ITEM 1. BUSINESS
General
We are a leader in the development, marketing and support of simulation software and related services. For 46 years, our simulation technologies have allowed manufacturing companies around the world to validate how designs behave in their intended environment. Engineers use our simulation software to construct computer models of products, components, systems and assemblies and to simulate performance conditions and to predict physical responses to certain variables such as stress, motion and temperature. These capabilities can 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 that help our customers implement simulation solutions across the enterprise and improve the integration and performance of their product development process, which can 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 as well as in universities and research. Advances in computer technology have made simulation cost effective for companies that manufacture products.
Our goal is to provide our customers with leading edge simulation technologies that will integrate design and engineering processes across the enterprise 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 serves four significant product development 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.
As a key component of CAE, simulation software enables engineers to prototype, simulate, test and iterate scenarios in a virtual environment. This 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, time to market, and lower development costs.
Enterprise simulation solutions integrate multi-disciplinary simulation technologies within the enterprise during all phases of the product development process and can be used in conjunction with PLM tools throughout the entire product lifecycle. 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 advantage in achieving business objectives. Using multi-discipline simulation during product development allows engineers to design, build, and test using many simulation technologies simultaneously, providing both time and cost savings.
According to estimates revised in early 2009 from industry analysis firm CIMdata, Inc., Simulation and Analysis (“S&A”) software and services totaled $2.1 billion in 2007, a year-over-year increase of 18%. In 2008, continued growth in S&A was expected to expand the market to $2.3 billion, with a 2009 market forecasted to be in excess of $2.5 billion. Spending on total PLM software and services totaled nearly $27 billion in 2008, a year-over-year increase of 10.6%. Approximately 8.7% of the PLM market came from S&A in 2008. Over the next five years, S&A is expected to be one of the growing segments of the total PLM market, with an 8.7% compound annual growth rate, expanding the market to nearly $3.3 billion in 2012, out of a total 2012 PLM market of $39 billion.
Our Competitive Strengths and Growth Strategy
We currently support three product lines through our portfolio of simulation software products and solutions - Engineering Tools, Multi-Discipline (“MD”) Solutions and SimEnterprise 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 MD and SimEnterprise products offer a better solution than point simulation tools by providing enterprise-integrated simulation solutions. We believe these products will enable designers, analysts, managers and the supply chain to integrate simulation throughout the design process in an open systems framework using service oriented architecture. 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 provide superior technology and functional breadth of simulation solutions by collaborating with customers to deliver state of the art 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.
Our goal for growth is to expand our position in the simulation software market by further penetrating our installed base, by adding new customers from the supply chains in our existing industries, including the aerospace and automotive markets, and by expanding with new customers in new markets. We also offer our engineering tools and enterprise simulation products to certain customer accounts using channel partners.
Software Products
We market and sell our simulation software products and solutions under three main product lines. Our Engineering Tools product line includes software to model and simulate the performance characteristics of a wide variety of complex mechanical conditions. Within this product line, we include our core engineering tools, including MSC Nastran, Patran, Adams and Marc. Our MD Solutions product line enables manufacturers to perform interoperable, multi-disciplinary analyses on ever-more complex products and assemblies in parallel. Within this product line, we include MD Nastran, and MD Adams. Our SimEnterprise Solutions product line integrates simulation workflows and data within the extended enterprise while enhancing the way engineering teams collaborate, access and work with standard simulation processes. Within this product line, we include SimXpert, SimManager Enterprise, and SimDesigner Enterprise.
Engineering Tools
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 the past 46 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 analysis capabilities, including linear static, 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.
Patran. Patran is an interactive finite element modeling, analysis data integration, analysis simulation, and visualization solution. 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 system-level motion simulation. Adams is used to perform dynamic simulations of complete systems and subsystems, such as vehicle suspensions and engines, and to evaluate functional attributes like vehicle handling, vibration behavior and durability.
Marc. Marc simulates complex nonlinear physical behavior such as 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.
In addition to these core engineering tools, MSC’s broad software portfolio consists of widely used simulation software in automotive, aerospace, and other key industries. Software applications such as Dytran, Easy5, SOFY and MSC Fatigue deliver capabilities which integrate with, or extend the capabilities of, the four primary engineering products described above. Recent acquisitions have increased the breadth of functionality of our portfolio and our market opportunities, including products with new capabilities such as computational fluid dynamics (“CFD”) and thermal analysis.
MD Solutions
MD Nastran. MD Nastran extends and improves MSC Nastran’s interaction across more comprehensive simulation domains to accurately model real life scenarios. Optimized for multi-discipline analysis, MD Nastran accelerates time-to-market by enabling customers to simultaneously perform linear, implicit nonlinear and explicit nonlinear analysis, all within a scalable simulation platform based on a common data model.
MD Adams. MD Adams extends multi-discipline simulation solutions to system-level motion and loads analysis. MD Adams allows customers to perform motion analysis and structures analysis with MD Nastran seamlessly, thus accelerating the multi-discipline simulation process.
SimEnterprise Solutions
MSC SimXpert. SimXpert is an advanced multi-discipline workspace CAE environment that provides comprehensive depth and functionality to perform system level simulations faster and to 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. 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. 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 is designed to integrate with SimXpert and SimDesigner, which enables the users to collaborate on simulation projects.
Product Maintenance and Customer Support
Our software products are generally sold with one year of maintenance that entitles the customer to unspecified software upgrades, enhancements and technical post-contract support. Maintenance and support services are provided online, through our technical support web site, by telephone and electronic mailing and access to technical personnel located in call centers and by support personnel in various locations throughout the Americas, EMEA and Asia.
Customers have the option of renewing their maintenance agreements each year for an annual fee. For 2006, 2007 and 2008, maintenance fees represented approximately 44%, 51% and 54%, respectively, of our total revenues.
