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MSC.Software 10-K 2007 Documents found in this filing:Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 2006 Commission File Number 1-8722
MSC.SOFTWARE CORPORATION (Exact Name of Registrant as Specified in its Charter)
(Registrant’s Telephone Number, Including Area Code): (714) 540-8900 Securities Registered Pursuant to Section 12(b) of the Act: Common Stock Securities Registered Pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act Yes ¨ No x Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ¨ No x Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): Large Accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act. Yes ¨ No x As of June 30, 2006, the last business day of the registrant’s most recently completed second quarter, the aggregate market value of MSC.Software Corporation’s voting common stock held by non-affiliates was approximately $764,100,000 (based on the last closing price of such stock as reported on that date). As of January 31, 2007, there were outstanding 43,993,141 shares of Common Stock of MSC.Software Corporation. Documents Incorporated By Reference: Part I, Part II and Part III: Portions of the Company’s Proxy Statement for the Annual Meeting of Shareholders to be held May 22, 2007 are incorporated by reference in Part III.
Table of ContentsMSC.SOFTWARE CORPORATION DECEMBER 31, 2006
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Table of ContentsCAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties. The statements contained in the Report on Form 10-K that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Report on Form 10-K are based on information available to us on the date hereof. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results to differ materially from those implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “could,” “expects,” “plans,” “ intends,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “targets,” “goals,” “projects,” “continue,” or variations of such words, similar expressions, or the negative of these terms or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Neither we nor any other person can assume responsibility for the accuracy and completeness of forward-looking statements. Important factors that may cause actual results to differ from expectations include, but are not limited to, those discussed in “Risk Factors” beginning on page 10 in this document. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.
General We are a leader in the development, marketing and support of enterprise simulation solutions, including simulation software and related services. For over 40 years, our solutions have allowed manufacturing and technology companies, as well as universities and research institutions around the world to accurately validate how their designs will behave in their intended environments without having to build and test multiple physical prototypes. Engineers use our simulation software to construct computer models of products, components, systems and assemblies and to simulate performance conditions and predict physical responses to certain variables, such as stress, motion and temperature. These capabilities allow our customers to optimize product designs, improve product quality and reliability, comply with regulatory and safety guidelines, reduce product development costs and shorten the timeline in bringing new products to market. We also provide a broad range of strategic consulting services to help our customers implement enterprise simulation solutions and improve the integration and performance of their product development process, which will lower the total cost of ownership of their technology investments. We serve customers in various industries, including aerospace, automotive, defense, heavy machinery, electronics, consumer products, biomedical, shipbuilding and rail. Advances in computer technology have made virtual product development solutions available for any and all companies that manufacture products. Our goal is to provide our customers with leading edge enterprise simulation solutions that will integrate design and engineering processes to enable innovative product design and efficient product development. We seek to be an industry leader in each of the product categories in which we compete and to expand into new and emerging markets within the product lifecycle management (“PLM”) industry. Industry The PLM industry includes four significant segments: conception of the product, design of the product, manufacture of the product, and maintenance of the product. These product lifecycle segments utilize various digital technologies and software tools, often referred to as PLM tools, including mechanical computer-aided design (“CAD”), computer-aided engineering (“CAE”), computer-aided manufacturing (“CAM”), and product data management (“PDM”) and related services. Enterprise simulation solutions enable engineers to prototype, simulate, test and iterate scenarios in a virtual environment. This enterprise simulation environment allows engineers to migrate to “design-analyze-confirm” processes, which creates a more flexible, efficient and cost-effective solution for product development. As a result, companies obtain a competitive advantage through innovation, manufacturing efficiency, speed to market, and lower development costs. Enterprise simulation solutions, including our software and services, are used in conjunction with these PLM tools throughout the entire product lifecycle. Enterprise simulation solutions integrate multi-disciplinary CAE simulation software technologies with the enterprise during all phases of the product development process. As a result, designers, analysts, program managers and others on the product development team gain greater, more accurate, and more timely insight into product behavior, thus providing a strategic element in achieving business objectives. Before the development of enterprise
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Table of Contentssimulation software, product design and simulation was often disjointed, unrepeatable, and error prone requiring intensive manual redesign prior to and during manufacturing. With a lack of multi-discipline simulation during product development, engineers were involved in “design-build-test-break” processes which limited the number of cycles such processes could be repeated due to time and cost limitations. According to an industry report from Daratech, Inc. CAE software and services topped $2.4 billion in 2006, a year-over-year increase of 8%. Daratech, Inc. projects that CAE software and services spending is expected to grow 9% and reach nearly $2.7 billion in 2007, while spending on PLM software and services totaled nearly $11.4 billion in 2006, a year-over-year increase of 8%. Our Competitive Strengths and Growth Strategy We currently support four product categories of simulation technologies through a portfolio of simulation software products and solutions. We consider our portfolio of simulation software to be one of the broadest and most widely used within the CAE segment of the engineering software market. We believe our simulation software is the de-facto standard within the aerospace and automotive industries, capable of being utilized on various computer platforms ranging from large mainframes to basic laptops. We believe our newly introduced SimEnterprise and multi-discipline (“MD”) products will transform the industry from offering point simulation tools to one providing enterprise integrated simulation solutions, thereby giving our customers a complete enterprise integrated suite of simulation software. Such transformation will enable designers, analysts, managers and the supply chain to integrate simulation throughout the design process in an open systems framework. With thousands of global accounts among diverse industries, including aerospace, automotive, machinery, electronics, equipment and consumer products, we believe we have a unique competitive advantage in leveraging new product releases and related professional services to existing and new customers and in penetrating new markets. We intend to maintain this competitive advantage by providing superior technology and functional breadth of simulation solutions and collaborating with customers to deliver the next generation of enterprise simulation software and solutions. We will continue to evaluate our business model, including our product mix and positioning, marketing strategies and sales channels to maximize our market opportunities and to improve our operating results. We are committed to improving our cost structures and will continue to streamline our business operations as necessary to successfully compete in all our geographic locations. Our goal for growth is to expand our leading position in the simulation software market by further penetrating our installed base, by adding new customers from the supply chains in our existing aerospace and automotive markets, and by expanding with new customers in new markets such as biomedical and consumer products. Software Products Our simulation software products consist of physics-based solvers, accessible through graphical user interfaces sometimes referred to as pre- and post-processors, which are enterprise enabled thus supporting the management of the simulation across the various enterprise users. The governing principle for our enterprise software is to provide an integrated suite of simulation software applications to enhance engineering productivity for product design teams at large global manufacturers as well as at small and medium manufacturers. We market our enterprise simulation software products under four main product categories: Engineering Products—This category includes software to model and simulate the performance characteristics of a wide variety of complex mechanical conditions. Within this category we include our core engineering simulation software, including MSC Nastran, Patran, Adams, Marc, Dytran, Easy5 and SOFY. MD Solutions—This category, introduced in 2006, is designed for manufacturers who need to perform interoperable, multi-disciplinary analyses on ever-more complex products and assemblies. Within this category we include our MD Nastran, MD Patran, and MD Adams products.
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Table of ContentsEnterprise Solutions—This product category, also introduced in 2006, is an emerging approach to engineering analysis which integrates simulation to the enterprise while managing the simulation workflows and data to deliver repeatable, automated simulation processes early in the product design cycle. Key to this category is SimEnterprise, created to enhance the way engineering teams collaborate, access and work with standard simulation processes, and manage simulation data across the extended enterprise. Within this category we include our SimEnterprise solutions of SimXpert, SimManager Enterprise, and SimDesigner Enterprise. Channel Products—This product category is designed to enable companies of any size to realize the many benefits of early, accurate design validation using computer simulation. Within this category we include our SimOffice product. Engineering Products Category MSC Nastran. MSC Nastran was derived from NASTRAN, an open-source computer program, originally developed for the NASA space program and owned by the United States Government. We have upgraded MSC Nastran over the past 40 years resulting in substantially greater capabilities and scope. MSC Nastran is a powerful, general purpose finite element analysis solution for small to complex assemblies. As a proven and standard tool in the field of structural analysis, MSC Nastran provides a wide range of modeling and analysis capabilities, including linear statics, displacement, strain, stress, vibration, heat transfer and more. MSC Nastran is the leading program for engineering analysis worldwide based on capability, functionality, international acceptance and number of installations, and is recognized as the de facto standard in high-end analysis within the automotive and aerospace industries. Patran. Patran is a universal graphical user interface, which provides finite element modeling, analysis data integration, analysis simulation, and visualization capabilities. All of the functions of Patran may be integrated, automated and tailored to the user’s specific requirements using a powerful programming command language. Adams. Adams is the market leading motion simulation software that simulates system-level motion and loads. Adams is used to perform dynamic simulations of systems and subsystems, such as suspensions and engines, and to evaluate attributes like vehicle handling, vibrational behavior and durability. Marc. Marc simulates nonlinear physical behavior due to material contact conditions resulting in material failure under extreme stress. Marc is used in areas where materials, such as rubber, plastics or metal forming, undergo large deformations, and for many other applications. Dytran. Dytran is complementary to Marc and uniquely combines fluid-structure interaction to facilitate the simulation of high-speed interactions including crash, projectiles, or drop-test analysis. Easy5. Easy5 is a system-level, block-diagram-oriented simulation program that includes a large number of “application libraries” with pre-built, ready-to-use components targeted to a specific engineering discipline. SOFY. SOFY is a finite element pre- and post-processor which enables engineers to build templates to automate and replicate standard engineering scenarios. Customers can build a standard set of templates to address test suites to validate the design performance. MSC Actran. MSC Actran is used for determining the acoustics and vibro-acoustics performance of structural and mechanical systems. MSC Fatigue. MSC Fatigue is used for durability analysis based on component stresses predicted by load histories by Adams and stress histories predicted by MSC Nastran. MD Solutions Category MD Nastran. MD Nastran is an extension of MSC Nastran that delivers enterprise simulation optimized for multi-discipline analysis which accelerates time-to-market by enabling customers to perform linear, implicit nonlinear and explicit nonlinear analysis, all within a scalable simulation platform based on a common data model. Furthermore, MD Nastran accounts for the interaction across discipline domains to accurately model real life scenarios. MD Patran. MD Patran links design, analysis, and results evaluation in a single environment powered by MD Nastran. Through the seamless integration of CAD geometry, pre- and post-processing capabilities and the ability to perform sophisticated multi discipline simulation on virtual parts, assemblies and structures, MD Patran is a key part of the design process for companies that rely on fast time to market and excellence in product quality. MD Adams. MD Adams extends the enterprise simulation multi-discipline solution to system-level motion and loads analysis. MD Adams allows customers to perform motion analysis and structures analysis seamlessly thus accelerating the end-to-end simulation process from structures to motion and back.
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Table of ContentsEnterprise Solutions Category MSC SimXpert. SimXpert is an advanced multi-discipline workspace CAE environment that provides comprehensive depth and functionality to speed system level simulations and allow companies to build, share, and execute best practices for simulation standardization throughout the enterprise. SimXpert’s highly-integrated advanced workspaces include Structures, Motion, Thermal, and Crash that are all powered by MD solutions. Using SimXpert companies can gain productivity improvements through the use of expert templates, enterprise automation, a multi-discipline common data model, and native CAD interoperability. MSC SimDesigner Enterprise. SimDesigner is a CAD-embedded simulation solution that allows design engineers to streamline the task of building and testing virtual prototypes by simulating stress, motion, and heat transfer within their preferred CAD environment. SimDesigner’s workbenches seamlessly embed our multi-discipline simulation solutions into the CAD environment. SimXpert templates can be executed by SimDesigner users in the native CAD interface, thus providing a significantly new level of ease of use and up-front simulation. MSC SimManager Enterprise. SimManager is an enterprise environment that manages and automates simulation processes, manages all associated data and data history, and increases efficiency and innovation by delivering product performance knowledge integrated to the product development cycle. SimManager improves quality by ensuring best-practice simulation processes and full traceability of input parameters, and increases productivity by greatly reducing the number of manual tasks required. SimManager comes with an out-of-the-box integration with SimXpert and SimDesigner which enables the users to collaborate on simulation work practices. Channel Product Category MSC SimOffice. SimOffice, introduced in 2006, is a powerful, easy-to-use simulation application that enables engineers to verify designs in the Microsoft Windows desktop environment. SimOffice interfaces with the tools engineers already employ such as CAD systems, Microsoft Excel, and other productivity applications. As the world’s first Microsoft Vista-ready simulation software, SimOffice also provides built-in connectivity to Microsoft SharePoint and Groove for information management and real-time collaboration. Professional Services We offer professional services in the areas of enterprise simulation automation, engineering consulting, funded development, and training and onsite support services. Terms of the projects are set forth in the individual arrangements with each customer, including services to be provided, amounts to be charged, and other terms of the engagement. Consulting and training services are not included in software license fees, but are generally provided on a time and materials basis. With enterprise simulation engagements, we work closely with our customers to enhance their simulation processes, enabling them to make better products in less time and for less cost. We use a three-step process to do this by assessing our customers’ current simulation processes, comparing them to industry best practices and indicating areas for improvement. As a result of these assessments we design new enhanced processes and implement them within the customer’s product development process. With engineering consulting engagements, we provide engineering simulation to our existing software customers and to companies who do not use our software. These services are delivered to our current customers to provide simulation or design expertise that they may not have and to augment their capabilities if they have a personnel shortage. These services are also provided to companies who do not have any simulation or design professionals on staff but who need these capabilities provided via outsourcing. We have provided services to automotive, aerospace, biomedical, electronic packaging, petrochemical, nuclear and consumer product manufacturers and suppliers. Our training and onsite support services help our customers get the most out of their MSC Software enterprise solution. We have developed educational tools designed to train users of our products as an extension of our software business. Training seminars are conducted in local languages on a frequent basis at our offices worldwide, and at client sites. We also provide personnel dedicated to onsite support for our software.
