ANSYS, Inc. (NASDAQ:ANSS) Q3 2023 Earnings Call Transcript

ANSYS, Inc. (NASDAQ:ANSS) Q3 2023 Earnings Call Transcript November 2, 2023

Operator: Ladies and gentlemen, thank you for standing by, and welcome to the ANSYS Third Quarter 2023 Earnings Conference Call. With us today are Ajei Gopal, President and Chief Executive Officer; Nicole Anasenes, Chief Financial Officer; and Kelsey DeBriyn, Vice President, Investor Relations. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. At this time, I would like now to turn the conference over to Ms. DeBriyn for opening remarks. Please go ahead.

Kelsey DeBriyn: Good morning, everyone. Our earnings release, the related prepared remarks document and the link to our third quarter 2023 Form 10-Q have all been posted on the homepage of our Investor Relations website. They contain the key financial information and supporting data relative to our third quarter financial results and business update, as well as our Q4 and fiscal year 2023 outlook and the key underlying quantitative and qualitative assumptions. Today’s presentation contains forward-looking information. Important factors that may affect our future results are discussed in our public filings. Forward-looking statements are based upon our view of the business as of today, and ANSYS undertakes no obligations to update any such information.

During this call, we will be referring to non-GAAP financial measures unless otherwise stated. A discussion of the various items that are excluded and reconciliations of GAAP to the comparable non-GAAP financial measures are included in our earnings release materials. I would now like to turn the call over to our President and CEO, Ajei Gopal, for his opening remarks. Ajei?

Ajei Gopal: Good morning, everyone. And thank you for joining us today. In Q3, ANSYS was on track to deliver against our third quarter guidance commitments when we were notified by the U.S. Department of Commerce of additional restrictions on sales to certain Chinese entities, as well as incremental approval processes and export restrictions on the sale of some ANSYS products and services to entities located in China. These incremental approval processes take the form of additional vetting of prospects located in China. They introduce delays in transacting certain orders for prospects in China, resulting in the potential loss or deferral of some business that was scheduled to be closed in Q3. As a result, we came in below our expectations in both ACV and revenue for the quarter.

Despite these developments, ANSYS delivered a strong quarter marked by double-digit growth in ACV. These updated export restrictions and incremental processes will mute ANSYS’ growth in China in 2023 and 2024, after which we expect our business in China to return to steady state growth. Nicole will give the specifics in a few minutes. It is important to remember that China represents only a small portion of our overall business. Given the strength of our business worldwide, I’m confident in our ability to execute on our short and long-term objectives. Looking back on Q3, high-tech and semiconductors, aerospace and defense, and automotive and ground transportation were our top contributing industries. We saw strength in Q3 for ACV across all customer types, and our geographical performance was as expected with the exception of China as I already mentioned.

Our largest contract in the quarter was a three-year eight-figure agreement with the North American aerospace and defense company that has used our solutions for years. The new agreement with this customer increases the number of users of ANSYS technology. Thanks in part to ANSYS technology, the customer has secured a key contract with the U.S. government. On our calls, I typically highlight a specific aspect of our business. I have discussed the critical role that ANSYS solutions play in sustainability initiatives as well as in the development of next generation semiconductors and how ANSYS simulation is driving fundamental changes in the commercial aerospace industry. A similar simulation power transformation is taking place in the automotive industry, which is where I’d like to focus today’s discussion.

As you were aware, automotive and ground transportation is our third largest industry, and ANSYS is already working with over 50 of the top transportation OEMs around the world and 93 of the top 100 global automotive suppliers. Yet with all the innovation taking place within the sector, there is still significant room for ANSYS to grow through more users, more products, and more computations. ANSYS simulation is helping to usher in a new era of mobility through key – to three key areas, electrification, autonomy and driver assistance and software defined vehicles. And of course, we’re also driving continued innovation in vehicle development. I’ll walk through each with some pertinent examples. The first area of profound change in the industry is around electrification.

From battery management systems to fuel cells to integrated electrified powertrain systems, ANSYS solutions are enabling rapid electric vehicle innovation from the components to the system levels. For example, our multiphysics battery simulation solutions provide interdisciplinary expertise at different scales. ANSYS’ solutions for powertrain electrification provide a complete development flow from the system level to the software level, including system simulation, model-based development and functional safety analysis. Using ANSYS, customers have reduced battery project costs by up to 30% and design cycle times by up to 50% [ph]. Porsche Motorsports turns to ANSYS simulation to speed up development time for its electric race car. With ANSYS, the engineers from the TAG Heuer Porsche Formula E Team optimize their cars inverter and e-motor efficiency and then test it on a virtual racetrack.