We believe that effective support of our customers and products during the license term is a substantial factor in product acceptance and subsequent new product sales. We believe our installed base is a competitive advantage and intend to continue to provide customer support and product upgrades to assure a continuing high level of customer satisfaction. During 2006, 2007 and 2008, we experienced a high customer maintenance renewal rate.
Professional Services
Our professional services include consulting, training and onsite support services, which are provided in connection with the deployment of solutions and/or the development of new simulation methods using MSC’s products and technologies. We believe these services are critical in competing in the S&A market.
Consulting services consist of implementation services, including funded development, process consulting, and simulation services, as more fully described below.
Implementation Services. Implementation services consist of installation, configuration and integration of MSC products into the customers’ technology environment. Any technology must communicate and access other services in a customer environment to function. IT components such as databases, directory services, file systems, and other systems such as PDM systems require configuration and integration for MSC products to communicate. Tasks belonging to these categories are considered implementation services.
Process Consulting. The process consulting role consists of the analysis of a customer’s CAE and product development process, and developing and configuring products from MSC and other vendors consistent with the customer’s product development process. In some instances, this includes the use of MSC products to capture specific customer processes into a data structure internal to the MSC products called “templates.” In other instances, this often involves the creation of complex user interfaces that are independent but loosely coupled to the MSC product suite.
Simulation Methods Development. Simulation services are defined as the application of engineering knowledge and industry experience with the MSC software tools to customers’ simulation requirements. In this role, MSC engineers work on behalf of the customer and, using MSC’s and other software tools, develop new methods to analyze the customer’s engineering problem and provide analytical results. The work product of this effort is in the form of scripts or code that provides input to the MSC products as well as predicted (by computer simulation) engineering performance data (e.g. stress levels, temperatures, deflections, etc.) that are summarized numerically and graphically in engineering reports.
Post Deployment Support Services. Post deployment support is provided on custom software implementations. Tasks include providing updates for scheduled releases of custom code that incorporate the latest releases of supported software usage in the custom solution, performing routine bug fixes and tracking the status of bug/enhancements requests and answering application related questions from the customer.
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 either a time and materials or fixed fees basis.
Our training and onsite support services help our customers get the most out of their MSC products. 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 installed software.
Research and Development
We dedicate significant resources to the development and enhancement of new and existing 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 2006, 2007 and 2008, our research and development expenditures totaled $43.2 million, $51.1 million and $51.1 million, respectively. In 2009, we expect to spend approximately $47 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 2006, 2007 and 2008, our operations outside of the Americas generated approximately 71%, 70% and 68%, respectively, of our total revenue.
Information regarding risks involving our international operations is described in the risk factor entitled “Our future results could be harmed by economic, political, regulatory and other risks associated with international sales and operations” included in Part I, Item 1A.
ITEM 1A. RISK FACTORS
The global financial crisis will have an impact on our business and financial condition in ways that we currently cannot predict.
Recently, general worldwide economic conditions have worsened due to deteriorating credit markets, slower economic activity, unprecedented volatility, volatile energy costs, decreased consumer confidence, reduced corporate profits and capital spending, adverse business conditions and liquidity concerns. These conditions make it extremely difficult for our customers, our vendors and us to accurately forecast and plan future business activities, and they could continue to cause U.S. and foreign businesses to slow spending on our products and services, which would delay and lengthen sales cycles. Furthermore, during challenging economic times our customers face issues gaining timely access to sufficient credit, which could result in an impairment of their ability to make timely payments to us. This is especially true with respect to our automotive customers, and in particular U.S. automotive customers and their suppliers, which constitute a substantial source of revenue for us. If that were to occur, we may be required to increase our allowance for doubtful accounts and our cash flows would be negatively impacted. We cannot predict the timing, strength or duration of any economic slowdown or subsequent economic recovery, worldwide. If the economy or markets in which we operate continue at their present levels, our business, financial condition and results of operations will likely be materially and adversely affected. Additionally, the combination of our lengthy sales cycle coupled with challenging macroeconomic conditions could have a synergistic negative impact on the results of our operations.
We have acquired and may continue to acquire other companies and may be unable to integrate successfully such companies with our operations.
Since 2002, we have acquired several companies and businesses, including Mechanical Dynamics, Inc. (“MDI”) in 2002, SOFY Corporation in 2004, Pioneer Solutions, Inc. in August 2007, Network Analysis, Inc. (“NAI”), in January 2008 and The MacNeal Group (“TMG”) in June 2008. See Note 2-Business Acquisitions in Notes to Consolidated Financial Statements.
We may continue to expand and diversify our operations with additional acquisitions. Some of the risks that may affect our ability to integrate the operations, technologies, products and personnel of, or realize any anticipated benefits from companies we acquire, include those associated with:
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unexpected losses of key employees or customers of the acquired company;
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conforming the acquired company’s standards, processes, procedures and controls with our operations;
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coordinating our new product and process development;
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hiring additional management and other critical personnel;
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increasing the scope, geographic diversity and complexity of our operations;
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difficulties in consolidating facilities and transferring processes and know-how;
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other difficulties in the assimilation of acquired operations, technologies or products; and
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adverse effects on existing business relationships with customers.
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.
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. Currently we defer these costs and treat them 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.
We have recorded, and may continue to record, a significant amount of goodwill and other intangible assets in connection with our acquisitions, which are subject to impairment testing that may result in future write-downs of carrying values if operating results deteriorate.
As a result of our acquisitions, goodwill and other intangibles accounted for $183.7 million, or 41% of our total assets, as of December 31, 2008. We may record additional goodwill and other intangibles related to future acquisitions. Under current generally accepted accounting principles, we do not amortize goodwill and indefinite-lived intangibles. We will, however, assess the recoverability of these assets and other intangible assets recorded as part of our acquisition by performing an impairment analysis on the carrying value of these assets at least annually and/or if indicators of impairment exist, which may include decreases in the market price of our common stock, weakening revenue, change in strategies and other factors. If the fair value of goodwill or other intangibles exceeds the related carrying values, we could be required to write down some or all of the unamortized costs. As a result of such write-down, our results of operations will be adversely affected. During 2007 and 2008, we recorded impairment charges totaling $4.4 million and $10.0 million, respectively, related to intangibles assets. See Note 4-Goodwill and Other Intangible Assets in Notes to Consolidated Financial Statements.