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Table of ContentsResearch and Development We dedicate significant resources to the development and enhancement of our simulation software products as well as to new product research and development. Our development activities have historically involved developing new products to address new simulation market opportunities, adding new capabilities to our suite of simulation software, or converting those programs for use on new computer platforms. These activities are intended to drive and maintain market leadership as well as to prevent technological obsolescence. In 2004, 2005 and 2006, our research and development expenditures totaled $42.1 million, $47.3 million and $43.2 million, respectively. In 2007, we expect to spend approximately $49 million in research and development. Sales and Marketing We market and sell our products and services in North America and Latin America (“the Americas”), Europe, the Middle East and Africa (“EMEA”), and Asia Pacific through a dedicated sales force, as well as through third parties, including agents and value added resellers. In 2004, 2005 and 2006, our foreign operations generated approximately 66.6%, 70.4% and 70.8%, respectively, of our total revenue. We also market our products by advertising in trade publications, participating in industry trade shows, conferences and exhibits, conducting training seminars and working with our strategic partners. Historically, our software products were used primarily by the simulation experts supporting the design phase of product development. Accordingly, we targeted our marketing efforts on the product design engineers and analysts. With the addition of our MD and Enterprise solutions, we expanded our marketing efforts to target the senior management of engineering and IT departments. We now have a value proposition that drives the entire enterprise lifecycle of a product. Pricing In general, we provide two types of licensing alternatives for the use of our software products - an annual non-cancelable lease license and a perpetual (paid-up) license. We also offer MSC MasterKey, a token-based model, enabling customers to access our engineering products from a single, flexible license; and Enterprise Advantage, a license unit model enabling customers to access our MD and Enterprise solutions software from a scalable enterprise license. MasterKey tokens and Enterprise Advantage license units are offered on a paid-up basis. With both annual and paid-up software licenses, the license fee is set at a fixed rate and the customer is invoiced at the time of sale. Software licenses are generally sold with maintenance, which entitles the customer to receive unspecified upgrades, enhancements and support. Maintenance fees typically approximate 20% of software license fees, and maintenance agreements are generally for one year. Pricing of products licensed in Europe through our European subsidiaries are generally denominated in Euros or other local currencies. Products licensed in Asia Pacific through our Asia Pacific subsidiaries are generally denominated in Japanese Yen or other local currencies. Post Sales Support Client service is an integral aspect of our marketing program. We maintain both on-line web support and toll-free phone numbers as a hot line service for our clients. We conduct formal training for clients, ranging from three-day introductory courses to intensive courses on specialized subjects for experienced users. Onsite courses for clients are provided for larger user organizations. We also host technology conferences in the United States, Europe, Asia Pacific, Australia and Latin America to gather data on client needs, new engineering applications, and new trends in computing technology. Sales and Support Offices We have sales and client support offices at our worldwide headquarters in Santa Ana, California, and in over 55 other locations throughout the Americas, EMEA and Asia Pacific. Our products are marketed, distributed and supported outside of North America through a network of foreign subsidiary offices, including a European subsidiary headquartered in Munich, Germany, and an Asia Pacific subsidiary headquartered in Tokyo, Japan. Product support and training are also available in many of our locations. Customers Our customer base consists of thousands of companies and is diversified across industry sectors and geographies. Our customers include industry leaders in automotive, aerospace, defense and heavy machinery. No single customer accounted for more than 10% of our revenue in 2004, 2005, or 2006.
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Table of ContentsWe have long-standing relationships with many of our customers, and the average tenure of our top 10 customers is more than 20 years. Our major end-user customers, based upon 2006 revenue, include: Boeing, Airbus, BAE, Lockheed Martin, Nissan Motor (NML), Toyota, Northrop Grumman and Honda. Backlog We generally ship our software products within 30 days after acceptance of an order and execution of a software license agreement. Accordingly, we do not believe that our backlog of software arrangements at any particular point in time is indicative of future sales. Backlog for our consulting services is currently not material. Intellectual Property Rights We regard our software as proprietary and rely on a combination of trade secret, copyright and trademark laws, license agreements, nondisclosure and other contractual provisions and technical measures to protect our proprietary rights in our products. We distribute our software products under software license agreements that grant customers nonexclusive licenses for the use of our products, which are generally nontransferable. Use of the licensed software is restricted to designated computers at specified sites, unless the customer obtains a license offering other access to the software. Software and hardware security measures are also employed to prevent unauthorized use of our software, and the licensed software is subject to terms and conditions prohibiting unauthorized reproduction and export of the software. MSC, MSC/, Adams, Patran, Mvision, Dytran, Marc, Mentat and Easy5 are some of our registered trademarks. NASTRAN is a registered trademark of NASA. MSC Nastran is an enhanced proprietary version of NASTRAN. Many of our trademarks have also been registered in foreign countries. In addition, we maintain federal statutory copyright protection with respect to our software programs and products and have copyrights on documentation and manuals related to these programs. Competition The CAD, CAE, and broader PLM markets are intensely competitive and characterized by rapidly changing technology and evolving standards. We expect competition to increase both from existing competitors and new market entrants. We believe that the principal competitive factors affecting the software business include ability to solve customer problems, quality, functionality, performance, ease of use and, to a lesser extent, price. In our services business, we believe that the principal competitive factor is expertise. With respect to our software business, the Company’s primary competitors include:
In our services business, we compete with in-house information technology personnel and consulting groups. Although we believe we currently compete effectively with respect to these factors, we may not be able to maintain our competitive position against current and potential competitors, who may have greater financial, technical, marketing and other resources than we do. It is also possible that partnerships among competitors may emerge and acquire market share or that competition will increase as a result of industry consolidation. Increased competition could result in price reductions, reduced profitability and loss of market share, any of which could materially adversely affect our business, operating results or financial conditions. Employees As of December 31, 2006, we employed 1,234 persons, of whom 590 were involved in sales, marketing and field support, 396 in technical activities, and 248 in administration. None of our U.S. employees are represented by a labor union. Certain foreign jurisdictions have workers councils that typically represent workers on matters generally affecting terms of employment. We have never experienced any work stoppages and believe our relations with employees are good. Reliance upon employees in other countries may increase risks associated with government instability or regulation unfavorable to foreign-owned companies that could negatively impact our operations in the future.
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Table of ContentsRecruiting and retaining highly skilled employees, especially software developers and engineers, is highly competitive. We believe our growth and future success is dependent on our ability to attract, retain and motivate highly skilled employees. In January 2007, we announced a cost reduction program, which included a 7% reduction of our workforce, to better align our operations and costs in support of the transition to MD, Enterprise and Channel products. We believe the cost reduction program will enhance our ability to compete aggressively in all markets and to improve operating profit. Available information We were re-incorporated in Delaware in 1994 and have been in business since 1963. Our executive offices are located at 2 MacArthur Place, Santa Ana, California, 92707, and the telephone number at that location is (714) 540-8900. Our web site is www.mscsoftware.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended are available free of charge under the Investor Relations menu on our website at www.mscsoftware.com. These reports are posted on our website the same day they are filed with the SEC. In addition, copies of our code of business conduct and ethics, and any waivers thereto, are on our website and available in print to any shareholder upon request to our Investor Relations department. The contents of our website are not part of this Form 10-K. Executive Officers of MSC Our executive officers are:
Mr. Weyand became Chairman of the Board and Chief Executive Officer effective February 10, 2005. From 1997 to 2001, Mr. Weyand served as the Chairman and Chief Executive Officer of Structural Dynamics Research Corporation (“SDRC”), a product lifecycle management software company which was acquired by Electronic Data Systems Corporation in 2001. From January to June 2003, he served as the Chief Executive Officer of Pavilion Technologies, an enterprise neural network software company for advanced process control. From late 2002 to the present, he continues to serve as a Director, and from June 2003 to the present, continues to serve as Vice Chairman of Pavilion Technologies. Mr. Weyand also serves as a Director for Riverstone Networks, Inc. Mr. Wienkoop was hired in August 2005 as our President and Chief Operating Officer. Prior to joining us, he served as President and Chief Operating Officer of BDNA Corporation, a software solution provider of IT asset management and governance from July 2004 to August 2005, and President and Chief Operating Officer at Portal Software, Inc., a software solution provider of billing and revenue management solutions for telecommunications from 2001 to 2004. From 2000 to 2001 Mr. Wienkoop served as President and Chief Operating Officer of SDRC. Mr. Laskey was hired in 2004 as our Senior Vice President and Chief Financial Officer. He was recently promoted to Executive Vice President. Prior to joining us, Mr. Laskey served as Vice President and Chief Financial Officer of Webplan, Inc., a provider of operational planning tools from April 2001 to March 2003. From October 1998 to February 2001, Mr. Laskey served as Vice President and Chief Financial Officer of Quest Software, Inc., a provider of application management software. Mr. Laskey also held financial management positions at Continuus Software Corporation, Starbase Corporation, File Net Corporation and MAI/Basic Four, Inc. Mr. Mongelluzzo was hired in March 2005 as Senior Vice President, Business Administration, General Counsel and Secretary. He was recently promoted to Executive Vice President, and in addition to his other duties was given responsibility for Human Resources worldwide. Mr. Mongelluzzo’s current title is Executive Vice President, Business Administration, Legal Affairs and Secretary. Prior to joining us, Mr. Mongelluzzo served as of counsel for Vorys, Sater, Seymour and Pease LLP law firm from 2002 to 2005. From 1986 to 2001 Mr. Mongelluzzo was employed by SDRC where he served in many roles, most recently as Senior Vice President, General Counsel, and Secretary.
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Downturns in the aerospace and automotive industries we serve would adversely affect our sales and operating results. In 2006, sales to customers in the aerospace and automotive industries accounted for a majority of our revenue. Reductions in capital spending and cyclical trends affecting customers in these industries could adversely affect revenue from these customers and our results of operations. In addition, these types of customers tend to adhere to a technology choice for long periods, possibly an entire development cycle. As a result, a lost opportunity with a given customer may not again become a new opportunity for several years. If we do not acquire other companies, we may not be able to increase our revenue at historical growth rates. Our historical revenue growth has been augmented by acquisitions. Our future revenue growth rate may decline if we do not make acquisitions of similar size and at a comparable rate as in the past. We have acquired and may continue to acquire other companies and may be unable to integrate successfully such companies with our operations, and we have recorded, and may continue to record, a significant amount of goodwill in connection with our acquisitions. Since 1998, we have acquired several companies and businesses, most recently SOFY in 2004. We may continue to expand and diversify our operations with additional acquisitions. Some of the risks that may affect our ability to integrate or realize any anticipated benefits from companies we acquire include those associated with:
If we are unsuccessful in integrating these companies or product lines with our operations, or if integration is more difficult than anticipated, we may experience disruptions that could have a material adverse effect on our business, financial condition and results of operations. As a result of our acquisitions, goodwill accounted for approximately $151.7 million, or 33.0%, of our total assets, as of December 31, 2006. We may record additional goodwill related to future acquisitions. Under current generally accepted accounting principles, we do not amortize goodwill. We will, however, perform an impairment analysis on the carrying value of our goodwill at least annually. If the financial benefits of our acquisitions do not ultimately exceed the associated costs, we could be required to write down some or all of the unamortized goodwill. As a result, our results of operations would be adversely affected. Mergers and acquisitions and investments in technology companies are inherently risky, and no assurance can be given that our previous or future acquisitions or investments will be successful and will not materially adversely affect our business, operating results, or financial condition. Failure to manage and successfully integrate acquisitions could materially harm our business and operating results. Even when an acquired company has already developed and marketed products, there can be no assurance that product enhancements will be made in a timely fashion or that pre-acquisition due diligence will have identified all possible issues that might arise with respect to products or the acquiree’s business. If we are unable to complete an acquisition or an acquisition is delayed, our business could be adversely affected due to diversion of management attention and company resources from alternative approaches, which may prevent us from achieving strategic goals. We may also incur third party costs in the evaluation, negotiation and completion of acquisitions. These costs are deferred and treated as part of the acquisition cost upon completion of the acquisition. If an acquisition is not completed, the deferred costs are charged to earnings in the period in which the acquisition is certain not to be completed, which can impact our results of operations.
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Table of ContentsWe have had losses and, should they recur, it could have a material adverse effect on our business, results of operations and financial condition. Our net income for the years ended December 31, 2004, 2005, and 2006 was $10.9 million, $11.8 million and $13.8 million, respectively, and we had an accumulated deficit of $97.0 million as of December 31, 2006. We cannot assure you that we will operate profitably, and if we cannot operate profitably, we may not be able to meet our debt service requirements or our working capital or other needs. Our inability to meet these needs could have a material adverse effect on our business, results of operations and financial condition. We may periodically restructure our operations or change our pricing model, which could adversely impact our operating results in the short term before we receive any benefits from these changes, if at all. We continually evaluate the strengths and weaknesses of our operations. In connection with this evaluation, we may decide to reduce or realign our available resources and, as a result, consolidate, shut down or sell product lines that do not fit into our long-term business plan. If we reduce headcount in the future, we will incur significant severance and termination costs and other related expenses that could harm our business before we were to receive any benefit, if at all, from the reduced headcount expenses. If we shut down or otherwise dispose of any of our product lines in the future, we may incur costs or charges, receive less in the sale than such assets are worth, disrupt customer goodwill or lose revenue streams in connection with such a restructuring that could harm our business before we were to receive any benefit, if at all, from the restructuring. In addition, we may introduce changes to our pricing model, and these changes may not result in increased or even the same level of revenue in the timeframes that we anticipate, or at all. On January 17, 2007, our Board of Directors approved the implementation of a cost reduction program that included a workforce reduction of 85 employees, or approximately 7%, and facility closings and consolidations. The cost reduction program was deemed necessary to better align the Company’s global operating costs with its new enterprise sales strategy in an effort to compete aggressively in all markets and to improve operating profit. The Company estimates that total costs related to the cost reduction program will be between $6.0 million and $8.0 million, which includes a charge for severance and termination benefits of between $5.0 million and $6.5 million and charges related to facility closings and consolidations of between $1.0 million and $1.5 million. The Company expects such charges will be incurred and recognized in the first and second quarters of 2007. Our operating results are dependent in part on our ability to develop and introduce new and enhanced products and we may not be able to develop new and enhanced products to satisfy changes in demand. Our operating results depend in part on our ability to develop and market new and enhanced products on a timely basis. Successful product development and marketing depends on numerous factors, including our ability to anticipate customer requirements, changes in technology, our ability to differentiate our products from those of our competitors, and market acceptance. We may not be able to develop and market new or enhanced products in a timely or cost-effective manner or to develop and introduce products that satisfy customer requirements. Our products also may not achieve market acceptance or correctly anticipate technological changes. Our sales cycle is lengthy and complicated. The development of a business relationship with a potential licensee can be a lengthy process, spanning twelve months or longer, especially for large enterprise transactions. The Company’s strategy is to increasingly allocate sales resources towards large enterprise transactions. The sales cycle can involve multiple divisions within a potential licensee’s organization and multiple layers of management, thus making our sales process relatively complicated and long. Additionally, negotiating the terms of a new license agreement can be a protracted process with no set timetable for completion. Due to the length and complicated nature of our sales cycle, predicting the fiscal period in which a new license agreement will be entered into, if at all, and the financial terms of such an agreement is difficult. The timing of orders and shipments, which frequently occur at the end of a quarter, can cause fluctuations of our operating results that, in turn, may impact the price of our common stock. We derive most of our revenue from licensing software products and selling services to high-end users of the product design markets. Our revenue growth and our ability to match spending levels with revenue growth rates will directly affect our future operating results. Historically, a significant portion of our revenue has been generated in the last month of a quarter, with this revenue frequently concentrated in the last weeks or days of a quarter. In addition, higher volumes of orders have been experienced in the fourth quarter. The concentration of orders makes projections of quarterly financial results difficult. Accordingly, we may experience fluctuations in our future operating results on a quarterly and annual basis which, in turn, could adversely affect the price of our common stock.