Simulation has proved to be pivotal for managing the battery’s temperature and maximizing the cost performance within these demanding driving conditions. The next area I’d like to discuss is autonomy and driver assistance systems. While the road to truly autonomous vehicles may be a long one, the simulation driven advances required to bring this technology to market are leading to safer driving experiences today. Using ANSYS, customers are improving advanced driver assistance systems, also known as ADAS. For example, sensors play a critical role in providing human drivers as well as autonomous systems, the data they need to make intelligent and safe decisions. ANSYS solutions for lidar, radar, and cameras enable engineers to improve sensor performance to determine optimal vehicle integration configurations and to examine their behavior across a range of operational scenarios.

ANSYS customer continental is using ANSYS simulation for optical integration analysis and corner case studies that are integral to the development and validation of new sensors and computer vision algorithms. ANSYS simulation is helping continental/development time and physical testing, while reducing costs and freeing up engineering resources. The next area I would like to discuss is the development of software-defined vehicles. These automobiles have features that are primarily enabled through software and can be remotely upgraded over the cars’ lifetime. The market for software-defined vehicles is expected to grow from about $35 billion today to over $200 billion early in the next decade. Thanks to software-driven features for safety, infotainment and efficiency.

ANSYS solutions enable these feature-rich functions through model-based, certified embedded software and code generation, electronics reliability and connectivity systems. These advances enable engineers to meet industry safety requirements faster than manual approaches and at lower costs. Longtime ANSYS customer ZF Group is using our solutions to reduce the complexity of analysis for embedded systems. These embedded systems must be capable of operating reliably and safely on a challenging environmental conditions. In the past, ZF used different tools for failure modes and effects analysis and for fault tree analysis. By standardizing on ANSYS, the company reports saving hundreds of hours on each of the many analysis projects they run. The final area I would like to mention is in vehicle development.

This is a space in which ANSYS has a long history as we play a key role in such critical areas as aerodynamics, lighting, crash safety analysis, and material management for sustainability initiatives. For example, ANSYS LS-DYNA simulates crash scenarios and accurately predicts the impact on the vehicle as well as the driver and passengers. Thanks to human body models. On materials intelligence solutions enable vehicle lightweighting efforts while assessing the environmental impact of materials throughout their lifecycle. With the growth of lighting technologies and headlamps and tail lamps, ANSYS lighting solutions have reduced the need for prototypes. One of our key contracts in the quarter was with a global automotive OEM based in Europe that has standardized on ANSYS for virtual crash testing and impact analysis replacing a competitive product.

The company is leveraging ANSYS simulations to help meet its goal of reducing engineering lead time by 30% and cutting the cost of physical testing by 50%. In Q3, we also signed a contract with the leading provider of automotive seeding products. This longtime customer has expanded its use of ANSYS multiphysics solutions from explicit dynamics, electromagnetics and functional safety to include mechanical, fluids and high performance computing. This expanded ANSYS footprint benefits a number of projects. For example, enabling the company to simulate the fan noise from its ventilated seats. With ANSYS technology, this automotive leader has dramatically cut development costs, reduced simulation time from days to hours, and enabled the company to respond faster and more accurately to customer requests for quotes.

I’d also like to mention a different kind of customer win. I’m excited to congratulate ANSYS customer Oracle Red Bull Racing on an amazing season, which culminated in capturing the 2023 Formula 1 World Constructors’ and World Drivers’ Championships. Using ANSYS solutions, the team simulated airflow interactions with differing shapes of the car’s surface, while also analyzing engine cooling intakes. As a result, the team drove away with the championship. Moving beyond the automotive industry, I’m excited to announce that we have enrolled our 2000th companies as a member of the ANSYS Startup Program. As I have said in the past, while members of our Startup Program represent a small piece of our overall business, they’re amongst the most innovative users of our products.

And with the program’s strong graduation rates more and more expand their use of ANSYS technology and become larger ANSYS customers. I’m also proud that ANSYS has received a number of awards this quarter related to employee engagement and satisfaction from organizations such as Newsweek, Best Workplaces in Europe in U.S. News and World Report. These recognitions are a testament to our supportive, diverse, and inclusive culture, as well as the quality of our team around the world. In summary, Q3 was marked by an external challenge that impacted our ability to process certain transactions. Our global business remains strong and the demand for ANSYS technology is robust. That’s because companies across industries rely on ANSYS to solve the most challenging problems that they’re facing.

These global organizations understand that ANSYS’ expertise and deep and broad portfolio of multiphysics solutions can help them solve their key product and business challenges. That combined with our best-in-class product portfolio, our deep customer relationships and the ongoing strength of our pipeline give me confidence in our ability to meet our commitments. And with that, I will turn the call over to Nicole. Nicole?