We 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 (loss) for the years ended December 31, 2006, 2007 and 2008 was $13.8 million, $(1.6) million and $(21.3) million, respectively, and we had an accumulated deficit of $120.4 million as of December 31, 2008. There is no assurance that we will operate profitably, and if we cannot operate profitably, we may not be able to meet our financial obligations, our working capital requirements or other needs. Our inability to meet these needs would 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 associated benefits, if any, 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, including loss on sale of assets, lose long-term customers and/or revenue streams in connection with such a restructuring that could harm our business before we receive associated benefits, if any, from the restructuring. In addition, we may introduce changes to our pricing model, which may not increase or sustain the same level of revenue in the timeframes that we anticipate, or at all.
In 2007 and 2008, we initiated two cost reduction programs that included workforce reductions, facility closings and consolidations, significant reductions in contracted services primarily impacting information technology and product development activities and/or reorganizations of various departments. As a result, we incurred restructuring charges in 2007 and 2008 totaling $8.5 million and $3.3 million, respectively. See Note 5-Restructuring Reserve in Notes to Consolidated Financial Statements.
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 timely 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 customer can be a lengthy process, spanning twelve months or longer, especially for large enterprise transactions. Our strategy is to allocate sales resources towards large enterprise transactions. The sales cycle can involve multiple divisions within a potential customer’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 in 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 providing services to high-end users of the product design markets. 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.
Our 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:
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changes in foreign currency exchange rates;
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changes in a specific country’s or region’s political or economic conditions, particularly in emerging markets;
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burdens on complying with a wide variety of foreign laws and regulations;
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natural disasters or outbreaks of infectious diseases affecting the regions in which we or our licenses sell products;
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tariffs, trade protection measures and import or export licensing requirements;
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potentially negative consequences from changes in foreign government regulations, tax laws and regulatory requirements;
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difficulty in managing a geographically dispersed workforce in compliance with diverse local laws and customs;
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disproportionate management attention or company resources;
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changes in diplomatic and trade relationships;
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longer accounts receivable payment cycles; and
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less effective protection of intellectual property.
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 increased expenses associated with fluctuation in those currencies.
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 numerous royalty agreements for use of such technology. Should any of these agreements be terminated, we would need to find an alternative source to replace the functionality of such technology. These agreements generally allow for significant lead time prior to termination by the third party. In the event that any of these agreements were terminated within a very short time period, there is no guarantee that we could replace the technology on a timely basis, if at all, 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 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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open source license terms may be ambiguous and may be subject to unanticipated obligations regarding our products and technologies;
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competitors may have improved access to information that may help them develop competitive products;
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open source software cannot be protected under trade secret law;
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it may be difficult for us to accurately determine the origin of the open source code and whether the acquired open source software in fact infringes third party intellectual property rights; and
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open source software potentially increases customer support cost because (i) such software typically does not contain warranties as to functionality or is not accompanied by any support offerings from the provider of such open source software and (ii) licensees can modify the software and potentially introduce errors.
In 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.
A substantial portion of our operating expenses are fixed in nature. Therefore, we have limited ability to quickly reduce expenses in response to any revenue shortfalls.
We plan our operating expense levels, in part, on expected revenue. Because a substantial portion of our operating expenses are fixed in nature, we are not able to adjust such expenses during periods of revenue shortfalls, particularly in the near term. As a result, our ability to operate at consistent profitable margins is limited if our future revenue is less than expected.
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 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 is 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 carry 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. In addition, our competitors may develop technology that is superior to our technology.
We 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 uncertain. We have initiated actions against former employees, and companies these former employees currently work for, to protect our intellectual property. 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. 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 may 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:
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division of our board of directors into three classes, with each class serving a staggered three-year term;
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removal of directors for cause only;
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ability of the board to authorize the issuance of preferred stock in series;
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vesting of authority in the board to determine the size of the board (subject to certain limited exceptions) and to fill vacancies thereon; and
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advance notice requirements for stockholder proposals and nominations for election to the board.
In addition to the above provisions, the Board of Directors adopted a Rights Agreement (the “Rights Agreement”) in October 2008. As part of the Rights Agreement, the Board declared a dividend of one preferred stock purchase right (a “Right”) for each outstanding share of common stock of MSC, payable to stockholders of record as of the close of business on October 16, 2008. These rights, which do not have any shareholder rights, including any voting or dividend rights will expire on October 16, 2018, unless earlier redeemed by MSC prior to expiration at a price of $0.01 per right. The rights automatically transfer with a transfer of common stock until the time they become exercisable, which happens when certain specified events occur. If the rights become exercisable, they entitle the holders thereof to purchase for $55.00 (the “Purchase Price”), one one-hundredth of a share of Junior Participating Preferred Stock, and, if a party becomes an Acquiring person (as defined in the Rights Agreement), each right will entitle the holder thereof to purchase shares of common stock of the other party to such business combination or sale having a market value twice the Purchase Price, all subject to other provisions of the Rights Agreement.