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Table of ContentsOur future results could be harmed by economic, political, regulatory and other risks associated with international sales and operations. Although we may not be successful in expanding into particular international markets, or generating revenue from foreign operations, we currently anticipate that revenue from international operations will continue to represent a substantial portion of our total revenue. Expansion into international markets requires management attention and resources. We may not be successful in expanding into particular international markets or in generating revenue from foreign operations. Accordingly, our future results could be harmed by a variety of factors related to our international operations, including:
We are subject to changes in demand for our products and services resulting from exchange rate fluctuations that make our products and services relatively more or less expensive in international markets. If exchange rate fluctuations occur, our business could be harmed by decreases in demand for our products and services or reductions in gross margins. We have entered into agreements with third parties for the inclusion of their technology as a component of some of our products. The termination of these agreements could adversely affect our business. Some of our products include technology licensed from third parties and we have entered into several royalty agreements for use of such technology. Should these agreements be terminated, we would need to find an alternative source to replace the functionality of such technology. We believe that we would be able to find an alternative source of the technology, or replace the functionality through internal development. In addition, these agreements allow for significant lead time prior to termination by the third party, which should allow us sufficient time to replace the functionality. However, in the event that all of these agreements were terminated within a very short time period, there is no guarantee that we could replace the technology and the marketability of our products could be harmed if we were unable to do so. In addition, certain products or technologies acquired or developed by us may incorporate so-called “open-source” software. Open source software is typically licensed for use at no initial charge, but certain open source software licenses impose on the licensee of the applicable open source software certain requirements to license or make available to others both the open source software as well as the software that relates to, or interacts with, the open source software. Our ability to commercialize products or technologies incorporating open source software or otherwise fully realize the anticipated benefits of any such acquisition may be restricted as a result of using such open source software because, among other reasons:
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Table of ContentsIn addition, the operation of our software will be impaired if errors occur in third-party software that we utilize. It may be more difficult for us to correct any defects in third-party software because the development and maintenance of the software is not in our control. Accordingly, our business could be adversely affected in the event of any errors in our software. There can be no assurance that these third-parties will continue to make their software available to us on acceptable terms, will continue to invest the appropriate level of resources in their products and services to maintain and enhance the software capabilities, or will continue to remain in business. Our operating expenses are fixed in advance. Therefore, we have limited ability to reduce expenses in response to any revenue shortfalls. We plan our operating expense levels, in part, on expected revenue growth. Our expense levels, however, are generally committed in advance and, in the near term, we are able to change only a relatively small portion of our expenses. As a result, our ability to convert operating outlays into expected revenue growth at profitable margins will affect our future operating results. If our future revenue is less than expected, our net income may be disproportionately affected since expenses are relatively fixed. Strong competition in the simulation software industry may affect prices, which could reduce margins and adversely affect our operating results and financial position, and we may not be able to maintain our competitive position against current and potential competitors. The simulation software industry is highly competitive. The industry may experience pricing and margin pressure which could adversely affect our operating results and financial position. Some of our current and possible future competitors have greater financial, technical, marketing and other resources than we do, and some have well-established relationships with our current and potential customers. It is also possible that alliances among competitors may emerge and rapidly acquire significant market share or that competition will increase as a result of software industry consolidation. To remain competitive, we must continue to invest significant resources in research and development, sales and marketing and customer support. Increased competition may result in price reductions, reduced profitability and loss of market share, any of which could have a material adverse effect on our business, financial condition and results of operations. We believe that the principal competitive factors affecting the software business include quality, functionality, ease of use and, to a lesser extent, price. In our professional services business, we believe that the principal competitive factor is expertise. We cannot assure you that we will be able to maintain our competitive position against current and potential competitors. Our future success depends in part on the continued service of our key technical and management personnel and our ability to identify, hire and retain additional personnel. There is intense competition for qualified personnel in the software industry. We may not be able to continue to attract and retain qualified personnel necessary for the development of our business or to replace qualified personnel who may leave our employ in the future. Any growth we experience is expected to place increased demands on our resources and will likely require the addition of management and technical personnel, and the development of additional expertise by existing management personnel. Loss of the services of, or failure to recruit, key technical and management personnel could harm our business. Business interruptions could adversely affect our business. Our operations and those of our licensees, developers and customers are vulnerable to interruptions by fire, flood, earthquake, power loss, telecommunications failure, terrorist attacks, wars and other events beyond our control. Our corporate headquarters are located in California, near major earthquake faults. A catastrophic event that results in the destruction of any of our critical business or information technology systems could severely affect our ability to conduct normal business operations and as a result, our future operating results could be adversely affected. The business interruption insurance under which we are covered may not be sufficient to compensate us fully for losses or damages that may occur as a result of these events, if at all. Any such losses or damages incurred by us could have a material adverse effect on our business. If we cannot adequately protect our intellectual property rights, our financial results may suffer. Our ability to compete is affected by our ability to protect our intellectual property rights. We rely on a combination of trademarks, copyrights, trade secrets, confidentiality procedures and non-disclosure and licensing arrangements to protect our intellectual property rights. Despite these efforts, the steps we take to protect our proprietary information may not be adequate to prevent misappropriation of our technology, and our competitors may independently develop technology that is substantially similar or superior to our technology.
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Table of ContentsWe may be required to spend significant resources to monitor and police our intellectual property rights. Policing the unauthorized use of our products or intellectual property is difficult and litigation may be necessary in the future to enforce our intellectual property rights. Regardless of the merits of any claim, intellectual property litigation is expensive and time-consuming and could divert our management’s attention from operating our business. Despite our efforts, we may not be successful in any litigation or other enforcement action we may bring and may not be able to detect infringement and, as a result, may lose competitive position in the market. In addition, competitors may design around our technology or develop competing technologies. Intellectual property rights may also be unavailable or limited in some foreign countries, which could make it easier for competitors to capture market share. Despite our efforts to protect our proprietary rights, existing laws, contractual provisions and remedies afford only limited protection. Intellectual property lawsuits are subject to inherent uncertainties due to the complexity of the technical issues involved, among other things, and we cannot assure you that we will be successful in enforcement of, or defending ourselves against, intellectual property claims. Moreover, attempts may be made to copy or reverse engineer aspects of our product or to obtain and use information that we regard as proprietary. Accordingly, we cannot assure you that we will be able to protect our proprietary rights against unauthorized third-party copying or use. Unauthorized use by others of our proprietary rights could materially harm our business. We could be harmed by litigation involving intellectual property rights. We may be accused of infringing the intellectual property rights of third parties. Furthermore, we may have certain indemnification obligations to customers with respect to the infringement of third-party intellectual property rights by our products. Infringement claims by third parties or claims for indemnification by customers or end users of our products resulting from infringement claims may be asserted in the future and such assertions, if proven to be true, may harm our business. Any litigation relating to the intellectual property rights of third parties, whether or not determined in our favor or settled by us, would at a minimum be costly and could divert the efforts and attention of our management and technical personnel. In the event of any adverse ruling in any such litigation, we could be required to pay substantial damages, cease the manufacturing, use and sale of infringing products, discontinue the use of certain processes or obtain a license under the intellectual property rights of the third party claiming infringement. A license might not be available on reasonable terms, or at all. Certain provisions of our certificate of incorporation may delay, defer or prevent a change in control which could impact the price of our stock. Certain provisions of our Certificate of Incorporation, as amended, and Restated Bylaws could make it more difficult for a third party to acquire control of us, even if the change in control would be beneficial to stockholders. These provisions include the following:
In addition to the above provisions, in 1998 we adopted a shareholder rights plan. This plan was amended as of October 18, 2004 and entitles each registered holder to purchase from us, under certain circumstances, one one-hundredth of a share of Junior Participating Preferred Stock at a price of $35.00, subject to adjustments. The rights are generally exercisable only if a person or group acquires 20.0% or more of our stock or announces a tender or exchange offer the completion of which would result in ownership by a person or group of 20.0% or more of our stock. In the event of a transaction commonly known as a “squeeze-out merger,” each holder of Junior Participating Preferred Stock may purchase either our common stock or the common stock of the merged entity at one-half of such stock’s market value. We may redeem the rights at a nominal value until ten days after the announcement of the acquisition of such a 20.0% interest and under certain other circumstances.
Not applicable
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All of our offices are leased under agreements expiring at various times over the next one to 10 years. Our corporate headquarters in Santa Ana, California includes 203,511 square feet under a lease expiring in 2013, of which approximately 92,000 square feet is sublet. We also lease approximately 374,000 square feet in 56 other offices throughout the world for sales, support, research and development, consulting and administrative personnel. All facilities are in good condition and are adequate to meet our requirements for the foreseeable future. See Note 12—Commitments and Contingencies in Notes to Consolidated Financial Statements for additional information regarding our lease obligations. In January 2007, as part of a company-wide restructuring plan, we announced our commitment to close or consolidate certain facilities that may eliminate up to 85,000 square feet of leased space from our operations.
We are subject to various claims and legal proceedings that arise in the ordinary course of our business, including claims and legal proceedings that have been asserted against us by former employees. The Company is vigorously defending these claims, and believes that it has adequately reserved for potential costs to the Company resulting from these matters. No assurance can be given, however, that the ultimate outcome of these claims will not have a material adverse effect on the Company’s financial condition or results of operations. On August 10, 2006, we settled an action by a former senior vice president alleging both employment-related claims as well as claims for breach of his stock option agreement. The amount of the settlement paid in August 2006 was accrued as of June 30, 2006. The Company is periodically audited by various taxing authorities in the United States of America and in other countries in which the Company does business. In the opinion of management, these matters will not have a material adverse effect on the Company’s consolidated balance sheet, statements of operations or liquidity. On November 16, 2006, the SEC notified us that it has terminated its investigation that has been underway since April 2005 in connection with matters related to the restatement of financial statements for periods subsequent to December 31, 2001. No enforcement action was recommended as a result of this investigation.
No matters were submitted to a vote of shareholders during the fourth quarter of the year ended December 31, 2006.
ISSUER PURCHASES OF EQUITY SECURITIES On September 5, 2006, the Company’s common stock began trading on NASDAQ under the symbol “MSCS”. From March 11, 2005 through September 4, 2006, our stock was traded on the Pink Sheets electronic quotation system under the ticker symbol “MNSC” after the New York Stock Exchange (the “NYSE”) informed us that, because of the ongoing delay in the filing of our 2003 Annual Report on Form 10-K with the SEC, the NYSE would suspend trading in our stock on the NYSE before the opening of the market on March 11, 2005. Prior to that, our common stock was listed for trading on the NYSE under the symbol “MNS”. The following table sets forth the high, low and closing prices, as reported on the respective trading systems, for the periods shown:
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Table of ContentsAs of December 31, 2006, there were 207 record holders of our common stock. Because many of our shares are held by brokers or other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by the record holders. We eliminated our dividend in September 1996 and do not anticipate paying a dividend in the foreseeable future. We maintain the MSC.Software Profit Sharing Plan which includes a 401(k) feature that allows participants to make contributions to the plan from their compensation on a before-tax basis. A participant’s contributions to the plan are credited to an account maintained in his or her name under the plan. Through March 2005, a participant was permitted to invest his or her Profit Sharing Plan account in the MSC Stock Fund, an investment alternative under the plan that was invested principally in our common stock. Shares held in the MSC Stock Fund under the Profit Sharing Plan were purchased by the plan trustee on the open market using contributions invested in that fund. This practice was suspended in March 2005 after our common stock was delisted from the NYSE. As of December 31, 2005 and 2006, the number of shares of our common stock held in the MSC Stock Fund totaled 94,638 and 81,729, respectively. Common Stock Repurchase Program On November 8, 2006, the Board of Directors authorized a stock repurchase program for up to 1,250,000 shares of common stock. Share repurchases will be made from time to time in the open market, based on stock availability and price. It is anticipated that the repurchases will be made during the next twelve months, although no assurance can be given as to when they will be made or the total number that will be repurchased. The stock repurchase program has no stated expiration date. Through December 31, 2006, the Company purchased an aggregate of 183,400 shares for $2,581,000. Payments made for repurchased stock are recorded in treasury stock in the accompanying consolidated balance sheet. The table below sets forth information regarding repurchases of MSC’s common stock by the Company during the quarter ended December 31, 2006.
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The following selected financial data should be read in conjunction with Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Consolidated Financial Statements and the related Notes to Consolidated Financial Statements, included elsewhere in this Form 10-K. The financial data as of December 31, 2005 and 2006 and for the years ended December 31, 2004, 2005 and 2006 is derived from the audited consolidated financial statements that are included in this report. The selected financial data as of December 31, 2002, 2003 and 2004 and for the years ended December 31, 2002 and 2003 is derived from audited consolidated financial statements that are not included in this report. Amounts in thousands, except per share data.
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Forward-Looking Statements and Factors That May Affect Future Results This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Item 1A. Risk Factors” included elsewhere in this report. You should also carefully review the risk factors set forth in other reports or documents that we file from time to time with the Securities and Exchange Commission, particularly Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K. You should also read the following discussion and analysis in conjunction with our consolidated financial statements and related notes included in this report. Overview We manage our business under two operating segments—software and services. Our revenue is derived through our direct sales force, a network of value-added resellers and other sales agents. Revenue generated by our software segment consists of licensing fees that are earned through time-based lease arrangements and paid-up (perpetual) license arrangements, whereby the customer purchases a license for the use of our software. Both lease and paid-up arrangements are typically sold with maintenance for a period of time. Revenue generated by our services segment consists of maintenance and services revenue. Maintenance revenue includes unspecified software upgrades, enhancements and technical post-contract support (together known as “E&S”). Services revenue includes consulting and training services, including services provided in connection with software installation. We operate our business in three geographic regions: The Americas (North America and Latin America), EMEA (Europe, Middle East and Africa), and Asia Pacific (Japan, Korea, The People’s Republic of China, Taiwan, Southeast Asia and India), and manage all of our operations based on software sold and services provided to our customers. These regions operate similarly with respect to industries, customer base and sales channels, but each has unique challenges and opportunities. Although our consolidated results are reported in United States currency, our foreign regions conduct a significant number of transactions in local currency. As a result, our consolidated results of operations may be significantly impacted by changes in foreign currency exchange rates. The following table shows the changes in the reporting currencies of our EMEA and Asia Pacific regions from which we derive a significant portion of our revenue:
Business Environment Significant portions of our current and past revenue sources are attributable to our long-term relationships with major OEM’s and their key suppliers, who have embedded our software solutions within their collaborative design and manufacturing processes. Such embedding of our software provides new and recurring revenue opportunities with respect to the development and marketing of new products, renewal of maintenance contracts, and consulting services. Our customers typically fund purchases of our software and services largely out of their manufacturing and capital budgets and, to a lesser extent, their research and development (“R&D”) budgets. As a result, our customers’ business outlook and willingness to invest in new product development significantly affect the growth of our business. Our customers, many of which have global operations, continue to reevaluate their business models to obtain competitive advantages through product innovation, manufacturing efficiency, speed to market and lower cost. This focus has often resulted in massive shifts of production and manufacturing capabilities to lower cost regions of the world, including developing countries. We believe this migration has helped our current and prospective customers to compete globally and will increase demand for their products in new markets. This phenomenon in turn creates both opportunities and challenges in the regions we operate. As our current customers expand or contract their operations and supporting supply chains, we are directly affected. In addition, the growth in developing countries within the regions we operate, namely Central and Eastern Europe, China, India and Korea, have allowed some companies who traditionally provided contracted services to expand into product development. This also will create new opportunities within new markets for us to pursue.