Nicole Anasenes: Thank you, Ajei. Good morning, everyone. Let me take a few minutes to add some perspective on our third quarter financial performance and provide context for our outlook and assumptions for Q4 and full year 2023. Our ability to deliver double-digit ACV constant currency growth in Q3 despite the disruption from the changes required for export compliance in China is a testament to the resilience of our business model. Our highly recurring business model, significant base of renewals, market-leading simulation portfolio and deep customer relationships, create a strong financial foundation and contribute to unwavering demand for our product. As a result, we are raising our full year ACV and revenue guidance for operational momentum in the business.

This momentum is offset by impacts of incremental approval processes and export restrictions in China and foreign exchange headwinds. I’ll provide additional details on our guidance in a few minutes. Now let me discuss some of our Q3 financial highlights. Beginning with ACV we delivered $457.5 million in Q3, which grew 12% year-over-year or 10% in constant currency. Our growth was broad-based across customer types, geographic regions and most industries. ACV from recurring sources grew 13% or 16% in constant currency on a trailing 12-month basis and represented 83% of the total. This momentum in recurring ACV growth is driven by the strong annuity created by our ongoing shift towards subscription lease licenses. This annuity creates resiliency and durability in our business model.

It provides a robust foundation for near and long-term growth, which enables us to navigate the impact of business disruptions that can occur from time-to-time, like the impact of the changes to export compliance that we saw in Q3. Q3 total revenue was $458.8 million and was down 3% or down 4% in constant currency, primarily due to ASC 606 dynamics given the quarterly mix of license types that generate upfront revenue recognition, which we previously discussed on our August earnings call and detailed in our Q2 prepared remarks document. During the third quarter, both ACV and revenue were below expectations. As incremental approval processes and export restrictions on certain prospects in China created a $20 million headwind. When we set our guidance range, we guide based on the pipeline and book of business that we see in front of us.

During the third quarter, we saw an impact on the contracts we expected to sign due to incremental approval processes and export restrictions that were not contemplated in our Q3 guidance provided in August. As a result, our Q3 ACV and revenue results were below our guidance. Without this impact, we would have landed near the high end of our third quarter guidance on ACV and above the high end of our revenue guidance. We have a very strong track record of achieving our guidance and it was unfortunate that we were not able to achieve our guidance for ACV and revenue this quarter. We continue to have a broad and diverse business model and a strong financial foundation with significant recurring ACV. We remain optimistic on our future growth. Despite the disruption in Q3, our year-to-date ACV performance was robust with ACV growing double-digit in constant currency at 12% and broad-based growth across geographies and customer types.

We closed the quarter with a total balance of GAAP deferred revenue and backlog of $1.2 billion, which grew 9% year-over-year. During the quarter, we continued to deliver a business model with strong operating leverage. This yielded a solid third quarter gross margin of 91% and an operating margin of 34.1%, which was better than our guidance. Operating margin was positively impacted by lower expenses and the timing of some investments. The result was third quarter EPS of $1.41, which was also better than our guidance. Similar to operating margin, EPS benefited from lower expenses and the timing of some investments. Our effective tax rate in the third quarter was 17.5%, which is the rate that we expect for the remainder of 2023. Our unlevered operating cash flow in the third quarter totaled $170.6 million and was in line with expectations and continues to be supported by strong cash collections.

We ended the quarter with $640 million of cash and short-term investments on the balance sheet. Now let me turn to the topic of guidance. Looking to the remainder of the year, the business continues to show momentum, which bolsters our confidence in achieving our 2023 and long-term outlook. Let me start with our full year 2023 guidance. We are updating our full year ACV outlook to a range of $2.243 billion to $2.288 billion which represents growth of 10.4% to 12.6% or 11% to 13.3% in constant currency. We continue to see our ACV growth driven by our broad-based customer demand for our product. And as a result, we are operationally increasing our full year ACV by $11 million relative to our August guidance. This momentum was offset by $25 million of the impact from additional export restrictions and approval processes for certain prospects in China and $28 million of additional foreign exchange headwinds.

This $25 million China export restriction and process headwind will mute ANSYS’ growth in China in 2023, and includes some timing and loss of business impact. Despite the impact from China, our ACV growth outlook for the full year is 12% constant currency growth at the midpoint, which is on our financial model of 12% ACV growth, including tuck-in M&A. We are updating our revenue outlook to a range of $2.234 billion to $2.284 billion, which is growth of 7.8% to 10.2% or 8.4% to 10.9% in constant currency. We are operationally increasing our full year revenue by $15 million relative to our August guidance. This momentum was offset by $25 million of impact from additional export restrictions and approval processes for certain prospects in China and $23 million of additional foreign exchange headwinds.

