround based on improved profitability and a return to growth. Current consensus growth estimates for the next five years are just 7%, or half the rate expected for the industry. The lower growth estimates are part of the reason for the cheaper valuation. However, they also make for a lower bar to clear, and the recent reversals of its deferred tax valuation allowance are a signal that the company is now “more likely than not” to earn sufficient income in future years to utilize tax losses from prior periods.

There are a few other issues that cause me to think Parametric’s low valuation is justified. For example, 58% of revenues are derived in North America, which faces an uncertain near-term economic outlook.

Another issue is earnings quality. Gross margins have been declining due to a higher percentage of revenue being derived from consulting and training rather than license and maintenance revenue. A bad debt charge-off in 2006 and increased customer financing activity are other signals that earnings quality may be low.

To get a feel for overall earnings quality, I calculated the accrual ratio, or the change in net operating assets divided by average net operating assets. This ratio describes the percentage of earnings contributed by discretionary accounting items rather than actual cash flows. An ideal accrual ratio would fluctuate around zero. Parametric’s has been all over the map, though it has been improving for several quarters.

Sources: Zacks Research Wizard, William A. Trent

If Parametric continues to improve its earnings quality, or if it gives back some of the stock gains it enjoyed post-earnings (or preferably both!) it could become an attractive buy candidate.  In the meantime, interested investors may find an option play worthwhile.

The January 17.50 puts were trading recently at $0.50/$0.75. If you could write the option for $0.60 it would offer a 3.1% 2.5-month return on the money at risk, which annualizes to nearly 15%. You’d be forced to pay $17.50 for the shares if they drop between now and then, but the option premium would give you an effective price of just $16.90. At that price, the 6.0% free cash flow yield would probably be enticing enough to justify a buy anyway.

Disclosure: Short naked put options on Ansys (ANSS)

William Trent currently has a short position in put options related to Office Depot (ODP).

This article was originally published at RealMoney on November 5, 2007.

Dassault Systemes (DASTY) is trading down nearly 6% after the company trimmed its earnings outlook by five Eurocents last week. The company now expects to earn between €1.96 and €2.00 in 2007, compared with earlier guidance of €2.00 - €2.05. With a solid overall business and a valuation that I believe looks reasonable, I think investors will ultimately find today’s price to have been an excellent entry point.

Dassault designs engineering software used for Product Lifecycle Management (PLM) (81% of 2006 revenue) and Mainstream 3-D design (19%). It has grown through organic growth and a series of acquisitions, including Abaqus in 2005 and MatrixOne in 2006 – each of which was in the order of $500 million consideration. It is 44.5% owned and effectively controlled by France’s Groupe Industriel Marcel Dassault.

Dassault offers software under several brands, including Solidworks for Mainstream 3D design and CATIA, DELMIA, SIMULIA and ENOVIA for PLM. However, a key aspect of its growth strategy is to combine the strengths of its various programs and allow customers to customize solutions using the company’s V5 platform.

The company generates 47% of its revenue in Europe, 31% in the Americas and the remainder in Asia. Although it blamed the lowered outlook on the weak dollar, the company’s latest annual report said its greatest currency exposures are between the Euro (its reporting currency) and the Yen, Pound and Korean Won.

More than half of the company’s sales are on a recurring (software rental or maintenance contract) basis rather than through perpetual license fees. With a largely industrial customer base, revenue growth drivers include business investment and industrial production in its end markets.

Competition

Dassault lists its primary PLM competitors as Parametric (PMTC) and Unigraphics, which was recently acquired by Siemens (SI). Its main competitor in Mainstream 3D is Autodesk (ADSK). The company also competes with Ansys (ANSS), Agile (AGIL), MSC Software (a href="http://stockmarketbeat.com/blog1/category/msc-software-mscs/">MSCS - Annual Report) and to a lesser extent Oracle (ORCL - Annual Report) and SAP (SAP - Annual Report).

The combined revenue of the nearest competitors and comparables, which I believe to be Dassault, Ansys, MSC and Parametric, has been approximately 11% annually over the last decade. Dassault has used its acquisitions and the opportunities provided by the V5 platform to grow at a faster rate than its peers.

In 2006 Dassault grew 24%, much of which was contributed by the Abaqus and MatrixOne acquisitions. On an organic basis sales grew 10% (12% assuming constant currency exchange rates.)

Risks

As I see it, the greatest risk Dassault faces is loss of a major customer. Although the company cites a customer base of 100,000 just 20 of those account for 25% of sales, with the largest customer accounting for 5%.

A potentially greater, though probably less likely risk is the company’s long-standing relationship with International Business Machines (IBM - Annual Report). IBM has a non-exclusive distribution relationship with Dassault and accounted for 45% of sales in 2006, so a rift between the companies could have a serious impact. The companies renegotiated the partnership earlier this year such that Dassault is taking responsibility for mid-market customers and IBM will serve enterprise customers. However, this adds a new risk related to maintaining a larger sales force.

Valuation

Dassault current market cap is approximately $7.3 billion, and with net cash on hand of nearly half a billion its enterprise value is about $6.8 billion. Given that it is on track to exceed its 2006 free cash flow generation of $300 million, the free cash flow yield of 4.4% compares favorably to the yield on five-year treasuries, and the 10% growth rate of recent years looks like a nice inducement for taking on the added risk.

By some common measures (5x book value and a P/E in the mid-20’s) the stock doesn’t exactly look like a bargain. But these measures overlook the cash flow generating power available to software companies. With essentially fixed costs and high margins, each dollar of sales contributes mightily to cash.

Although a recession or slowdown in Dassault’s key end markets or further dollar weakening could delay investor rewards, Dassault’s current valuation and long-term prospects appear to justify the wait.

Disclosure: Short naked put options on Ansys (ANSS)

Note: Set up high growth savings accounts and plan for your financial future today!

It has been said that cable’s major advantage over telcos and satellite tv is its ability to offer the “triple play” of video, voice and data over a single line. The ability to leverage its existing service to capture additional revenue streams gives it a unique edge that has been behind the telco’s own fiber roll-out.

At the same time, the telcos have enjoyed the advantage of wireless spectrum and services, which are largely replacing land-lines for voice service anyway. This gave the telcos a different triple-play: voice, data and wireless.

Thus the race was on to be the first to offer a quadruple play that included all four services. The telcos partnered with satellite companies, the cable companies partnered with independent wireless player Sprint-Nextel, and the telcos started their fiber expansion. But these interim partnerships appeared to us to be of limited value. There is no cost savings to the bells company from reselling satellite video - unlike video and data over the same pipe satellite was a different pipe, and one they didn’t own. Likewise for the cable companies offering wireless service. Until now. More »