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Table of ContentsDuring times of economic uncertainty, companies will place greater emphasis on creating the most cost effective and competitive business model, including expense reductions within their capital and R&D budgets. Some customers may reduce their PLM expenditures by decreasing their level of software purchases, use older generations of products or not renew maintenance services. In addition, customers will bargain more intensely on pricing and payment terms, which will affect PLM related revenues industry-wide. Lastly, some customers may consolidate their PLM purchases with fewer suppliers in order to lower their overall cost of ownership while at the same time meeting new technology challenges. This will increase competition among PLM vendors. Recognizing that companies will continue to justify their PLM spending and will work to aggressively contain costs, we are dedicated in improving our customers’ product development and manufacturing capabilities by providing more fully integrated simulation software within an enterprise solutions environment and offering customers a wide range of software products and solutions. Over the long term, we believe PLM spending growth will continue to depend on growth in product development and engineering spending and on continued growth in key markets and industries we serve. According to Daratech, Inc., approximately 21% of PLM investments came from CAE in 2006 and over the next four years, CAE is expected to match the overall PLM growth rate, which is expected to rise to 10% annual growth in 2010 with a total market exceeding $16 billion. However, we cannot currently predict whether this outlook will contribute to higher simulation software spending. Product Development and Revenue Growth Our goal for growing market share and profitability is to expand our leading position in the simulation software market by further penetrating our installed base, by adding new customers from the supply chains in our existing aerospace, automotive and heavy manufacturing markets, and by targeting new markets such as biomedical and consumer products. During 2006, we announced or introduced a number of new enterprise simulation solutions, including:
To support our long-term strategy in providing leading edge enterprise simulation solutions, during 2006 we discontinued or terminated development, support and/or marketing of numerous non-strategic products and consulting services. In addition, we entered into a worldwide strategic alliance with IBM that will embed and optimize IBM technology as part of our SimManager Enterprise solution to deliver high performance, enterprise scalability, storage flexibility and robust reliability and availability in an on demand world. This technology will also permit our customers to take advantage of deploying an on demand enterprise built from reusable components that will help lower development costs and improve time to market. We believe our strategy in providing our customers enterprise simulation solutions, including our enterprise simulation development platform – SimEnterprise, and its related component solutions— SimXpert, SimManager Enterprise and SimDesigner Enterprise, together with our MD software that delivers highly enhanced multi-disciplinary capabilities, will differentiate us from our competition. In addition to our new product strategy implemented in 2006, our management also focused on (i) improving global sales execution; (ii) strengthening our relationships with our most significant customers; (iii) accelerating time-to-market for new products through increasing the productivity of our research and development organization; (iv) selling more enterprise-wide transactions; (v) reducing our overhead and infrastructure costs; and (vi) improving our financial and management information systems and related processes.
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Table of ContentsWe will continue to evaluate our business model, including our product mix and positioning, marketing strategies and sales channels to maximize our market opportunities and to improve our operating results. We are committed to improving our cost structures and will continue to invest in or streamline our business operations as necessary to best serve the marketplace and to successfully compete in all our geographic locations. On January 17, 2007, our Board of Directors approved the implementation of a cost reduction program that included a 7% reduction of our workforce and additional facility closings and consolidations. We believe the cost reduction program will better align operating costs with our new enterprise sales strategy while allowing us to compete aggressively in all our markets and to improve operating profit. The Company estimates that total costs related to the cost reduction program will be between $6.0 million and $8.0 million, which includes a charge for severance and termination benefits of between $5.0 million and $6.5 million and charges related to facility closings and consolidations of between $1.0 million and $1.5 million. The Company expects such charges will be incurred and recognized in the first and second quarters of 2007. Discontinued Operations In the fourth quarter of 2005, we approved a plan to sell our wholly-owned Japanese service subsidiary, ESTECH Corporation (“ESTECH”). ESTECH was acquired in 2002 as part of the MDI acquisition and provides expert technical services, primarily in structural dynamics, motion, vibration and acoustics to customers primarily in the automotive and precision electronics industries. Accordingly, all current and prior financial information related to ESTECH has been presented as discontinued operations in the accompanying consolidated financial statements. Included as part of the accounting for discontinued operations of ESTECH is a loss on disposal of $1.1 million representing the accrued loss on the sale that was consummated in March 2006. 2006 Highlights During 2006, we began aggressive marketing of our SimEnterprise solutions - SimDesigner, SimManager and SimXpert – as part of our enterprise simulation solutions strategy. Our multi-disciplinary software products – MD Nastran, MD Patran and MD Adams – were also introduced to our customers as a valued-added alternative to certain of our legacy engineering products. The transition from selling software tools to selling enterprise simulation solutions required extensive recruiting and training of sales personnel throughout our regions, as well as comprehensive presentations to key customers to demonstrate the capabilities of these new solutions to manage their product design and engineering processes and simulation data more efficiently. The transition also required our major customers to re-evaluate their product engineering needs and to revise, review and approve higher funding requirements. As a result, our experience to date shows that selling enterprise solutions generally lengthens the sales cycles, leading to delays in purchasing our products. Our reported software revenue for 2006, particularly during the last six months of 2006, highlights the challenges we faced and continue to face during this transition. Billings for our engineering products and our MasterKey token-based program were lower in 2006, partially offset by billings for our new MD software and enterprise solutions introduced in 2006. We believe the transition from selling software tools to selling enterprise simulation solutions will accelerate in 2007 as market acceptance grows, ultimately leading to higher average orders and increased software revenue, while providing our customers a significant return on their investment. Total reported revenue for 2006 was $259.7 million, a decrease of 12.2% compared to $295.6 million for 2005. The 2005 period included non-recurring revenue totaling $7.7 million related to our North American PLM business, which was sold in March 2006. Excluding the effects of changes in foreign currency rates during the 2006 period, and after adjusting the 2005 period for the non-recurring PLM revenue, our total revenue in 2006 decreased 8.5% to $263.6 million. Deferred revenue at December 31, 2006 was $78.2 million compared to $94.6 million at December 31, 2005. Our operating expenses increased 0.6% to $196.9 million compared to $195.8 million for 2005. Included in the 2006 period was a $4.6 million gain recognized on the sale of certain assets of our PLM business. In addition, the 2006 period included $6.0 million of audit and non-recurring professional services fees incurred in connection with the 2005 audit, $6.0 million of consulting expenses related to the implementation of a worldwide financial and management system, $5.3 million of additional stock based compensation recognized upon adoption of FAS 123(R) effective January 1, 2006 and $0.7 million to settle previously disclosed claims. The 2005 period included $25.0 million of special investigation, severance, facility and department closures and consolidations and other non-recurring expenses, including $5.7 million of expenses related to North American PLM business. Our operating margin during the 2006 period was 1.8% compared to 9.9% during the 2005 period. Net cash used in operations during 2006 was $4.5 million, a decrease of $44.6 million compared to cash provided by operations of $40.1 million during 2005. Our cash, cash equivalents and investments increased 12.2% to $126.0 million at December 31, 2006 compared to $112.3 million at December 31, 2005.
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Table of ContentsCritical Accounting Policies Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). These accounting principles require us to make estimates, judgments and assumptions that affect the reported amounts of revenue, costs and expenses, assets, liabilities and contingencies, and related disclosures. All significant estimates, judgments and assumptions are developed based on the best information available to us at the time made and are regularly reviewed and updated when necessary. Actual results will generally differ from these estimates. Changes in estimates are reflected in our financial statements in the period of change based upon on-going actual experience, trends or subsequent settlements and realizations depending on the nature and predictability of the estimates and contingencies. The following accounting policies are considered to be critical in evaluating and understanding our financial results because they involve inherently uncertain matters or their application requires the most significant and complex judgments and estimates. Revenue Recognition We derive revenue from licensing our software products and providing maintenance, consulting, and training services. Our standard software license agreement is a perpetual license to use our products on an end user basis. We record revenue from licensing our software products to end users provided there is persuasive evidence of an arrangement, the fee is fixed or determinable, collection is reasonably assured and delivery of the product has occurred, as prescribed by Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition.” For arrangements with multiple elements, and for which vendor specific objective evidence (“VSOE”) of fair value exists for the undelivered elements, revenue is recognized for the delivered elements based upon the residual method in accordance with SOP 98-9, “Modifications of SOP 97-2 with Respect to Certain Transactions.” Amounts billed or payments received in advance of revenue recognition are recorded as deferred revenue. Maintenance agreements are generally twelve-month prepaid contracts that are recognized ratably over the service period. VSOE of fair value for maintenance is measured by the stated renewal rate included in the agreement or, when not stated in the agreement, VSOE is calculated based on actual, historical evidence. Customers may also enter into arrangements for consulting and training services that are either on a time and materials basis or for a fixed fee. VSOE of fair value for consulting and training services is based upon the standard hourly rate we charge for such services when sold separately. Training services are generally prepaid prior to rendering the service. Consulting and training revenue are typically recognized as earned. Consulting revenue is generated primarily from implementation services related to the installation of our products and other VPD solutions. These arrangements are generally not essential to the functionality of the software and are generally accounted for separately from the license revenue because the arrangements qualify as “service transactions” as defined in SOP 97-2. Our products are fully functional upon delivery of the product and implementation does not require significant modification or alteration. Our consulting revenue under fixed fee arrangements is generally recognized using the percentage-of-completion method of contract accounting in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Product-Type Contracts” and Accounting Research Bulletin No. 45, “Long-Term Construction-Type Contracts,” which approximates the proportional performance method. When percentage-of-completion accounting is not possible due to our inability to accurately calculate percentage-of-completion, we recognize revenue using the completed-contract method. If the fair value of any undelivered element included in a multiple-element arrangement cannot be objectively determined, revenue is deferred until all elements are delivered, services have been performed, or until fair value can be objectively determined. License revenue from agents is recognized upon sell-through to the end customer. If we determine that collection of a license fee is not reasonably assured, the fee is deferred and revenue is recognized at the time collection becomes reasonably assured, which is generally upon receipt of cash. If in the future we were unable to support VSOE of fair value for an undelivered element, the entire amount of revenue from the arrangement would be deferred and recognized ratably over the life of the contract.
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Table of ContentsAllowance for Doubtful Accounts We maintain allowances for doubtful accounts for estimated losses resulting from the unwillingness or inability of our customers to make required payments. This requires us to make estimates of future write-offs of bad debt accounts related to current period revenue. The amount of our allowances is based on historical experience and our current analysis of the collectibility of accounts receivable. If the financial condition of our customers were to deteriorate, resulting in their inability to make payments, additional allowances may be required which would result in an additional general and administrative expense in the period such determination was made. While such amounts have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. If for some reason we did not reasonably estimate the amount of our doubtful accounts in the future, it could have a material impact on our consolidated results of operations. Income Taxes During the preparation of our consolidated financial statements, we estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating actual current tax expense together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the consolidated balance sheet. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and, to the extent we believe that recovery is not likely, a valuation allowance is established. To the extent we establish a valuation allowance or increase this allowance in a period, an expense is recorded within the tax provision in the consolidated statements of operations. Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, and any valuation allowance recorded against the net deferred tax assets. We record a valuation allowance when uncertainties exist as to our ability to utilize some of our deferred tax assets before they expire. The valuation allowance is based on estimates of taxable income by jurisdiction in which we operate and the period over which the deferred tax assets will be recoverable. In the event that actual results differ from these estimates, or these estimates are adjusted in future periods, additional valuation allowances may need to be recorded which could materially impact our financial position and results of operations. Our accounting for income taxes also requires us to exercise judgment for issues relating to known matters under discussion with tax authorities and transactions yet to be settled. If material, we record tax liabilities for known tax contingencies when, in our judgment, it is probable that a liability has been incurred and regularly assess the adequacy of this tax liability. It is reasonably possible that actual amounts payable resulting from audits by tax authorities could be materially different from the liabilities we have recorded due to the complex nature of the tax legislation that affects us. Valuation of Goodwill, Intangibles, and Long-Lived Assets We account for goodwill under Statement of Financial Accounting Standards SFAS No. 142, “Goodwill and Other Intangible Assets,” which requires us to review for impairment of goodwill on an annual basis and between annual tests whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. This impairment review involves a two-step process as described in Note 1 in Notes to Consolidated Financial Statements. Based upon our management of resources, we have determined that we have two reporting units—software and services, and we are required to make estimates regarding the fair value of each reporting unit when testing for potential impairment. We estimate the fair value of our reporting units using the income approach. We account for finite-lived intangibles and long-lived assets under SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which requires us to review for impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Factors considered important which could trigger an impairment review include (1) significant underperformance relative to historical or projected future operating results, (2) significant changes in the manner of use of the assets or the strategy for our overall business, (3) significant decrease in the market value of the assets, and (4) significant negative industry or economic trends. Costs allocated to acquired in-process research and development (“IPR&D”) are charged to operations on the acquisition date. Assets to be disposed of are separately presented in the consolidated balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the consolidated balance sheets, if material.
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Table of ContentsContingencies and Litigation We may, from time to time, be subject to various proceedings, lawsuits and claims relating to products and services, technology, labor, shareholder and other matters. We are required to assess the likelihood of any adverse outcomes and the potential range of probable losses in these matters. If the potential loss is considered probable and the amount can be reasonably estimated, we accrue a liability for the estimated loss. If the potential loss is considered less than probable or the amount cannot be reasonably estimated, disclosure of the matter is considered. The amount of loss accrual or disclosure, if any, is determined after analysis of each matter, and is subject to adjustment if warranted by new developments or revised strategies. Due to uncertainties related to these matters, accruals or disclosures are based on the best information available at the time. Significant judgment is required in both the assessment of likelihood and in the determination of a range of potential losses. Revisions in the estimates of the potential liabilities could have a material impact on or consolidated financial position or consolidated results of operations. Recently Adopted Accounting Standards In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”, which is effective for fiscal years ending after November 15, 2006. SAB No. 108 requires an entity to evaluate the impact of correcting all misstatements, including both the carryover and reversing effects of prior year misstatements, on current year financial statements. If a misstatement is material to the current year financial statements, the prior year financial statements should also be corrected, even though such revision was, and continues to be, immaterial to the prior year financial statements. Correcting prior year financial statements for immaterial errors would not require previously filed reports to be amended. Such correction should be made in the current period filings. We completed our evaluation of uncorrected differences pursuant to SAB 108, and concluded that no cumulative effect transition adjustment was necessary. In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statement No. 87, 88, 106 and 132(R)”. SFAS No. 158 requires an employer that sponsors one or more single-employer defined benefit plans to: 1) recognize the funded status of a benefit plan; 2) recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period, but are not recognized as components of net periodic benefit cost pursuant to FASB Statement No. 87, “Employers Accounting for Pensions”, or No 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions”; 3) measure defined benefit plan assets and obligations as of the date of the employer’s fiscal year ended statement of financial position; and 4) disclose in the notes to financial statement additional information about certain effects on the net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. SFAS No. 158 will require an employer to initially recognize the funded status and provide the required disclosure as of the end of fiscal year ending after December 15, 2006. Accordingly, we adopted SFAS No. 158 for the year ended December 31, 2006, the effects of which are disclosed in Note 9 to Consolidated Financial Statements. In February 2006, the FASB issued FASB Staff Position (“FSP”) No. SFAS 123(R)-4 “Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event.” FSP SFAS 123(R)-4 addresses the classification of options and similar instruments issued as employee compensation that allow for cash settlement upon the occurrence of a contingent event and amends paragraphs 32 and A229 of SFAS No. 123(R). We were required to apply the guidance in FSP SFAS 123(R)-4 in the quarterly period ended March 31, 2006. Such adoption of FSP SFAS 123(R)-4 did not impact our consolidated financial statements included in this report. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R), “Share-Based Payment,” which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes Opinion 25, and amends SFAS No. 95, “Statement of Cash Flows.” Under SFAS No. 123(R), compensation cost for all stock-based awards, including grants of employee stock options, restricted stock and other equity awards, are measured at fair value at date of grant and recognized as compensation expense on a straight line basis over the service period that the awards are expected to vest. In addition, SFAS No. 123(R) requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow as prescribed under previous accounting rules. In its adoption, the Company elected to use the modified prospective method, which recognized compensation expense for all share-based payments granted after January 1, 2006 and for all awards granted to employees prior to January 1, 2006 that remain unvested on the date of adoption. Accordingly, prior period amounts have not been restated. See Note 1 to Consolidated Financial Statements. In November 2005, the FASB issued FSP No. SFAS 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards,” which allows an entity up to one year from the later of its initial adoption of FAS 123(R) or the effective date of FSP SFAS 123(R)-3 to evaluate its available transition alternatives in calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123 for recognition purposes (the “APIC pool”) and to make its one-time election. We elected to apply the alternative transition method under SFAS 123(R)-3 to calculate the tax effects of stock-based compensation under SFAS 123(R) as of December 31, 2005. The alternative transition method includes simplified methods to establish the beginning balance of the APIC pool related to the tax effects of employee stock-based compensation expense, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of employee stock-based compensation awards outstanding at the adoption of SFAS 123(R). We computed an APIC Pool of $0 at adoption of SFAS 123(R).