We expect our full year EPS to be in the range of $8.34 to $8.75. Relative to our August guidance, our updated full year EPS contemplates $0.25 of operational improvement, which was offset by $0.21 of impact from additional export restrictions and approval processes for certain prospects in China, and $0.13 of additional foreign exchange headwinds. Now let me turn to our full year unlevered operating cash flow guidance. As a reminder, we now provide guidance for unlevered operating cash flow as it aligns to the long-term cumulative $3 billion cash flow outlook we provided at our 2022 investor update. Our 2023 guidance is a range of $705 million to $735 million and relative to our August guidance includes a $10 million increase from operational improvement, which was offset by $7 million of impact from additional export restrictions and approval processes for certain prospects in China and $7 million of additional foreign exchange headwind.

The underlying operating leverage in our business remains robust. Further details on the reconciliation of GAAP operating cash flow to the comparable non-GAAP unlevered operating cash flow are contained in our prepared remarks document. Although we experienced an unexpected impact in Q3 from changes in export compliance, our underlying model remains strong. This is driven by robust market growth, a best-in-class portfolio, deep customer relationships and a highly recurring business model with strong operating leverage. Our current full year 2023 guidance midpoint implies a two-year unlevered operating cash flow CAGR of 14% since 2021. This reflects the strong top line momentum and operating leverage where unlevered operating cash flow growth outpaces ACV growth.

Now let me turn to guidance for Q4. For the fourth quarter, we expect ACV in the range of $897.8 million to $942.8 million. Turning to the P&L, we expect Q4 revenue in the range of $769.2 million to $819.2 million. We expect Q4 operating margin in the range of 48.9% to 51.2% and EPS in the range of $3.48 to $3.89. Given the robust renewal business in our fourth quarter, we are confident in achieving our Q4 guidance. Our core simulation market is strong and diversified with consistent demand from our customers as they encounter increasingly complex product development challenges. Despite the headwinds we expect to see from the impact of additional export restrictions and approval processes for certain prospects in China, we have confidence in our long-term model.

As a result, in February, we expect to initiate full year 2024 guidance with ACV of around 10% constant currency growth, excluding tuck-in M&A, which is consistent with our model. Within this outlook, we are absorbing the impact of the updated export restrictions and incremental processes related to certain prospects located in China, which will mute ANSYS’ ACV and revenue growth in China in 2024. We continue to focus our efforts on areas of opportunity and innovation to ensure continued growth. As a result, we also reaffirm our long-term outlook from 2022 to 2025 of 12% constant currency ACV growth including tuck-in M&A and $3 billion of cumulative unlevered operating cash flow. Further details around specific currency rates and other assumptions that have been factored into our outlook for 2023 and Q4 are contained in the prepared remarks document.

ANSYS’ business is highly resilient with a diverse and broad customer base, market-leading portfolio, deep customer relationships and recurring financial model. To the entire ANSYS team, thank you for your dedication and hard work in supporting our customers and delivering world-class innovation. We saw some complexity during the quarter, and we executed well in a challenging environment. I remain confident in our ability to deliver our 2023 and long-term outlook while working alongside the best team in the industry. Operator, we will now open the phone lines to take questions.

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Q&A Session

Operator: [Operator Instructions] Our first question comes from Jay Vleeschhouwer of Griffin Securities. Please go ahead.

Jay Vleeschhouwer: Thank you. Good morning. Let’s start with China. With respect to the enhanced processes that you referred to in the prepared remarks and the 10-Q, could you elaborate on what that means, what with ANSYS not doing perhaps efficiently internally to vet the customers? And would it be fair to say that the ANSYS products in question we’re not solely EDA products, in other words this isn’t just a product that we’re going to Chinese semis, but other non-EDA products as well to perhaps other end customers in China, then my follow-up.

Ajei Gopal: Hey. Good morning, Jay. So let me take that. And so there’s a – there’s clearly a bit of a misunderstanding in your question. So let me just try to sort of lay this out so that you have more clarity on the context here. So as you know, in the context of the broader U.S. foreign policy shifts, the Department of Commerce is engaging both privately and publicly with companies to apply export controls to China of certain technologies. And of course, elite high-tech companies are facing new restrictions. And given the capabilities of ANSYS products and their broad applicability across industries and across use cases we have implemented an additional layer of vetting for prospects located in China to comply with the incremental requirements from the U.S. Department of Commerce.