The Board of Directors adopted the Rights Agreement and declared the distribution of Rights in connection with the expiration of MSC’s previous stockholders rights plan that was in effect from October 16, 1998 until October 16, 2008.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
ITEM 2. PROPERTIES
All of our offices are leased under agreements expiring at various times over the next one to seven years. Our corporate headquarters in Santa Ana, California includes approximately 203,500 square feet under a lease expiring in 2013, of which approximately 69,400 square feet is sublet, and an additional 51,400 square feet is available to be sublet. We also lease approximately 281,700 square feet in 45 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 13-Commitments and Contingencies in Notes to Consolidated Financial Statements for additional information regarding our lease obligations.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The information required by this Item is incorporated herein by reference to Note 13-Commitments and Contingencies in Notes to Consolidated Financial Statements under Item 8 of this Report.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of shareholders during the fourth quarter of the year ended December 31, 2008.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is listed for trading on NASDAQ under the symbol “MSCS”. The following table sets forth the high, low and closing prices, as reported on the respective trading systems, for the periods shown:
As of February 28, 2009, there were 185 record holders of our common stock.
We eliminated our dividend in September 1996 and do not anticipate paying a dividend in the foreseeable future.
We maintain the MSC Defined Contribution 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 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 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, 2007 and 2008, the number of shares of our common stock held in the MSC Stock Fund totaled 75,132 and 60,979, respectively.
Performance Graph
Set forth below is a line graph comparing the yearly percentage change in the cumulative total stockholder return on MSC’s common stock, based on the market price of our common stock, with the total return of companies included within the NASDAQ Market Index and Hemscott Group Index selected by us, for the period commencing January 1, 2004 and ended December 31, 2008. The calculation of total cumulative returns assumes a $100 investment in MSC’s common stock, the NASDAQ Stock Market Index and the Hemscott Group Index on December 31, 2003 at market close, and the reinvestment of all dividends, and accounts for all stock splits. The historical information set forth below is not necessarily indicative of future performance.
Repurchases of Common Stock
On November 8, 2006, the Board of Directors authorized a stock repurchase program for up to 1,250,000 shares of common stock that expired November 7, 2007. Share repurchases under the program were made in the open market, based on stock availability and price. Over this time, we purchased an aggregate of 263,500 shares at an average price of $14.04 per share. The aggregate purchase price of $3.7 million was recorded in treasury stock as of December 31, 2007.
In addition, during 2007 and 2008 we withheld 176,192 shares and 141,069 shares related to vested restricted stock units as settlement of income taxes paid by MSC on behalf of employees totaling $2.4 million and $1.5 million, respectively. Such withholding activities are considered repurchases of stock and accordingly, the amounts were recorded in treasury stock in the accompanying consolidated balance sheet.
The following tables set forth the number of shares withheld as settlement of income taxes paid by MSC on behalf of employees during each quarter of 2008 and for each month during the fourth quarter of 2008:
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with Item 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-Looking Statements and Factors That May Affect Future Results
This discussion contains forward-looking statements that involve risks and uncertainties. Forward looking statements are subject to risks and uncertainties that could cause our actual results to 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 are a global leader in the development, marketing and support of simulation software and related services. Our customers vary in size and operate across many industry sectors and geographies, and include industry leaders in aerospace, automotive, defense and heavy machinery industries. For over 46 years, our simulation technologies have allowed manufacturing companies around the world to validate how their designs will behave in their intended environment. Engineers use our simulation software to construct computer models of products, components, systems and assemblies and to simulate performance conditions and to predict physical responses to certain variables such as stress, motion and temperature. These capabilities can 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 operate in the three geographic regions, The Americas, EMEA and Asia, and manage our businesses in each region 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 dollars, our foreign regions conduct their 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 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 affects the growth of our business.
Our customers, many of which have global operations, continue to re-evaluate 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. This shift 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.
During times of economic uncertainty, we believe companies will place greater emphasis on creating the most cost effective business model, which may result in expense reductions within their capital and R&D budgets. Some customers may reduce their PLM expenditures by decreasing their level of software purchases, using older generations of products or not renewing maintenance services. In addition, customers may bargain more intensely on pricing and payment terms, which may 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 scrutinize their PLM spending and will work to aggressively contain costs, we are dedicated to 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 early 2009 estimates from industry analysis firm CIMdata, Inc., Simulation and Analysis (S&A) software and related services totaled $2.1 billion in 2007, a year-over-year increase of 18%. Continued growth in S&A was expected to expand the market to $2.3 billion in 2008, and $2.5 billion in 2009. Spending on total PLM software and services totaled nearly $27 billion in 2008, a year-over-year increase of 10.6%. Approximately 8.7% of the PLM market came from S&A in 2008. Over the next five years, S&A is expected to be one of the growing segments of the total PLM market, with a 8.7% compound annual growth rate, expanding the market to nearly $3.3 billion in 2012, out of a total 2012 PLM market of $39 billion.
2008 Highlights
We completed key technical enhancements of our core engineering tools, as well as our MD technologies through the release of our engineering analysis product suite in June 2008. This engineering analysis suite provides a common technology foundation to fully integrate our engineering tools and MD solutions with a direct connectivity to our SimEnterprise solution. This new technology provides our customers a seamless path forward to enterprise simulation with next generation technology that will work with current products in an interoperable way.
In addition, as part of our product transition strategy to provide fully integrated simulation solutions, we released SimEnterprise R3 and its key components, SimXpert R3, SimDesigner R3 and SimManager R3, which we believe will significantly improve the way analysts, designers and suppliers collaborate. In October 2008, we extended the SimEnterprise offerings with the release of FluidConnection R3, which is integrated with SimManager to provide the benefits of process capture and automation available to computational fluid dynamics (“CFD”) applications. We believe these new releases improve upon our scalable solution for enterprise simulation management that should result in faster, more innovative design methodologies that decrease development costs and establish a competitive advantage for our customers.
Since 2006, when we initiated this product transition strategy, our software sales have been and continue to be adversely impacted. Our major customers were required to re-evaluate their simulation and engineering needs and to revise, review and approve higher funding requirements. Although many of our strategic customers became early adopters of the enterprise solutions, our experience to date shows that selling enterprise solutions lengthens the sales cycles, leads to delays in licensing all our products and is more difficult to gain acceptance. In addition, we are currently facing the unanticipated challenge of selling larger, more expensive enterprise solutions during a severe economic downturn.