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Table of ContentsRecently Issued Accounting Standards In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement”. This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. It also applies under other accounting pronouncements that require or permit fair value measurement as a relevant attribute. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and all interim periods within that fiscal year. The Company is evaluating what effect the adoption of SFAS No. 157 will have on the Company’s consolidated results of operations and financial condition. In June 2006, FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FAS 109, Accounting for Income Taxes” (FIN 48), to create a single model to address accounting for uncertainty in income tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum probability threshold a tax position must meet to be recognized in the financial statements. FIN 48 also provides guidance on the measurement, derecognition and classification of recognized tax benefits, interest and penalties, accounting for interim periods, and the transition of the accounting method upon the adoption of FIN 48. It also requires footnote and tabular disclosures about unrecognized tax benefits. FIN 48 is effective for years beginning after December 15, 2006. We will adopt FIN 48 in the first quarter of 2007 and record the cumulative effect of adopting FIN 48 in retained earnings and other accounts, as applicable, as of January 1, 2007. Certain tax account classifications on our balance sheet may change to account for the differences in taxes payable and deferred tax assets calculated under FIN 48. The Company is currently evaluating what effect the adoption of FIN 48 will have on the Company’s consolidated financial statements. Results of Operations The following table sets forth items included in the consolidated statements of operations data (amounts in thousands).
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Table of ContentsRevenue by Geography by Type The following table sets forth for the periods indicated, revenue in each of the three geographic regions in which we operate (amounts in thousands):
Results of Operations Revenue Background We generate our revenue from the sale of software licenses, maintenance and consulting and training services. We recognize revenue from software licenses, maintenance and services agreements at varying times. In general, we recognize revenue on a paid up software license in the month in which the license is shipped and on a time-based software license monthly over the license term. Maintenance revenue, generated either as an element of a software license or by a separate renewal agreement, is recognized ratably over the maintenance period (normally one year). Consulting and training agreements generally generate revenue upon completion and customer acceptance of contractually agreed milestones or upon providing the service. A more complete description of our revenue recognition policy can be found above under Critical Accounting Policies. Our revenue in any reporting period is equal to the sum of our software license, maintenance and services revenue for the period. Software revenue includes revenue derived from paid up transactions recorded and shipped during the quarter and from lease arrangements received and delivered in prior quarters. Maintenance revenue in any quarter is derived from paid up and renewal agreements received in prior quarters since our maintenance orders generally yield revenue ratably over a term of one year. Consulting and training revenue is derived from orders received in prior quarters, since we recognize revenue from those services when they are delivered and accepted, not when they are booked. Revenue not recognized in a given reporting period is deferred accordingly. Due to the cyclical nature of new product releases and spending by larger global accounts, our revenue is sensitive to individual large transactions that are neither predictable nor consistent in size or timing. No single customer or reseller represented more than 10% of total revenue during the periods presented. Total Revenue Total revenue decreased 12.2% in 2006 to $259.7 million compared to $295.6 million in 2005 primarily as a result of lower software and services revenue recognized in all our regions. Excluding the effects of changes in foreign currency rates during the 2006 period, and after adjusting the 2005 period for non-recurring PLM revenue totaling $7.7 million, our total revenue decreased 8.5% to $263.6 million.
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Table of ContentsTotal revenue increased 10.6% in 2005 compared to 2004. The growth in revenue in 2005 was due to increases in both software and maintenance and services revenue offset by unfavorable changes in foreign currency exchange rates. The change in foreign currency exchange rates unfavorably affected total revenue in 2005 by approximately $2.4 million due to the strengthening of the U.S. Dollar relative to the Japanese Yen and favorably affected total revenue in 2004 by approximately $13.8 million due to the increase in strength of the Euro and Japanese Yen against the U.S. dollar. Software Revenue. Software revenue in 2006 decreased 22.8% to $111.2 million compared to $144.0 million in 2005. The decrease was associated with lower software revenue in each of the regions. Such decreases were generally the result of our transition to selling enterprise solutions that specifically caused delays in purchasing decisions by our major customers. We believe that selling higher valued enterprise solutions generally lengthen the overall sales cycles. In addition, software revenue in the Americas decreased due to the sale of our PLM assets in March 2006. As a percent of total revenue, software revenue was 42.8% in 2006 compared to 48.7% in 2005. Excluding the effects of changes in foreign currency rates during the 2006 period, and after adjusting the 2005 period for the PLM software revenue totaling $4.5 million, software revenue decreased 19.0% to $113.1 million. Software revenue increased 12.9% to $144.0 million in 2005 compared to $127.5 million in 2004 due to increased penetration within the aerospace and automotive industries in EMEA. As a percent of total revenue, software revenue was 48.7% in 2005 and 47.7% in 2004. In constant dollar terms software revenue increased 14.3% in 2005 to $145.7 million. Maintenance and Services Revenue. Maintenance and services revenue in 2006 decreased 2.0% to $148.5 million compared to $151.6 million in 2005. Maintenance revenue increased 7.1% to $115.1 million primarily due to the incremental growth in our installed customer base and high renewal rates. Services revenue decreased 24.4% to $33.4 million due to the nature, size and timing of consulting and training arrangements provided to our larger global accounts and the loss of services revenue attributable to our North American PLM business. In addition, we have restructured our consulting business by discontinuing certain low value services. As a percent of total revenue, maintenance revenue was 44.3% and services revenue was 12.8% in 2006 compared to 36.4% and 14.9%, respectively, in 2005. Excluding the effects of changes in foreign currency rates during the 2006 period, and after adjusting 2005 for the PLM services revenue totaling $3.2 million, maintenance and services revenue increased 1.4% to $150.6 million. Maintenance and services revenue increased 8.5% to $151.6 million in 2005 compared to 2004. Maintenance revenue increased 15.2% to $107.5 million in 2005 primarily due to year-over-year growth of our installed customer base in all our regions. Services revenue decreased 5.0% to $44.1 million primarily due to the nature and timing of consulting services provided to our larger customers, particularly in the Americas and EMEA. As a percent of total revenue, maintenance and services revenue was 52.0% in 2005 and 52.3% in 2004. In constant dollar terms, maintenance and services revenue increased 10.6% in 2005 to $154.5 million. Revenue by Geography Americas – Total revenue in the Americas in 2006 was $75.7 million, a decrease of 13.5% compared to $87.6 million in 2005. After adjusting 2005 for non-recurring software and services revenue totaling $7.7 million attributable to our North American PLM business, total revenue in the Americas decreased 5.3%. Our non-PLM software revenue decreased 12.4% to $25.7 million as a result of delays in orders resulting from the transition to selling our MD and enterprise solutions, which impacted sales to major customers in our key industries. Maintenance revenue increased 11.7% to $38.0 million due to a growing installed customer base with high renewal rates. Our non-PLM services revenue decreased 27.7% to $12.0 million due to a decrease in training and consulting arrangements, particularly larger global accounts in the aerospace and automotive sectors, due to the completion of projects and discontinuance of services offered. In 2005 software revenue decreased 4.1% compared to 2004 due to reduced corporate technology spending and the reorganization of the Americas’ sales organization in the latter half of 2005. Maintenance and services revenue remained virtually unchanged due to increased maintenance revenue resulting from growth of their installed customer base offset by lower revenues from consulting services provided to major customers in the aerospace and automotive industries. EMEA - Total revenue in EMEA in 2006 was $103.4 million, a decrease of 9.8% compared to $114.7 million for the same period in 2005. The decrease was attributable to a 24.3% decrease in software revenue caused primarily by nonrecurring conversions of leasing arrangements to paid up in 2005 and the transition to selling enterprise solutions to our major customers, partially offset by a 10.8% increase in maintenance revenue resulting from renewals and a growing installed base and a 2.0% increase in services revenue. Excluding the effects of changes in the EURO during the 2006 period, total revenue in EMEA in 2006 was $102.5 million, a decrease of 10.6% compared to 2005.
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Table of ContentsIn 2005 software revenue increased 37.6% compared to 2004 primarily due to further penetration of key customers within the aerospace and automotive industries. In constant dollar terms software revenue increased 39.4% compared to 2004. Maintenance and services revenue increased primarily due to increased maintenance revenue due to growth of their installed customer bases partially offset by lower consulting services revenue caused by changes in the nature and timing of completing such services. In constant dollars terms maintenance and services revenue increased 2.3% compared to 2004. Asia Pacific - Total revenue in Asia Pacific in 2006 was $80.5 million, a decrease of 13.7% compared to $93.3 million in 2005. Software revenue decreased 19.9% to $37.0 million caused primarily by the transition to selling enterprise solutions to our major Japanese customers, partially offset by revenue growth in countries outside Japan. Maintenance revenue was $35.6 million, virtually unchanged compared to $36.1 million in 2005. Services revenue decreased 29.2% to $7.9 million due to the timing of the completion of consulting projects. Excluding the effects of changes in the YEN during the 2006 period, total revenue in Asia Pacific in 2006 was $85.4 million, a decrease of 8.5% compared to 2005. In 2005 software revenue increased 1% compared to 2004 that was attributable to higher sales to automotive customers. In constant dollar terms software revenue increased 2.9% compared to 2004. Maintenance and services revenue increased 30.0% primarily due to increased maintenance revenue resulting from growth of their installed customer bases. In constant dollars terms maintenance and services revenue increased 32.2% compared to 2004. Costs and Expenses A significant amount of our costs and expenses are considered fixed and do not vary based upon revenue levels. Our most significant fixed expenses include compensation, benefits and facilities, all of which are difficult to reduce quickly should our revenue levels not meet expectations. During the last several years, we have reevaluated our software and services businesses and have scaled these operations in response to economic and market conditions. We have taken actions to reduce operating expenses and to improve operating margins, including the decision to sell our ESTECH subsidiary in 2005 and to sell certain assets related to our PLM business in 2006, as well as initiating separate restructuring plans in 2002 and 2003. During the second half of 2005 we began to expand our software development activities in India through services provided by GSSL as a cost effective solution to maintaining our leadership in simulation software. In addition, during 2006 we have identified and/or began several cost reduction initiatives, including outsourcing our production, manufacturing and distribution capabilities, renegotiating third party royalty arrangements and IT software licensing and maintenance agreements, and transitioning to electronic delivery of our software. We allocate facility expenses among our functional income statement categories based on headcount within each functional area. Annually, or upon a significant change in headcount (such as a workforce reduction, realignment or acquisition) or other factors, management reviews the allocation methodology and the expenses included in the allocation pool. Cost of Revenue Cost of Software Revenue. Cost of software revenue consists primarily of royalties payable to third parties for technology embedded in or licensed with our software products, amortization of developed technology and the cost of product packaging and documentation materials. In 2006, cost of software revenue decreased 22.8% to $12.9 million compared to $16.7 million in 2005. The decrease was attributable primarily to the sale of the PLM business, lower royalty expenses resulting from renegotiated agreements and changes in product mix, including termination of products previously subject to royalties, and lower packaging and shipping costs. As a percent of software revenue, cost of software revenue was 11.6% in 2006, unchanged compared to 2005. After adjusting the 2005 period for non-recurring PLM cost of software revenue totaling $1.5 million, cost of software revenue in 2006 decreased 14.2% compared to 2005. In 2005 cost of software revenue was essentially flat compared to 2004 at $16.7 million. Cost of software revenue as a percent of software revenue was 11.6% in 2005 and 13.1% in 2004. Cost of Maintenance and Services Revenue. Cost of maintenance and services consists primarily of personnel, outside consultancy costs and other direct costs required to provide post sales support, consulting and training services. Cost of maintenance and services revenue in 2006 decreased 16.1% to $45.2 million compared to $53.9 million in 2005. The decrease was primarily the result of lower salaries, wages and benefits attributable to a reduction of personnel, lower accruals for incentive compensation, lower facility related expenses and the sale of the PLM business. As a percent of maintenance and services revenue, cost of maintenance and services revenue decreased to 30.4% in 2006 from 35.6% in 2005 as a result of lower utilization rates and timing of costs incurred in providing consulting and training services versus the recognition of related revenue by our EMEA and Asia Pacific regions under completed contract accounting. Excluding the effects of changes in foreign currency rates during the 2006 period, and after adjusting the 2005 period for non-recurring PLM cost of services revenue totaling $1.0 million, cost of maintenance and services revenue decreased 13.5% to $45.8 million.