So let me just sort of walk through how the quarter unfolded. So we were on track to delivering against our third quarter guidance commitments when the Commerce Department informed us of these additional restrictions as well as incremental approval processes on the sale of certain ANSYS’ products to entities located in China. And so we immediately complied. We suspended processing orders from those affected prospects that were located in China pending the resolution of some ambiguities that were related to the process. And we work with the Commerce Department, but unfortunately, by the time we received clarity on the incremental vetting that was required above and beyond our existing compliance program, it was the last business day of Q3, and that made it too late to complete our vetting process within the quarter.

Now moving forward, we have internally aligned our business operations to adjust to these new betting requirements and the result is an increase in the time that it takes us to process transactions with certain prospects that are located in China. But as I said in the call, despite these developments related to prospects in China, the ANSYS business overall is performing well. We delivered a strong quarter, marked by double-digit growth in ACV, and we continue to see robust and broad-based demand for our technologies and the products. And given the critical role that our solutions play in our customers’ product development initiatives, and the strength of the underlying foundations of our global business, we’re confident in our ability to execute against our short and our long-term objective.

Jay Vleeschhouwer: Okay. With respect to guidance for Q4 and the initial thoughts on next year, was the operational raise for Q4, both renewals business, in other words you’re expecting some higher ACV in the renewals and new business, perhaps from new logos. And then for the 10% for next year, how are you thinking about the contribution from the new AIML enhanced products that you’re beginning to deploy as per the schedule you gave back in July?

Nicole Anasenes: So Jay, maybe I’ll just take the Q4 guidance question, and then we can add some more color on your last part of your question. So although we experienced an unexpected impact from changes in export compliance in China, the underlying model remains strong, as Ajei said. And as a testament to this year-to-date, we achieved 12% ACV growth in constant currency, which is of course on our model. Our business is very resilient. As you know, 80% of it comes from recurring sources. And as we look to Q4, the robust renewal business that we see in the fourth quarter gives us confidence in achieving our guidance. And maybe just to add an additional data point to add some color as to where we stand as of October. As of the end of October we have just under half the business in our Q4 outlook already committed, so despite the disruption from changes required for export or compliance in China, we’re continuing to see the operational momentum in the rest of our business.

That’s what gave us the confidence in raising the full year ACV by $11 million compared to the August guidance, which, of course, was offset by the $25 million of impact from additional restrictions and processes in our business in China and of course, the foreign exchange impact of $28 million. But outside of this impact, we continue to see momentum across the business, and we haven’t seen any notable changes in customer activity.

Jay Vleeschhouwer: Thank you very much.

Operator: The next question comes from Joe Vruwink from Baird. Please go ahead.

Joe Vruwink: Great. Hi, everyone. I also want to start on the 10% growth outlook for 2024. I’m wondering how did you go about ring-fencing the potential risk from China export controls into next year. Is it just kind of run rating the 2023 experience? Or are you layering on incremental assumptions? And then I was hoping you could maybe be a bit more explicit on just total ACV exposure from China and then a sense of maybe how much business has assumed not to transact within the 2024 initial outlook?

Nicole Anasenes: Sure. Happy to do that. So why don’t I kind of take you through – why don’t I take you through the kind of the Q3 impact, how we – kind of how that we think that impacts 2023 and what the flow-through impact to 2024 in the long-term will be to kind of try to holistically answer some of your questions. But just too kind of give some overall context going into that in terms of your question around China exposure overall. Our business is broad and diverse, and as you know, we’re diversified across many industries and geographies and customer types. And our business in China is around 5% of ACV, both on a trailing 12-month basis and full year 2022. So it’s a relatively a smaller portion of the portfolio. Now in the third quarter, again, our ability to deliver that double-digit constant currency growth in the quarter despite the disruptions we saw is really a testament to the resilience of our business model, which as we talk about 2024 is what gives us the confidence in our outlook.

Now the third quarter results were impacted by those incremental vetting processes and restrictions to certain prospects in China that created about a $20 million headwind to ACV and revenue, which was not contemplated in our third quarter guidance. But without this impact, we would have landed near the high-end of our third quarter guidance range on ACV and above the high end of our revenue guidance. Now we expect that the majority of the $20 million to be a timing shift with a small portion of being lost in business. So as you extend into our 2023 outlook – embedded in the 2023 outlook, it does reflect that incremental operational performance and the momentum that we’ve seen in the business overall, which is of course, offset by the impact from the export compliance changes, but for the full year in 2023, we expect the impact from incremental export restrictions in the vetting processes in China to have a $25 million impact on ACV and revenue, and we believe just to kind of give a rough sizing, about a third of that is loss of business and two-thirds of that would be an expected timing shift from the elongated transaction cycle.