In addition, the transition to developing and selling enterprise solutions has impacted our operations in a variety of ways including requiring significant expenditures on research and development activities, changes in our sales force and sales processes and changes in our employee base. With the current releases of our engineering analysis products and simulation solutions, our management has committed to making improvements in our cost structures and other operational efficiencies. In 2008, our management implemented a new cost reduction initiative that included: (i) reductions in contracted services primarily impacting information technology and product development activities, (ii) workforce reductions, and (iii) reorganizations of various departments. The reductions in contracted services are possible given the completion of the current releases described above, as well as the completion of information technology projects, including post-implementation support for our worldwide financial and information system. The workforce reductions are expected to impact approximately 11% of our employees within various departments and will result in severance related payments totaling approximately $2.6 million. We have recognized $2.0 million of such costs during 2008, and expect to recognize the remaining costs in 2009. At December 31, 2008, we had 1,006 employees compared to 1,116 employees at December 31, 2007.
Our industry is also consolidating through acquisitions. We, along with many of our competitors, have been actively acquiring engineering software companies and key technologies that we believe will bring changes in the way products are developed, marketed and sold, including the transition within our industry to selling enterprise solutions. We believe that such consolidation will continue and will create new opportunities and challenges within our industry. Following our acquisition of Pioneer Solutions, Inc. and its FluidConnection products in August 2007, we acquired Network Analysis, Inc. in January 2008, which provided us thermal analysis technology, and also acquired developed technology from The MacNeal Group in June 2008, which provided us enhancements to our Nastran technology, as part of a long-term strategy to provide our customers superior and leading-edge simulation technology for the global enterprise environment.
Total revenue in 2008 increased 3% to $254.4 million when compared to $246.7 million in 2007. The 2008 period included $15.7 million of revenue resulting from favorable changes in foreign currency rates. Total operating expenses for 2008 increased to $212.7 million, or 84% of total revenue, compared to $210.7 million, or 85% of total revenue, in 2007. Included in total operating expenses were restructuring and impairment charges totaling $13.3 million in 2007 and $13.2 million in 2008. Also included in total operating expenses in 2008 was an unfavorable impact from changes in foreign currency rates totaling $7.0 million. Our operating loss in 2008 was $6.2 million compared to an operating loss of $10.3 million in 2007. Our net loss from continuing operations in 2008 was $21.3 million compared to $2.6 million in 2007. The 2008 results included a valuation allowance for deferred tax assets of $22.9 million.
Net cash provided by operations during 2008 was $32.1 million compared to $16.5 million in 2007. The increase resulted primarily from higher cash earnings and collections of trade receivables. Our cash, cash equivalents and investments increased 13% to $152.6 million at December 31, 2008 when compared to $135.0 million at December 31, 2007. Total deferred revenue at December 31, 2008 was $75.8 million compared to $80.6 million at December 31, 2007.
We continue to change the focus of our operations and as we move through this product transition operating expenses have been impacted in a variety of ways including increased research and development efforts, changes in the sales force and changes in our employee base.
Recent Economic Events
As more fully discussed above under “Item 1A. Risk Factors,” worldwide economic conditions have worsened due to the deteriorating credit markets, slower economic activity, unprecedented volatility, volatile energy costs, decreased consumer confidence, reduced corporate profits and capital spending, adverse business conditions and liquidity concerns. We do not believe these financial market disruptions and other developments will directly affect our liquidity over the next twelve months as it relates to our investments and access to credit markets. However, we believe that our future financial results will be significantly affected by the impact these disruptions have on certain key industries and customers we serve.
Any significant or prolonged economic downturn that directly impacts our customers in key industries we serve, such as aerospace and automotive, will have an adverse effect on our sales and operating results, including potentially higher allowance for doubtful accounts receivable and possible impairment of goodwill, other intangible assets and long-lived assets.
In addition, such downturn would require us to evaluate our operations that may lead to various changes to our business operations and related processes, curtailment of product development and/or changes to our pricing model. Such decisions may result in additional expenses or may impact our ability to effectively compete in our market.
Critical 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.
We believe that the estimates, assumptions and judgments involved in revenue recognition, allowance for doubtful accounts, income taxes, valuation of goodwill and other intangibles, contingencies and litigation, restructuring charges and incentive compensation have the greatest potential impact on our Consolidated Financial Statements, so we consider these to be our critical accounting policies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. There have been no significant changes in our critical accounting policies during 2008.
In addition to these estimates and assumptions that we utilize in the preparation of historical financial statements, the inability to properly estimate the timing and amount of future revenue could significantly affect our future operations. We must make assumptions and estimates as to the timing and amount of future revenue. Specifically, our sales personnel monitor the status of all proposals, including the estimated closing date and potential dollar amount of such transactions. We aggregate these estimates periodically to generate a sales pipeline and then evaluate the pipeline to identify trends in our business. This pipeline analysis and related forecasts of revenue may differ significantly from actual revenue in a particular reporting period as the forecasts and assumptions were made using the best available data at the time, which is subject to change. Specifically, slowdowns in the global economy and information technology spending has caused and may continue to cause customer purchasing decisions to be delayed, reduced in amount or cancelled, all of which have reduced and could continue to reduce the rate of conversion of the pipeline into contracts. A variation in the pipeline or the conversion rate of the pipeline into contracts could cause us to plan or budget inaccurately and thereby could adversely affect our business, financial condition or results of operations. In addition, because a substantial portion of our software license contracts close in the latter part of a quarter, we may not be able to adjust our cost structure to respond to a variation in the conversion of the pipeline in a timely manner, and thereby the delays may adversely and materially affect our business, financial condition or results of operations.
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 provides the end user with a perpetual license to use our products.