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Table of ContentsIn 2005 cost of maintenance and services revenue decreased 3.1% to $53.9 million compared to 2004. The decrease in cost of maintenance and services revenue in 2005 compared to 2004 was principally due to decreases in compensation related expenses. In constant dollar terms, cost of maintenance and services revenue decreased approximately 2.4% to $54.3 million. Cost of maintenance and services revenue as a percent of maintenance and services revenue decreased to 35.6% in 2005 from 39.8% in 2004 due to improved utilization rates. Operating Expenses Total operating expenses in 2006 increased 0.6% to $196.9 million compared to $195.8 million in 2005. Included in the 2006 period was a $4.6 million gain recognized on the sale of certain assets of our PLM business. In addition, the 2006 period included $6.0 million of audit and non-recurring professional services fees incurred in connection with the 2005 audit, $6.0 million of consulting expenses related to the implementation of a worldwide financial and management system, $5.3 million of additional stock based compensation recognized pursuant to FAS 123(R) and $0.7 million to settle previously disclosed claims. The 2005 period included expenses totaling $8.6 million related to the special investigation and the 2004 restatement audit, a provision of $4.8 million related to the closure and consolidation of facilities and certain departments, severance expense totaling $3.9 million related to terminated officers, and $2.0 million of expense incurred in connection with the termination of a product and distribution agreement. As a percent of total revenue, total operating expenses increased to 75.8% in 2006, from 66.2% in 2005. Excluding the effects of changes in foreign currency rates during the 2006 period, and after adjusting the 2005 period for non-recurring PLM operating expenses totaling $5.7 million, total operating expenses increased 4.2% to $198.0 million. Research and Development. Our research and development expenses consist primarily of salaries and benefits, facility expenses, contracted services, incentive compensation and computer technology. Major research and development activities include developing our enterprise solutions strategy, including our MD software, and enhancing the features and functionality of existing engineering products. Research and development expenses in 2006 decreased 8.7% to $43.2 million compared to $47.3 million in 2005 due to lower employee related expenses, including incentive compensation, and facility costs. As a percent of total revenue, research and development expenses were 16.7% in 2006 compared to 16.0% in 2005. Research and development expenses increased 12.4% to $47.3 million in 2005, or 16.0% of revenue, from $42.1 million in 2004, or 15.8% of revenue. The increase was attributable to higher compensation and benefits primarily due to annual salary increases, higher incentive compensation expenses and increases in our research and development headcount, especially in India. In addition, 2004 included a write off of $0.3 million of acquired in-process research and development costs in connection with the acquisition of SOFY Technologies Corporation. The projects associated with this charge were completed by the end of 2004. Selling, General and Administrative. Our selling expenses consist primarily of salaries and benefits, sales commissions, facility costs, travel and entertainment, incentive compensation, product marketing, and professional services. General and administrative expenses consist primarily of salaries, benefits and incentive compensation of administrative, executive, financial and legal personnel, facility costs, outside consulting and other professional services and travel and entertainment. Selling, general and administrative expenses in 2006 increased 3.3% to $152.7 million compared to $147.8 million in 2005. Included in the 2006 period was a $4.6 million gain recognized on the sale of certain assets of our PLM business. In addition, the 2006 period included $6.0 million of audit and non-recurring professional services fees incurred in connection with the 2005 audit, $6.0 million of consulting expenses related to the implementation of a worldwide financial and management system, $4.9 million of additional stock based compensation recognized pursuant to FAS 123(R) and $0.7 million to settle previously disclosed claims. The 2005 period included expenses totaling $8.6 million related to the special investigation and the 2004 restatement audit, a provision of $4.8 million related to the closure and consolidation of facilities and certain departments, severance expense totaling $3.9 million related to terminated officers, and $2.0 million of expense incurred in connection with the termination of a product and distribution agreement. The 2006 period was also impacted by higher expenses for recurring audit and related services, increased travel and entertainment and product marketing expenses incurred in connection with our transition to selling enterprise simulation solutions, higher salaries, wages and benefits, and a lease termination charge of $0.6 million resulting from our decision to outsource certain production, manufacturing and distribution capabilities, partially offset by lower accruals for incentive compensation. As a percent of total revenue, selling, general and administrative expenses increased to 58.8% in 2006 from 50.0% in 2005. Excluding the effects of changes in foreign currency rates during the 2006 period, and after adjusting the 2005 period for non-recurring PLM expenses totaling $5.7 million, selling, general and administrative expenses increased 8.3% to $153.8 million.
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Table of ContentsSelling, general and administrative expenses increased 9.2% to $147.8 million in 2005, or 50.0% of revenue, compared to $135.4 million, or 50.7% of revenue, in 2004. Included in these expenses were non-recurring expenses related to the independent investigation and restatement audit totaling $8.6 million and $8.1 million in 2005 and 2004, respectively; severance and related expenses related to the termination of departing officers of $3.9 million and $0.9 million in 2005 and 2004, respectively; costs related to the closure and consolidation of facilities and certain departments aggregating $4.8 million in 2005, and payments of $2.0 million related to the termination of a product and distribution agreement in 2005. In addition, selling, general and administrative expenses for 2005 were impacted by higher salaries and wages, benefits, sales commissions and incentive compensation, including stock-based compensation of $4.5 million in 2005 and $3.3 million in 2004, and lower facility related costs compared to 2004. In constant dollar terms, selling, general and administrative expenses increased 6.7% to $144.5 million in 2005. Amortization of Intangibles. Amortization of intangibles, primarily related to customer lists with useful lives ranging from five to fifteen years, was $0.8 million in 2006, 2005 and 2004. Impairment Charges. In 2006 and 2004, we recognized impairment charges for assets held for sale. Interest and Other (Income) Expense, Net Interest expense consists of interest on our long-term debt and the amortization of debt issue costs and discounts. Interest expense in 2006 was $3.6 million compared to $4.4 million in 2005 and $4.6 million in 2004. The decrease in 2006 is attributable to the redemption of our Convertible Notes in June 2006, partially offset by a write off of related debt issue costs totaling $1.4 million. Other expense (income) includes interest income, foreign currency transaction gains and losses resulting from the remeasurement of intercompany accounts denominated in the functional currency of the foreign subsidiary, and other non-operating income and expense. Other income, net in 2006 increased to $5.3 million compared to $0.9 million in 2005 due to the recognition of foreign currency transaction gains versus foreign currency transaction losses in 2005 and higher interest income resulting from higher cash balances and rising interest rates. Other income declined in 2005 compared to 2004 primarily due to a $2.6 million unfavorable impact from foreign currency transactions. Provision for Income Taxes The relative proportions of our domestic and foreign revenue and income directly affect our effective tax rate. We are also subject to changing tax laws in the multiple jurisdictions in which we operate. As of December 31, 2006, current deferred tax assets, net of current deferred tax liabilities, totaled $15.7 million. Non-current deferred tax assets, net of non-current deferred tax liabilities, totaled $4.8 million. We believe it is more likely than not that our results of future operations will generate sufficient taxable income to utilize our net deferred tax assets of $20.5 million. We consider future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for any valuation allowance, and if we determine we would not be able to realize all or part of our net deferred tax assets in the future, we would record a charge to income and an adjustment to the deferred tax assets in the period we make that determination. We have not provided taxes for undistributed earnings of our foreign subsidiaries because we plan to reinvest such earnings indefinitely outside the United States. If the cumulative foreign earnings exceed the amount we intend to reinvest in foreign countries in the future, we would provide taxes on such excess amount. As of December 31, 2006, there was approximately $20.9 million of earnings upon which income taxes have not been provided. Our effective tax rate, based on taxable income by regional tax jurisdiction, was <108.1>% in 2006 compared to 53.7% in 2005 and 36.3% in 2004. The negative rate in 2006 primarily resulted from the release of valuation allowances established against domestic deferred tax assets, aggregating $12.7 million. The increase in the effective tax rate during 2005 reflect the impact of foreign earnings on consolidated earnings, foreign tax rate variances and changes in valuation allowances established against domestic deferred tax assets. Discontinued Operations In March 2006, we completed the sale of our wholly owned Japanese service subsidiary, ESTECH Corporation, which has been accounted for as a discontinued operation within the consolidated financial statements.
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Table of ContentsLIQUIDITY AND CAPITAL RESOURCES
As of December 31, 2006, our principal sources of liquidity included cash and cash equivalents of $111.9 million and marketable equity securities available-for-sale of $14.1 million. Our working capital (current assets minus current liabilities) increased $36.5 million during 2006 to $98.4 million at December 31, 2006, and increased $41.2 million during 2005 to $61.9 million at December 31, 2005. The increases in working capital were primarily due to the timing of cash receipts on billings and payment of accounts payable and accrued liabilities, including those related to restructuring activities and non-recurring expenses, and changes in deferred revenue. In the past, working capital needed to finance our operations has been provided by cash on hand and by cash flow from operations. We believe that cash on hand and cash generated from operations will provide sufficient capital for normal working capital needs over the next twelve months. Our ability to generate cash flows from operations is dependent on our ability to generate income from our operations, and effective cash management, including timely billing and collections of trade accounts receivable and payment of our expenses primarily related to compensation, benefits, facilities, royalties and third party services. Outside of these expenses, we generally do not have a significant amount of vendor payables. Our operations used $4.5 million in cash during 2006, compared to generating cash of $40.1 million in 2005 and $31.9 million in 2004. The decrease in cash generated from operations during 2006 was primarily attributable to lower cash earnings and higher levels of disbursements related to income taxes, accounts payable and accrued liabilities, partially offset by higher collections of billings and changes in deferred revenue. The increase in cash generated in 2005 was primarily attributable to higher cash earnings, and lower payments of accounts payable and accrued liabilities, partially offset by lower collections of billings and changes in deferred revenue. Our days sales outstanding was 98 days at December 31, 2006, 79 days at December 31, 2005 and 90 days at December 31, 2004. Our days sales outstanding generally exceed 60 days due to the high proportion of billings generated from our international operations, which generally have longer payment terms compared to the U.S. In addition, our days sales outstanding are also negatively impacted by the significant volume of sales transactions and invoicing that occurs near the end of any given quarter. During 2004, 2005 and 2006, our research and development expenditures totaled $42.1 million, $47.3 million and $43.2 million, respectively, none of which was capitalized due to the short duration between technological feasibility and general availability of the new software to our customers. We expect to continue to invest a substantial portion of our revenues primarily for the development of our new enterprise simulation solutions and integrated multi-disciplinary software. In 2007, we estimate our expenditures for research and development activities will be approximately $49 million. As of June 16, 2006 (the “Redemption Date”) all of our outstanding 2 1/2% Senior Subordinated Convertible Notes due 2008 were converted under a previously announced notice to call such notes at a redemption price of 100% of principal outstanding, plus interest accrued and unpaid thereon to, but not including, the Redemption Date. Holders of the Notes converted their Notes to shares of our common stock, at a conversion rate of 117.4398 shares of our common stock per $1,000 principal amount of the Notes. Net cash provided by investing activities was $11.2 million in 2006 and $27.1 million in 2005 compared to net cash used of $33.4 million in 2004. Our principal investing activities during 2006 included proceeds from the sale of our ESTECH subsidiary and the PLM assets totaling $14.5 million, net capital expenditures of $8.2 million and proceeds of $4.8 million received from the sale of pledged securities no longer needed after the conversion of our Subordinated Convertible Notes in June 2006. During 2005, our principal investing activities included proceeds of $35.5 million received from sales of auction rate securities, purchases of investment securities totaling $7.5 million and capital expenditures of $2.3 million.
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Table of ContentsCapital expenditures in 2006, 2005 and 2004 included purchases of computer equipment and related software used in the development and support of our software products and business processes, including $4.0 million in 2006 related to the upgrade of our worldwide financial and management information systems that was substantially completed in 2006. In 2007, we estimate that our capital expenditures will total approximately $8.4 million and will be primarily for the purchase of computer equipment and related software used in our development and business processes. On November 8, 2006, our Board of Directors authorized the repurchase of up to 1,250,000 shares of the Company’s common stock from time to time in open market or private transactions. Net cash provided by financing activities was $5.7 million in 2006 and $0.6 million in 2005 compared to net cash used of $0.8 million in 2004. During 2006 our principal financing activities included proceeds from the exercise of stock options totaling $9.5 million, payments on capital lease obligations totaling $2.6 million, the repurchase of 183,400 shares of common stock for $2.6 million and $1.3 million of excess tax benefits related to stock-based compensation. Principal financing activities in 2005 included proceeds from the exercise of stock options totaling $1.2 million and payments on capital lease obligations totaling $0.6 million. Our current debt service obligations consist of interest and principal payments on the 8% Subordinated Notes Payable due June 17, 2009. As of December 31, 2006, annual principal payments will total $0.8 million in 2007 and 2008 and $6.4 million in 2009. We may engage in additional financing methods that we believe are advantageous, particularly to finance potential acquisitions. Contractual Obligations The following summarizes our contractual obligations at December 31, 2006 (in thousands).
We are exposed to the impact of foreign currency fluctuations and interest rate changes. Foreign Currency Risk International revenue represented 66.6%, 70.4% and 70.8%, of our total revenue for 2004, 2005 and 2006, respectively. International sales are made mostly from our foreign sales subsidiaries in Europe and Asia Pacific and are typically denominated in the local currency of each country. These subsidiaries also incur most of their expenses in the local currency. Accordingly, all foreign subsidiaries use the local currency as their functional currency. Our exposure to foreign exchange rate fluctuations arises in part from intercompany accounts in which cash from sales of our foreign subsidiaries are transferred back to the United States. These intercompany accounts are typically denominated in the functional currency of the foreign subsidiary in order to centralize foreign exchange risk with the parent company in the United States. We are also exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into United States Dollars in consolidation. As exchange rates vary, these results, when translated, may vary from expectations and impact overall expected profitability. In 2006, a 5% change in both the EURO and Yen would have impacted our revenue by approximately $8.8 million and our income from continuing operations by approximately $1.7 million. We do not currently hedge any of our foreign currencies.
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Table of ContentsInterest Rate Risk We do not have any variable interest rate borrowings and, accordingly, our exposure to market rate risks for changes in interest rates is limited. Refer to Note 1 in the accompanying Notes to Consolidated Financial Statements discussing fair value of financial instruments. We have not used derivative financial instruments in our investment portfolio. We invest our excess cash primarily in debt instruments of U.S. municipalities and other high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer. We protect and preserve our invested funds by limiting default, market and reinvestment risk. Investment Risk As of December 31, 2006 our investments included only marketable equity securities. We periodically evaluate whether any declines in fair value of our investments are other-than-temporary, which may result in an impairment of such assets. This evaluation consists of a review of qualitative and quantitative factors. We had no such impairments during 2004, 2005 or 2006. Refer to Note 1 in the accompanying Notes to Consolidated Financial Statement, discussing fair value of financial instruments. Our marketable equity securities consist entirely of stock in Geometric Software Solutions Co. Ltd. (“GSSL”), a public company headquartered in India, which we use for certain software development projects. All unrealized gains and losses related to our investment in the stock of GSSL are recorded as a component of other comprehensive income. In the event we decide to sell all or any part of the stock of GSSL, amounts realized from such sale, and any resulting gains or losses, would be dependent upon the market price of the stock at the time of sale. As of December 31, 2006, we owned 5,200,000 shares of GSSL stock with an original cost of $68,000.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
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Table of ContentsCONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2005 AND 2006 (in thousands except per share value amounts)
See accompanying notes to consolidated financial statements.
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Table of ContentsCONSOLIDATED STATEMENTS OF OPERATIONS FOR YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006 (in thousands, except per share data)
See accompanying notes to consolidated financial statements.
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Table of ContentsCONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS) FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006 (in thousands)
See accompanying notes to consolidated financial statements.
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Table of ContentsCONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006 (in thousands)
See accompanying notes to consolidated financial statements.
