This article is a reprint of my February 8, 2008 RealMoney column

One of my favorite investment themes is engineering and infrastructure software, which I think combines the high margins and cash flow stability of a software investment with the positive long-term trends in global infrastructure development. I think investors can profit handsomely from a potential 64% rise in Autodesk, the leading player in this market.

In November I wrote bullishly about Dassault (DASTY) and Ansys (ANSS), which I bought in January. Since those columns were written the stocks have performed in-line with the market, which is a nicer-sounding euphemism for saying they have gone down. I was more bearish about Parametric (PMTC), which has indeed turned in the worst performance of the three.

Long term, however, I still think the space has tremendous opportunity and think the overall market downturn is providing additional opportunities – most notably that of industry leader Autodesk (ADSK). Autodesk is best known for its AutoCAD software, a customizable and extendable computer aided design (CAD) application for 2D drafting, detailing, functional design documentation and basic 3D model-based design.

A common misperception is that AutoCAD is focused on architectural markets, and that a slowdown in construction activity could be disproportionately harmful. However, the largest end market is manufacturing (product design) and the civil engineering/infrastructure market is nearly as meaningful as construction.

The shares were downgraded by an analyst at Jeffries in January, who cited “anecdotal channel evidence of slowing manufacturing demand in Europe” and a “decent chance” that spending on computer-aided design software and related technologies will slow in both North America and Europe in 2008. Yet his less-than-2% trims to his EPS estimates, which simply brought them in line with the rest of the crowd, are more than reflected in the 25% decline in the share price since the December.

At any rate, Autodesk continues to meet or exceed earnings estimates and has seen modest positive revisions to estimates over the last month. Since its products are used in the early stages of the construction process, if the potential slowdown doesn’t show up soon it likely won’t show up at all.

Furthermore, with more of its customers migrating to a subscription-based model some of the uncertainty surrounding upgrade adoption has been mitigated and revenue growth and stability are more transparent. Subscription revenues are growing at twice the rate of license sales. Deferred revenues have grown 12% in the last nine months, including an 18% increase in long-term deferred revenues. All of this lends to greater confidence in the level of sales and earnings over the next year.

Autodesk generated $640 million in free cash flow over the last 12 months, which amounts to a free cash flow yield approaching 8% of enterprise value. With a 500-basis point advantage over Treasuries and a long-term expected growth rate of 16% (which is more than justified by the company’s high return on equity) the stock looks very attractive here.

If Autodesk grows in line with estimates and narrows the spread between its cash flow yield and the Treasury yield to a still-attractive 100%, its shares could rise to $63, for a potential return of 64%. The shares offered a similar spread to Treasuries as recently as December, when the shares were trading above $51. Meanwhile, short of a considerable decline from the existing level of sales and cash flow it is hard to see significant further downside.

Disclosures: Long Ansys (ANSS)

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!

I am taking a look at a couple of the engineering software stocks, and a review of recent conference call transcripts can frequently be a good place to start.

Ansys (ANSS) provides software that simulates physical forces such as turbulence, heat and pressure. Seldom was heard a discouraging word on that call, and for good reason. The closest I could come to was:

So even as we increase our outlook this will also be tempered of course by our short term engineers’ paranoia which I have to say has also served us well.”

(Excerpt from full ANSS conference call transcript)

Dassault Systemes (DASTY) has simulation and 3D design, plus software to help companies manage the product life cycle. It, too, has been on a tear for the past few years, and is showing no signs of stopping.

One of our most visible initiatives is the successful transformation of our PLM channel. Looking at the quarter, we had good progress in the PLM value channel and with IBM in large accounts. Our results today demonstrate that we are well in line with our plans, driving growth for CATIA and ENOVIA.

CATIA performed well with both large accounts and mid-market. We continue to invest in strengthening and broadening the CATIA product line. In mid-June, we completed the acquisition of ICEM, expanding our presence at the front-end of design. ENOVIA’s strong results demonstrate that our products form a powerful combination and are clearly complementary.

In total, we have had a dynamic product release schedule during the 2007 first half. We continue to advance our technology and strategic roadmap. During the second quarter, we launched our newest brand, 3DVIA, whose goal is to enable 3D to become a universal media for online product experiences.

(Excerpt from full DASTY conference call transcript)

Parametric (PMTC) has much in common with Dassault. Except for the being on a tear and showing no signs of stopping, that is.

We are disappointed with our performance in other areas. Most of the revenue shortfall was in license revenue. Our Desktop Solutions revenue declined year-over-year, which is counter to our recent trend of strong growth in this line of business.

The performance was spread across Pro/ENGINEER new seats, modules, and upgrades, with the most significant change from recent quarters in upgrade and module sales. By geography the revenue weakness was concentrated in North America and Japan.

(Excerpt from full PMTC conference call transcript)

The next question, of course, is to determine whether the successes at Ansys and Dassault are priced in, or whether Parametric has taken enough of a beating to be worth taking the risk.

Disclosure: Author is long IShares MSCI Japan Index (EWJ) at time of publication.