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 contract 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, by analysis of actual maintenance renewal agreements, and has been between 20% and 23% of software license fees.
Customers may also enter into arrangements for consulting and training services. Consulting services are sold under fixed fee or on a time and material basis. Consulting revenue under a fixed fee arrangement 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.” When percentage-of-completion accounting is not possible we recognize the revenue using the completed-contract method. Consulting revenue under a time and material arrangement is recognized as services are provided. Training revenue is recognized as the related services are provided. These arrangements are not essential to the functionality of the software and are therefore accounted for separately from the license revenue because the arrangements qualify as “service transactions” as defined in SOP 97-2 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.
If the fair value of any undelivered element included in a multiple-element arrangement cannot be objectively determined, the entire amount of revenue from the arrangement is deferred. Depending upon the type of transaction and on which elements fair value cannot be determined, such deferred revenue will be recognized (1) after all elements have been delivered or fair value is objectively determined or (2) ratably over the period appropriate for that transaction.
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 our allowances is based on historical experience and our current analysis of the collectability 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 we do 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 change the allowance in a period, the impact 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. In assessing our ability to realize deferred tax assets, our management considers whether it is “more likely than not” that some portion or all of the deferred tax assets will not be realized. We consider taxable income in carry back years, the scheduled reversal of deferred tax liabilities, tax planning strategies, and projected future taxable income in making this assessment. In the event that actual results differ from these estimates, or these estimates change in future periods, adjustments to the valuation allowances may need to be recorded which could materially impact our financial position and results of operations.
Based on the assessment made as of December 31, 2008, our management believes it is “more likely than not” that we will not realize the benefit of the all of our federal U.S. and certain of our foreign and state deferred tax assets. Accordingly, we recorded additional valuation allowances totaling $22.9 million in 2008.
On January 1, 2007 we adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“FIN 48”). Under FIN 48, we use a “more likely than not” threshold to recognize tax benefits of uncertain tax positions. We evaluate the need to establish reserves for uncertain tax positions based on the probability of success on audit of the tax position. Many years might elapse before we resolve an uncertain tax position for which we have established a reserve. We adjust each reserve and income tax provision in the period: 1) we settle with tax authorities and pay amounts, if any, in settlement that differ from our established reserves, 2) the statute of limitations expires for the particular tax authority to audit the uncertain tax position, or 3) when more information becomes available. In evaluating exposures related to our various tax filing positions and the need to establish reserves, we rely on reasoned interpretation of laws, regulations, administrative guidance, and case law to forecast the likely outcome upon the relevant tax authority’s audit of each uncertain tax position.
Although we believe our estimates of tax expense are supportable, actual results could differ, possibly exposing us to material losses or gains. Our effective income tax rate could be materially affected to the extent we settle with a tax authority for less than our established reserves, or pay amounts in excess of our established reserves. An unfavorable tax settlement could require use of our cash and would result in an increase in our effective income tax rate in the period of resolution. We would recognize a favorable tax settlement as a reduction in our effective income tax rate in the period of resolution.
Valuation of Goodwill and Other Intangibles
Goodwill is tested annually for impairment in the fourth quarter of each fiscal year (at October 1), and is tested more frequently if events and circumstances indicate that the asset might be impaired. For 2008, we tested for impairment as of December 31, 2008 due to the significant declines in our stock price occurring after October 1, 2008. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, we determine the fair value of a reporting unit and compare it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with FASB Statement No. 141, “Business Combinations.” The residual fair value after this allocation is the implied fair value of the reporting unit goodwill.
The fair values of our reporting units are determined using an average of the fair values calculated under (i) a discounted cash flow (income) approach and a (ii) market multiple (market) approach. For 2008, the income approach was given a 75% weighting compared to a 25% weighting for the market approach due to the recent volatility in the stock market and significant changes in stock prices. In 2007, each of these approaches was given a 50% weighting in the determination of fair value.
The key assumptions used under the income approach for 2008 were as follows:
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A discount rate of 17.5% (for our software reporting unit) and 16.5% (for our services reporting unit), each based on a weighted average cost of capital (WACC)
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A terminal multiple of 5.0x based on an analysis of peer company data
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A long-term terminal growth rate of 4%
The key assumptions used under the market approach for 2008 were as follows:
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Revenue multiples of 1.0x -1.2x based on an analysis of peer company data
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Earnings before income taxes and depreciation and amortization and stock option expense (EBITDAO) multiples of 4.0x-5.5x based on an analysis of peer company data
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A control premium of 30% based on recent acquisitions in our industry
The determination of fair value of our reporting units is sensitive to changes in these key assumptions. For example, a change in our discount rate from 17.5% to 18.5% decreases the fair value of the software reporting unit by approximately $7.0 million; and a change in our control premium from 30% to 20% decreases the fair value of the software reporting unit by approximately $2.5 million.
As of December 31, 2008, our reporting units had an aggregate fair value of $391.6 million, which exceeded the aggregate book value by $65.4 million. We believe that reasonable changes in any of these assumptions would not have resulted in an impairment of the book value of our reporting units as of our testing date. In addition, the aggregate fair value of our reporting units is higher than our market capitalization (based on diluted shares) of approximately $310 million as of December 31, 2008 by an amount approximating the control premium.
No impairment charges for goodwill were recorded in 2006, 2007 or 2008 as a result of our impairment testing.
The fair value of indefinite-lived and other intangibles, consisting primarily of trademarks and trade names of various software products we sell, is determined using discounted cash flow and other methodologies under an income approach after consideration of other factors that may exist. During 2007 and 2008, we recorded impairment charges totaling $4.4 million and $10.0 million, respectively, related primarily to trademarks and trade names for certain software products.
Significant management judgment is required in determining the fair value of goodwill and other intangible assets. 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 charge equal to the amount by which its carrying value exceeds its actual or estimated fair value.
Contingencies 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.