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Table of ContentsNOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2006 NOTE 1—NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations—MSC.Software Corporation (“MSC” or the “Company”) designs, produces and markets proprietary enterprise simulation solutions, including simulation software and related professional services. Our enterprise simulation solutions are used in conjunction with computer-aided engineering to create a more flexible, efficient and cost effective environment for product development. Our products and services are marketed internationally to various industries, including aerospace, automotive and other industrial concerns, computer and electronics manufacturers, biomedical, shipbuilding and rail. Principles of Consolidation—The consolidated financial statements include the accounts of the Company and its subsidiaries. All intercompany accounts and transactions have been eliminated. The Company completed an acquisition in 2004. The results of the operations of the acquired company have been included in the consolidated statements of operations from the date of acquisition. Refer to Note 2—Business Acquisitions. Use of Estimates—The preparation of financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”) requires management to make estimates and judgments that significantly affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Significant estimates include those related to revenue recognition, accounts receivable allowances, income taxes, valuation of long-lived assets, and certain accrued liabilities, among others. Actual results could differ from those estimates, and such differences could affect the results of operations reported in future periods. Revenue Recognition—We derive revenue from licensing our software products and providing maintenance, consulting, and training services. Our standard software license agreement is a perpetual license to use our products on an end user basis. We record revenue from licensing our software products to end users provided there is persuasive evidence of an arrangement, the fee is fixed or determinable, collection is reasonably assured and delivery of the product has occurred, in accordance with Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition.” For arrangements with multiple elements, and for which vendor specific objective evidence (“VSOE”) of fair value exists for the undelivered elements, revenue is recognized for the delivered elements based upon the residual method in accordance with SOP 98-9, “Modifications of SOP 97-2 with Respect to Certain Transactions.” Amounts billed or payments received in advance of revenue recognition are recorded as deferred revenue. Maintenance agreements are generally twelve-month prepaid contracts that are recognized ratably over the service period. VSOE of fair value for maintenance is measured by the stated renewal rates included in the agreements or, when not stated in the agreement VSOE is calculated based upon actual, historical evidence. Customers may also enter into arrangements that are typically on a time and materials basis for consulting and training services. VSOE of fair value for consulting and training services is based upon the standard hourly rate we charge for such services when sold separately. Training services are generally prepaid prior to rendering the service. Consulting and training revenue are typically recognized as earned. Consulting revenue is generated primarily from implementation services related to the installation of our products and other enterprise simulation solutions. These arrangements are generally accounted for separately from the license revenue because the arrangements qualify as “service transactions” as defined in SOP 97-2. Our services are generally not essential to the functionality of the software. Our products are fully functional upon delivery of the product and implementation does not require significant modification or alteration. Our consulting revenue is generally recognized using the percentage-of-completion method of contract accounting in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Product-Type Contracts” and Accounting Research Bulletin No. 45, “Long-Term Construction-Type Contracts” which approximates the proportional performance method. When percentage-of-completion accounting is not possible due to our inability to accurately estimate percentage-of-completion, we recognize revenue using the completed-contract method.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
If the fair value of any undelivered element included in a multiple-element arrangement cannot be objectively determined, revenue is deferred until all elements are delivered, services have been performed, or until fair value can be objectively determined. License revenue from agents is recognized upon sell-through to the end customer. If we determine that collection of a license fee is not reasonably assured, the fee is deferred and revenue is recognized at the time collection becomes reasonably assured, which is generally upon receipt of cash. If in the future we were unable to support VSOE of fair value for an undelivered element, the entire amount of revenue from the arrangement would be deferred and recognized ratably over the life of the contract. Revenue is derived through the Company’s direct sales force, a network of value-added resellers and other sales agents. Revenue from the sale of products by other sales agents, for which a commission is due to the sales agent, is reported as net revenue (gross sales price less commission due to the sales agent) earned from the product sale. Revenue from the sale of products provided by other suppliers, for which a royalty is due to the suppliers, is reported as gross revenue earned from the product sale. Royalties due to these other suppliers are recorded as royalty expense in cost of software revenue. The Company does not offer any rights of return, rebates, stock balancing rights or price protection on the Company’s software products. Deferred Revenue—As of December 31, 2005 and 2006, deferred revenue consisted of the following (in thousands):
Discontinued Operations—During the fourth quarter of 2005, the Company approved a plan to sell its Japanese service subsidiary, ESTECH Corporation (“ESTECH”). In March 2006, the sale of ESTECH was completed. In 2003, the Company ceased operations of its Systems business. Accordingly, all current and prior financial information related to ESTECH and the Systems business has been presented as discontinued operations in the accompanying consolidated financial statements. Refer to Note 15—Discontinued Operations. Cash and Cash Equivalents—The Company considers investments with maturities of three months or less when purchased to be cash equivalents. Investments—Marketable equity securities and debt securities are classified as trading, held-to-maturity or available-for-sale in accordance with SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” Management determines the appropriate classification of securities at the time of purchase and re-evaluates such designation as of each balance sheet date. Available-for-sale securities are carried at fair value, with temporary unrealized gains and losses, net of tax, reported in shareholders’ equity as a separate component of accumulated other comprehensive income (loss) in the consolidated balance sheets, until realized. As of December 31, 2005 and 2006, all of our short-term investments were classified as available-for-sale. Even though the stated maturity dates of these investments may be one year or more beyond the balance sheet dates, we have classified all marketable investments as short-term investments as they are available for current operations. Realized gains and losses on sales of investment securities and declines in value judged to be other than temporary are included in other expense (income) in the consolidated statements of operations. The cost of securities sold is based on the specific identification method. Our debt securities held in 2005 were classified as held-to-maturity and were reported at amortized cost in the consolidated balance sheets as other assets. Such debt securities are referred to as pledged securities in connection with our Convertible Notes. Refer to Note 7—Long-Term Debt.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As of December 31, 2005 and 2006, our non-qualified supplemental retirement plan had investments in marketable equity securities classified as available-for-sale, which are included in other assets in the accompanying consolidated balance sheets. Refer to Note 9—Pensions and Other Employee Benefits. Available-for-sale and held-to-maturity equity and debt securities were as follows at December 31, 2005 and 2006 (in thousands):
The pledged securities classified as held-to-maturity debt securities as of December 31, 2005 were sold in connection with the redemption of Convertible Notes in June 2006. Refer to Note 7 – Long-Term Debt for further discussion. We had no contractual maturities of any equity or debt securities as of December 31, 2005 and 2006. Allowance for Doubtful Accounts—We maintain allowances for doubtful accounts for estimated losses resulting from the unwillingness or inability of our customers to make required payments. This requires us to make estimates of future write-offs of bad debt accounts related to current period revenue. The amount of the allowance is based on historical experience and our current analysis of the collectibility of accounts receivable. If the financial condition of our customers were to deteriorate, resulting in their inability to make payments, additional bad debt provisions may be recorded in the period such determination was made. Our allowance for doubtful accounts at December 31, 2005 and 2006 was $1,296,000 and $1,555,000, respectively. Our provision for doubtful accounts totaled $991,000, $498,000 and $625,000 in 2004, 2005 and 2006, respectively, and were recorded in selling, general and administrative expense in the consolidated statements of operations. Uncollectible trade accounts receivable written-off, net of recoveries, were $91,000, $2,515,000 and $366,000 in 2004, 2005 and 2006, respectively.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Property and Equipment—Property and equipment, including software for internal use, are recorded at cost, less accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful lives of the assets, ranging from two to five years. Amortization of leasehold improvements is calculated on the straight-line method over the shorter of the estimated useful lives of the assets or the corresponding lease term. Refer to Note 3—Property and Equipment. Software for internal use is capitalized in accordance with SOP 98-1, “Accounting for the Cost of Computer Software Developed or Obtained for Internal Use.” Costs for purchased software and internal software development activities are capitalized beginning when the Company has determined (1) that technology exists to achieve the performance requirements, (2) buy versus internal development decisions have been made and (3) the Company’s management has authorized the funding for the project. Capitalization of software costs ceases when the software is substantially complete and is ready for its intended use and is amortized over its estimated useful life of two years using the straight-line method. Amounts capitalized during 2005 and 2006 totaled $178,000 and $3,556,000, respectively. Long-Lived Assets—We evaluate the recoverability of our long-lived assets, including property and equipment and certain identifiable intangible assets, in accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS 144 requires the Company to review for impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Factors considered important which could trigger an impairment review include:
When we determine that the carrying amount of long-lived assets may not be recoverable based upon the existence of one or more of the above indicators, we assess the assets for impairment based on the estimated future undiscounted cash flows expected to result from the use of the asset and its eventual disposition. If the carrying amount of an asset exceeds its estimated future undiscounted cash flows, an impairment loss is recorded for the excess of the asset’s carrying amount over its fair value. Fair value is generally determined based on the estimated future discounted cash flows over the remaining useful life of the asset using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. The assumptions supporting the cash flows, including the discount rates, are determined using management’s best estimates as of the date of the impairment review. If these estimates or their related assumptions change in the future, the Company may be required to record additional impairment charges for these assets, and future results of operations could be adversely affected. Assets to be disposed of are separately presented in the consolidated balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the consolidated balance sheets, if material. In addition to the assets of ESTECH, which have been presented as part of discontinued operations, long-lived assets with a net book value of $200,000 (after a write-down of $141,000) were held for sale and classified as other current assets. Goodwill and Other Indefinite Lived Intangibles—We account for goodwill and other indefinite lived intangibles under SFAS 142, “Goodwill and Other Intangible Assets,” which requires the Company to review for impairment of the intangible asset on an annual basis, and between annual tests whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. This impairment review involves the following two-step process:
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In calculating the impairment charge, the fair value of the impaired reporting unit would be estimated using the income approach. Significant management judgment is required in determining the allocations required under this process and projecting cash flows. Any changes in the assumptions used in projecting cash flows or determining an appropriate discount rate could impact the assessed value of an asset and result in an impairment charged equal to the amount by which its carrying value exceeds its actual or estimated fair value. No impairment charges were recorded in 2004, 2005 and 2006 as a result of our impairment testing. Refer to Note 4—Goodwill and Other Intangible Assets. Software Development Costs—Development costs for software to be sold or otherwise marketed are included in research and development expenses as incurred. After technological feasibility is established, significant software development costs are capitalized and amortized on a straight-line basis over the estimated life of the software product. To date, the period between achieving technological feasibility, which typically occurs when the beta testing commences on a working model, and the general availability of such software to our customers has been short. As a result, software development costs qualifying for capitalization have been insignificant and we have not capitalized any software development costs. Advertising Expense—The cost of advertising is expensed as incurred. The Company incurred $1,087,000, $813,000 and $1,012,000 in advertising costs during the years ended December 31, 2004, 2005 and 2006, respectively. Royalties to Third Parties—The Company has agreements with third parties requiring the payment of royalties for sales of third party products or inclusion of such products as a component of the Company’s products. Royalties are charged to cost of software license revenue when incurred and totaled $6,658,000, $5,905,000 and $5,578,000 in 2004, 2005 and 2006, respectively. Stock-Based Compensation— For the years ended December 31, 2004, 2005 and 2006, the Company maintained stock plans covering a broad range of potential equity grants including stock options, stock appreciation rights, restricted stock, performance stock, stock units, phantom stock and dividend equivalents. In addition, the Company sponsored an Executive Cash and Bonus Plan (“Bonus Plan”), whereby certain amounts of bonus earned during a year are paid in common stock of the Company, and an Employee Stock Purchase Plan (“ESPP”), whereby eligible employees were entitled to purchase common stock semi-annually, by means of limited payroll deductions, at a 10% discount from the fair market value of the common stock as of specific dates. The ESPP was qualified under Sections 421 and 423 of the Internal Revenue Code and was a non-compensatory plan under APB Opinion No. 25. Since July 31, 2004, there have been no additional purchases of the Company’s stock under the ESPP. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R), “Share-Based Payment,” which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes Opinion 25, and amends SFAS No. 95, “Statement of Cash Flows.” Under SFAS No. 123(R), compensation cost for all stock-based awards, including grants of employee stock options, restricted stock and other equity awards, are measured at fair value at date of grant and recognized as compensation expense on a straight line basis over the service period that the awards are expected to vest. In addition, SFAS No. 123(R) requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow as prescribed under previous accounting rules. In its adoption, the Company elected to use the modified prospective method, which recognized compensation expense for the fair value of all share-based payments granted after January 1, 2006 and for the fair value of all awards granted to employees prior to January 1, 2006 that remain unvested on the date of adoption. Accordingly, prior period amounts have not been restated. Prior to January 1, 2006, the Company accounted for stock-based awards using the intrinsic method in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and FASB Interpretation No. 44 (“FIN 44”), Accounting for Certain Transactions Involving Stock-Based Compensation, an Interpretation of APB Opinion No. 25” and related interpretations. Accordingly, the Company was not required to recognize compensation expense for stock options granted or for shares issued under the ESPP. Prior to the adoption of SFAS No. 123(R), the Company recognized compensation expense only for restricted stock and restricted stock unit awards and for amounts earned under the Bonus Plan.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Had stock-based compensation for 2004 and 2005 been determined based on the estimated fair value at the grant date for all equity awards consistent with the provisions of SFAS No. 123, the Company’s net income (loss), earnings (loss) per share for the years ended December 31, 2004 and 2005 would have been adjusted to the following pro forma amounts (in thousands, except per share data):
The effect of recording stock-based compensation for the year ended December 31, 2006 in accordance with SFAS No. 123(R) was as follows (in thousands, except per share data):
The tax effect on stock-based compensation was limited to the tax benefit realized after considering limitations or qualification of tax deductions, and realization of resulting deferred tax assets. Refer to Note 6 – Income Taxes for additional information.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Using the Black-Scholes option-pricing model, the estimated per share weighted-average fair value of stock options granted in 2004, 2005 and 2006 was $5.29, $7.69 and $8.58, respectively. The estimated per share weighted-average fair value of ESSP shares purchased in 2004 was $2.07. These estimated per share fair values were determined using the following weighted-average assumptions used for the periods indicated:
The expected stock price volatility rates are based on historical volatilities of our common stock. The risk-free interest rates are based on the U.S. Treasury yields in effect at the time of grant for periods corresponding with the expected life of the option. The expected life represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns. For the year ended December 31, 2006, the average expected life was determined using the simplified approach described under SAB 107. In addition, we estimate forfeitures when recognizing compensation expense, and we will adjust our estimate of forfeitures over the requisite service period based on the extent to which actual forfeitures differ, or are expected to differ, from such estimates. Changes in estimated forfeitures will be recognized through a cumulative catch-up adjustment in the period of change and will also impact the amount of compensation expense to be recognized in future periods. Income Taxes—The Company uses the asset and liability method of accounting for income taxes. Provision is made in the Company’s consolidated financial statements for current income taxes payable and deferred income taxes arising primarily from temporary differences in accounting for intangible assets, capitalized software costs, deferred revenue, compensation and various state and federal tax credits. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company records a valuation allowance to reduce deferred tax assets to an amount whose realization is more likely than not. Refer to Note 6—Income Taxes. Foreign Currency—The Company translates the assets and liabilities of its foreign subsidiaries at the rate of exchange in effect at the end of the period. Revenue and expenses are translated using an average of exchange rates in effect during the period. Translation adjustments are recorded in shareholders’ equity as a separate component of accumulated other comprehensive income (loss) in the consolidated balance sheets. Transaction gains and losses are included in net income in the period in which they occur. Our intercompany accounts are typically denominated in the functional currency of the foreign subsidiary. Gains and losses resulting from the remeasurement of intercompany receivables that we consider to be of a long-term investment nature are recorded in accumulated other comprehensive income (loss) while gains and losses resulting from the remeasurement of intercompany receivables from those international subsidiaries for which we anticipate settlement in the foreseeable future are recorded in the consolidated statements of operations. The aggregate foreign currency transaction (gains) and losses included in other expense (income) on the consolidated statements of operations were $(1,574,000), $1,279,000 and $(1,232,000) for the years ended December 31, 2004, 2005 and 2006, respectively.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Earnings (Loss) Per Share—Earnings (loss) per share is calculated in accordance with SFAS No. 128, Earnings per Share. Under the provisions of SFAS No. 128, basic earnings (loss) per share is computed by dividing net income (loss) by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock, or resulted in the issuance of common stock. Diluted earnings per share is computed by using the weighted-average number of common and potentially dilutive shares outstanding during each period. Potentially dilutive shares are not included in the per share calculations where their inclusion would be anti-dilutive. Refer to Note 13—Earnings (Loss) Per Share. Other Comprehensive Income (Loss)—Comprehensive income (loss) includes foreign currency translation adjustments, unrealized gains and losses on marketable securities categorized as available-for-sale, and recognition of the funded status of its pension plans. Comprehensive income (loss) and its components are presented in the accompanying consolidated statements of shareholders’ equity and comprehensive income (loss). Concentrations—Financial instruments that potentially subject MSC to a concentration of credit risk are principally comprised of cash and cash equivalents, short-term investments, and accounts receivable. Regarding cash equivalents and short-term investments, MSC only invests in instruments with investment grade credit ratings. We place our investments for safekeeping with high-credit-quality financial institutions and, by policy, limit the amount of credit exposure from any one issuer. The Company has historically derived a significant portion of its net revenue from computer software products for use in computer-aided engineering. These products are expected to continue to account for a significant portion of net revenue for the foreseeable future. As a result of this revenue concentration, the Company’s business could be harmed by a decline in demand for, or in the prices of, these products as a result of, among other factors, any change in pricing model, a maturation in the markets for these products, increased price competition or a failure by the Company to keep up with technological change. In addition, the Company derives a significant portion of its revenue from the automotive and aerospace industries. As a result of this concentration, the Company’s business could be harmed if any one or more of these industries experienced economic difficulties. For 2004, 2005, and 2006, we had no customers that accounted for 10% or more of total revenue. As of December 31, 2004, 2005 and 2006, we had no customers that accounted for 10% or more of gross accounts receivable. MSC does not require collateral from its customers prior to granting credit. Self-Insurance—The Company is self-insured for certain medical claims and benefits offered to our employees in the United States. Based on analysis of the historical data, the estimated cost of future claims as of December 31, 2005 and 2006 was $696,000 and $604,000, respectively, which is reflected as an accrued liability in the accompanying consolidated balance sheets. Fair Values of Financial Instruments—At December 31, 2004, 2005 and 2006, the Company’s financial instruments included cash and cash equivalents, trade receivables, marketable securities, accounts payable, notes payable to shareholders, subordinated notes payable and subordinated convertible notes. The carrying amount of cash and cash equivalents, trade receivables and accounts payable approximates fair value due to the short-term maturities of these instruments. The estimated fair value of marketable equity investments, debt securities and subordinated convertible notes were determined based on quoted market prices at year-end. The estimated fair value of the notes payable to shareholders and subordinated notes payable was determined based on the present value of their future cash flows using a discount rate that approximates the Company’s current borrowing rate.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The carrying amounts and estimated fair values of the Company’s financial instruments as of December 31, 2005 and 2006 are as follows (in thousands):
Recently Adopted Accounting Standards In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”, which is effective for fiscal years ending after November 15, 2006. SAB No. 108 requires an entity to evaluate the impact of correcting all misstatements, including both the carryover and reversing effects of prior year misstatements, on current year financial statements. SAB 108 does not change the requirements within SFAS 154, “Accounting Changes and Error Corrections”, for the correction of an error in financial statements. If a misstatement is material to the current year financial statements, the prior year financial statements should also be corrected, even though such revision was, and continues to be, immaterial to the prior year financial statements. Correcting prior year financial statements for immaterial errors would not require previously filed reports to be amended. Such correction should be made in the current period filings. The SEC staff believes that registrants should quantify errors using both a balance sheet (iron curtain) and an income statement (rollover) approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. In the year of adoption, SAB 108 allows a one-time cumulative effect transition adjustment for errors that were not previously deemed material, but are material under the guidance in SAB 108. Historically, the Company has evaluated uncorrected differences utilizing the “rollover” approach. The Company completed its evaluation of uncorrected differences pursuant to SAB 108, and concluded that no cumulative effect transition adjustment was necessary. In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statement No. 87, 88, 106 and 132(R)”. SFAS No. 158 requires an employer that sponsors one or more single-employer defined benefit plans to: a) recognize the funded status of a benefit plan; b) recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period, but are not recognized as components of net periodic benefit cost pursuant to FASB Statement No. 87, “Employers Accounting for Pensions”, or No 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions”; c) measure defined benefit plan assets and obligations as of the date of the employer’s fiscal year ended statement of financial position; and d) disclose in the notes to financial statement additional information about certain effects on the net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. SFAS No. 158 will require an employer to initially recognize the funded status and provide the required disclosure as of the end of fiscal year ending after December 15, 2006. The Company has adopted the recognition and disclosure provisions of SFAS No. 158 as of December 31, 2006, which are discussed in Note 9 – Pensions and Other Employee Benefits. Because the Company had measured its plan assets and obligations as of the end of its fiscal year, the remeasurement provisions in SFAS No. 158 are not applicable.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In February 2006, the FASB issued FASB Staff Position (“FSP”) No. SFAS 123(R)-4 “Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event.” FSP SFAS 123(R)-4 addresses the classification of options and similar instruments issued as employee compensation that allow for cash settlement upon the occurrence of a contingent event and amends paragraphs 32 and A229 of SFAS No. 123(R). The Company was required to apply the guidance in FSP SFAS 123(R)-4 in the quarterly period ended March 31, 2006. Such adoption of FSP SFAS 123(R)-4 did not impact the Company’s consolidated financial statements included in this report. In November 2005, the FASB issued FSP No. SFAS 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards,” which allows an entity up to one year from the later of its initial adoption of FAS 123(R) or the effective date of FSP SFAS 123(R)-3 to evaluate its available transition alternatives in calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123 for recognition purposes (the “APIC pool”) and to make its one-time election. The Company elected to apply the alternative transition method under SFAS 123(R)-3 to calculate the tax effects of stock-based compensation under SFAS 123(R) as of December 31, 2005. The alternative transition method includes simplified methods to establish the beginning balance of the APIC pool related to the tax effects of employee stock-based compensation expense, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of employee stock-based compensation awards outstanding at the Company’s adoption of SFAS 123(R). The Company computed an APIC Pool of $0 at adoption of SFAS 123(R). In addition, under SFAS 123(R), SFAS No. 109, Accounting for Income Taxes, and EITF Topic D-32, Intraperiod Tax Allocation of the Tax Effect of Pretax Income from Continuing Operations, the Company has elected to recognize excess income tax benefits from stock-based compensation in additional paid-in capital in the period, and to the extent, it will realize an incremental income tax benefit after realizing the benefits of all other tax attributes available to the Company. Recently Issued Accounting Standards In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement”. This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. It also applies under other accounting pronouncements that require or permit fair value measurement as a relevant attribute. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and all interim periods within that fiscal year. The Company is evaluating what effect the adoption of SFAS No. 157 will have on the Company’s consolidated results of operations and financial condition. In June 2006, FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FAS 109, Accounting for Income Taxes” (FIN 48), to create a single model to address accounting for uncertainty in income tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum probability threshold a tax position must meet to be recognized in the financial statements. FIN 48 also provides guidance on the measurement, derecognition and classification of recognized tax benefits, interest and penalties, accounting for interim periods, and the transition of the accounting method upon the adoption of FIN 48. It also requires footnote and tabular disclosures about unrecognized tax benefits. FIN 48 is effective for years beginning after December 15, 2006. We will adopt FIN 48 in the first quarter of 2007 and record the cumulative effect of adopting FIN 48 in retained earnings and other accounts, as applicable, as of January 1, 2007. Certain tax account classifications on our balance sheet may change to account for the differences in taxes payable and deferred tax assets calculated under FIN 48. The Company is currently evaluating what effect the adoption of FIN 48 will have on the Company’s consolidated financial statements.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2—BUSINESS ACQUISITIONS SOFY Corporation In February 2004, the Company acquired certain assets and technology of SOFY Corporation (“SOFY”) for cash of $1,800,000 and 88,000 shares of MSC common stock valued at $880,000 in addition to $191,000 of forgiveness of prepaid expenses and the assumption of certain liabilities. The Company believes this transaction will enhance the engineering software product line and expand the penetration in the global automotive marketplace. The Company allocated the purchase price to developed technology, customer list and other identifiable intangibles. The Company also acquired $338,000 of in-process research and development costs, which were charged to operating expense at acquisition. The pro forma effect of this acquisition was not material to the consolidated financial statements. NOTE 3—PROPERTY AND EQUIPMENT As of December 31, 2005 and 2006 property and equipment, at cost consisted of the following (in thousands):
Included in software, computers and other equipment are capital lease costs totaling $2,518,000, $2,442,000 and $2,637,000, as of December 31, 2004, 2005 and 2006, respectively. Depreciation and amortization expense on property and equipment for the years ended December 31, 2004, 2005 and 2006 was $10,769,000, $7,687,000 and $6,967,000, respectively. NOTE 4—GOODWILL AND OTHER INTANGIBLE ASSETS The changes in the carrying amount of goodwill for each of our reporting units are as follows (in thousands):
The purchase accounting adjustments resulted primarily from the reversal of deferred tax liabilities and the release of valuation allowance established against deferred tax assets included in purchase accounting. Refer to Note 6— Income Taxes for additional information. Goodwill related to the discontinued operations of ESTECH was reclassified to Long Term Assets of Discontinued Operations. Refer to Note 15—Discontinued Operations. As of December 31, 2005 and 2006, indefinite lived intangibles totaled $26,768,000, primarily consisting of trademarks and trade names.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As of December 31, 2005 and 2006, other intangible assets consisted of the following (in thousands):
Estimated amortization expense for each of the five succeeding fiscal years is as follows (in thousands):
NOTE 5—RESTRUCTURING RESERVE During 2002 and 2003, the Company initiated separate restructuring plans. The 2002 Plan was created as a result of weakened economic conditions in all three world areas in which the Company operates. It was determined that workforce reductions and facility consolidations would be necessary to return the Company to profitability. In addition, the acquisition of Mechanical Dynamics, Inc. (“MDI”) in 2002 created certain redundant expenses that needed to be eliminated. In accordance with EITF No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination” (“EITF 95-3”), the costs related to the integration of MDI were included as assumed liabilities in the net tangible assets acquired. Under the 2002 Plan, the Company terminated 310 employees and subleased or terminated the leases on certain facilities. The 2003 Plan was initiated as further cost reductions were necessary to improve profitability and included the termination of 55 employees. A portion of the 2002 Plan has been reclassified to current liabilities of discontinued operations. Refer to Note 15—Discontinued Operations and Note 17 – Subsequent Event. The following is the activity in the restructuring reserve for the periods indicated by plan (in thousands):
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following is the activity in the restructuring reserve for the periods indicated by geographic segment (in thousands):
NOTE 6—INCOME TAXES The provision for taxes based on income from continuing operations for the years ended December 31, 2004, 2005 and 2006 consists of the following (in thousands):
The foreign tax provision for 2004, 2005 and 2006 includes withholding taxes of approximately $2,907,000, $618,000 and $623,000, respectively, assessed to the Company by foreign tax authorities on amounts remitted to the United States.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax liabilities and assets as of December 31, 2005 and 2006 are as follows (in thousands):
The balance sheet presentation of the net deferred tax assets as of December 31, 2005 and 2006 is as follows (in thousands):
In assessing the ability to realize deferred tax assets, management considers whether it is “more likely than not” that some portion or all of the deferred tax assets will not be realized. Management considers taxable income in carryback years, the scheduled reversal of deferred tax liabilities, tax planning strategies, and projected future taxable income in making this assessment. Based on the Company’s history of cumulative income, management believes it is “more likely than not” that the Company will realize the benefit of the domestic and foreign net deferred tax assets existing as of the taxable year ended December 31, 2006.
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Table of ContentsMSC.SOFTWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In the fourth quarter of fiscal 2006, we completed an analysis of our inter-company transfer pricing, which supported revising our intercompany transfer pricing retroactive to 2004. The revision reallocated a portion of consolidated pre-tax income from our foreign operations to domestic operations, and we concluded that we would more likely than not realize our domestic deferred tax assets. Accordingly, we released valuation allowances of $38,273,000 previously established against our domestic deferred assets, of which $8,050,000 and $4,652,000 reduced federal and state income tax expense on earnings from continuing operations, respectively. Of the remaining valuation allowance released, $1,274,000 was credited to additional paid-in-capital and $2,187,000 was credited to goodwill related to purchase accounting adjustments. As a result of our decision to permanently reinvest earnings of our foreign subsidiaries, we reduced deferred tax assets of $5,654,000 associated with estimated foreign tax credits of such foreign subsidiaries. Accordingly, there was a corresponding decrease in our valuation allowance. The tax benefit associated with the release of an additional $8,029,000 of valuation allowance was fully offset by an increase in our tax contingency reserve for the same amount. The remaining reduction of the valuation allowance of $8,427,000 primarily relates to adjustments to prior year intercompany transfer pricing as described above. At December 31, 2006, deferred tax assets exclude $1,762,000 of net operating losses (“NOLs”), representing the tax-effected portion of the NOLs pertaining to tax deductions from stock-based compensation. Upon future realization of these unrecognized benefits, the Company will increase additional paid-in-capital and decrease income taxes payable. The Company uses the with-or-without method under SFAS 123(R) to determine when it will realize excess tax benefits from stock-based compensation. Under this method, the Company will realize excess tax benefits only after it realizes the tax benefits of NOL’s from operations. At December 31, 2006, the Company has total federal, state, and foreign NOLs, including those associated with excess tax benefits from share-based compensation, of $21,280,000, $8,711,000 and $6,904,000, respectively. Federal NOLs begin to expire in 2026 and state NOLs begin to expire in 2016. Approximately $709,000 of the foreign NOLs begin to expire in years 2008 through 2011; the remaining $6,195,000 of foreign NOLs carry forward indefinitely until used. At December 31, 2006, the Company had federal, state, and foreign income tax credit carry forwards of approximately $4,362,000, $4,871,000 and $626,000, respectively. Federal income tax credits will expire at various dates from 2018 through 2026; state income tax credits have no expiration date; and foreign income tax credits expire at various dates from 2007 through 2017. The Company’s California income tax returns for the years ended December 31, 2001 and December 31, 2002 are under audit. Also its New York income tax returns for the years ended December 31, 2003 through December 31, 2005 are under audit. The Company believes it has adequately reserved for the tax effects of any adjustments expected from these audits. The following table reconciles the U.S. federal statutory tax rate to the combined effective tax rate for years ended December 31, 2004, 2005 and 2006.
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