Restructuring Charges
Our restructuring reserve includes accruals related to workforce reductions and consolidation of facilities. Such accruals are based on estimates and assumptions made by management about matters which were uncertain at the time, including the timing and amount of sublease income that will be recovered on vacated property and the net realizable value of assets no longer needed in our continuing operations. While we used our best current estimates based on facts and circumstances available at the time to quantify these charges, different estimates could reasonably be used in the relevant periods to arrive at different accruals and/or the actual amounts incurred or recovered may be substantially different from the assumptions utilized, either of which could have a material impact on the presentation of our financial condition or results of operations for a given period. As a result, we periodically review the estimates and assumptions and reflect the effects of those revisions in the period that they become known.
Incentive Compensation
Options
We use the Black-Scholes option pricing model to determine the fair value of stock options. The determination of the fair value of stock-based awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. In addition, we estimate forfeitures expected to occur over the vesting periods. If changes to any of these estimates are made in future periods, the impact on our consolidated financial statements could be material.
Non Time-Based Equity Awards and Bonus
We estimate the expense to be recognized in a period after assessing the likelihood that the performance criteria will be met over the vesting period. We periodically review the estimates and assumptions and reflect the effects of those revisions in the period that they become known. These effects could be material to our consolidated financial statements.
Recently Adopted and Issued Accounting Standards
Recently adopted and issued accounting standards are discussed in Note 1-Nature of Operations and Summary of Significant Accounting Policies in Notes to Consolidated Financial Statements.
Results of Operations
The following table sets forth items included in the consolidated statements of operations data (amounts in thousands).
Revenue
Revenue Background
We generate our revenue from the sale of software licenses, maintenance, consulting and training services. The timing and amount of revenue recognized from software licenses, maintenance and services agreements vary, particularly as recognized as part of a multi-element arrangement. We recognize (i) revenue on a paid-up software license in the period in which the license is delivered, and on a lease, ratably over the license term, (ii) maintenance revenue, generated either as an element of a software license or by a separate renewal agreement, ratably over the maintenance period (normally one year), and (iii) services revenue, generated primarily from consulting and training agreements when services are performed.
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.
Our software is used in critical design applications by OEM’s and their key suppliers in many industries, primarily automotive and aerospace. We have long-term relationships with these customers who rely on our software support services on an ongoing basis, which results in high maintenance renewal rates. As discussed above under 2008 Highlights, our transition to sell enterprise software products has impacted our license revenues causing these revenues to decline as a percentage of total revenues. Accordingly, maintenance fees have been, and we believe will continue to be, our largest source of revenue in the near term. For 2006, 2007 and 2008, maintenance revenue represented 44%, 51% and 54% of total revenue, respectively.
Total Revenue
Total revenue for 2008 increased 3% when compared to 2007 primarily due to the impact from favorable changes in foreign currency rates totaling $15.7 million. Excluding the effect of changes in foreign currency rates, total revenue decreased 3% as the result of lower software revenue, partially offset by increases in maintenance and services revenue.
Total revenue for 2007 decreased 5% when compared to 2006. The decrease reflects the loss of $2.4 million of sales attributable to our PLM business which we sold in March 2006. Changes in foreign currency rates during the 2007 period favorably impacted revenue by $7.2 million. The remaining decrease was primarily the result of lower software and services revenue recognized in all our regions, which are more fully discussed below.
Total deferred revenue at December 31, 2008 was $75.8 million compared to $80.6 million at December 31, 2007 and $78.2 million at December 31, 2006.
Software Revenue
Software revenue in 2008 decreased 6% to $89.3 million compared to $94.7 million in 2007 primarily due to lower sales of our engineering products partially offset by increases in sales of our MD and enterprise solutions, including sales of enterprise advantage license units. As more fully discussed in 2008 Highlights, we are in a product transition period, which has lengthened our sales cycle, and has caused our customers to evaluate licensing all of our products. In addition, the fourth quarter in 2008 was negatively impacted by the economic downturn caused in part by the recent financial market disruptions and related developments, including the credit crisis being addressed by governments worldwide. Revenue from sales of enterprise and MD solutions in 2008 was $28.7 million, or approximately 32% of total software revenue, compared to $20.3 million, or 21% of total software revenue, in 2007. We expect to see continuing declines in software revenue during 2009 due to the uncertain market conditions. During 2008, changes in foreign currency rates favorably impacted software revenue by $6.0 million. Excluding the effect from favorable changes in foreign currency rates, software revenue decreased 12% to $83.3 million in 2008 compared to 2007. During 2008 total deferred software revenue decreased $8.3 million or 31% to $18.1 million.
Software revenue in 2007 decreased 15% to $94.7 million compared to $111.2 million in 2006. The decrease reflects the loss of $1.3 million of sales attributable to our PLM business. In addition, changes in foreign currency rates favorably impacted software revenue in 2007 by $2.6 million. As previously discussed, we have been transitioning from engineering tools to enterprise products. As a result of this transition, engineering tools decreased by approximately $30.0 million while enterprise products revenue increased by $14.0 million. Other factors that adversely impacted our 2007 revenue included the effects from discontinued products, competitive pressures, and the timing of revenue recognition associated with the different mix of license arrangements. During 2007 total deferred software revenue increased $1.3 million or 5% to $26.4 million.
Maintenance Revenue
Maintenance revenue for 2008 increased 9% to $137.0 million compared to $125.5 million in 2007. The increase was primarily due to the timeliness of renewals, incremental growth in our installed customer base and continued high renewal rates from our prior years’ customer base. In addition, maintenance revenue in 2008 included $4.6 million of revenue recognized upon customers’ reinstatement of previously expired maintenance compared to $2.8 million recognized in 2007. During 2008, changes in foreign currency rates favorably impacted maintenance revenue by $8.2 million. Excluding these effects from changes in foreign currency rates during 2008, maintenance revenue increased 3% to $128.8 million in 2008 compared to 2007. During 2008 total deferred maintenance revenue increased $2.6 million to $55.5 million.
Maintenance revenue in 2007 increased by 9% to $125.5 million compared to $115.1 million in 2006. During 2007, changes in foreign currency rates favorably impacted maintenance revenue by $3.6 million. The remaining increase is the result of incremental growth in our installed customer base from 2007 activity coupled with high renewal rates from our prior years’ customer base. During the year ended December 31, 2007 total deferred maintenance revenue increased $1.6 million or 3% to $52.9 million.
Services Revenue
Services revenue for 2008 increased 6% to $28.1 million compared to $26.4 million in 2007 reversing the trend in prior years. The increase was attributable to higher simulation, implementation and post-deployment support services associated primarily with our MD solutions. During the 2008, changes in foreign currency rates favorably impacted services revenue by $1.5 million. Excluding these effects from changes in foreign currency rates during 2008, services revenue increased 1% to $26.6 million in 2008 compared to 2007. During 2008 total deferred services revenue increased $0.8 million to $2.1 million.
Services revenue in 2007 decreased by 21% to $26.4 million compared to $33.4 million in 2006. The decrease was due to changes in the nature, size and timing of consulting arrangements provided to our larger global accounts and the decision to discontinue certain low margin services. In addition, 2007 reflects the loss of $1.1 million of services revenue recognized in 2006 attributable to our PLM business that was sold in 2006. During 2007, changes in foreign currency rates favorably impacted services revenue by $1.0 million. During the year ended December 31, 2007 total deferred services revenue decreased $0.5 million or 28% to $1.3 million.
Revenue 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):
We believe that international revenue will continue to comprise a majority of our total net revenue. Economic weakness in any of the countries that contributes a significant portion of our revenue could have an adverse effect on our business in those countries. Changes in the value of the U.S. dollar relative to the Euro and Japanese Yen could significantly affect our future financial results for a given period.
Americas
The industries from which the Americas derive a significant portion of its revenue are aerospace, automotive, and manufacturing.
Total revenue in the Americas for 2008 increased 7% compared to 2007 as the result of increased sales to key customers in the automotive and aerospace industries. Software revenue increased during 2008 primarily due to greater product acceptance of our enterprise solutions demonstrated by higher sales of enterprise advantage license units. Maintenance revenue increased due to the timeliness of renewals, incremental growth in our installed customer base and continued high renewal rates from our prior years’ customer base. In addition, maintenance revenue in 2008 included $2.6 million of revenue recognized upon customers’ reinstatement of previously expired maintenance compared to $0.9 million in 2007. Services revenue increased due to higher revenue generated from process, implementation and post-deployment support services provided to key customers in the aerospace and automotive industries, including $1.1 million recognized upon completion of a long-term consulting arrangement with a key automotive customer in the third quarter of 2008.
Total revenue in the Americas for 2007 decreased 1% compared to 2006 due to the loss of PLM revenues and from lower sales resulting from the transition to selling our MD and enterprise products. We experienced lower sales activities within the automotive industry due to weak market conditions, partially offset by continued strength in our major accounts within the aerospace industry. The decrease in software revenue in 2007 also reflects the loss of PLM software revenue totaling $1.3 million. The increase in maintenance revenue in 2007 was due to a growing installed customer base coupled with high renewal rates. The decrease in services revenue was due to the loss of PLM services revenue totaling $1.1 million. In addition, the decrease in services revenue reflects the completion and non-replacement of significant consulting arrangements provided to larger global accounts in the aerospace and automotive sectors and the decision to discontinue certain services.
EMEA
The industries from which EMEA derives a significant portion of its revenue are automotive, aerospace, and manufacturing.
Total revenue in EMEA for 2008 increased 1% compared to 2007 due primarily to favorable changes in the Euro totaling $6.2 million. Excluding the effects of changes in foreign currency rates during 2008, total revenue decreased 6% compared to 2007. Despite changes in the Euro that favorably impacted software revenue by $2.0 million, software revenue decreased 11% due to lower sales of engineering products partially offset by higher sales of MD solutions. The decrease in revenue from engineering products is due in part to lower conversions of lease to paid-up licenses compared to 2007 as well as weakness in the fourth quarter of 2008 due to the recent economic downturn. Excluding the effects from changes in foreign currency rates during 2008, software revenue decreased 16% in 2008 compared to 2007. Maintenance revenue increased 10% primarily as a result of a favorable change in the Euro totaling $3.6 million and due to the timeliness of renewals, incremental growth in our installed customer base and continued high renewal rates from our prior years’ customer base. Excluding the effects from changes in foreign currency rates during 2008, maintenance revenue increased 3% in 2008 compared to 2007. Services revenue decreased 4% due to lower training revenue attributable to non-recurring training provided to key aerospace customers in 2007, partially offset by a favorable change in foreign currency rates totaling $0.7 million. Excluding the effects of changes in foreign currency rates during 2008, services revenue decreased 10% in 2008 compared to 2007.
Total revenue in EMEA in 2007 decreased 7% compared to 2006. During 2007, changes in the Euro favorably impacted total revenue by $8.2 million. Excluding the effects from changes in foreign currency rates during 2007, total revenue in 2007 decreased 15% compared to 2006. Software revenue decreased in 2007 due to lower sales to automotive customers in key markets, such as France and Germany, partially offset by higher sales to major customers in the aerospace industry. These decreases were attributable to non-recurring conversions of leasing arrangements to paid-up transactions totaling $1.4 million. In addition, indirect channel sales in 2007 were higher by $1.6 million compared to 2006 as the result of an increased focus on the channel program coupled with strong regional performance by our channel partners, particularly in Russia, the UK, Turkey and South Africa. During 2007, changes in the Euro favorably impacted software revenue by $3.1 million. Excluding the effects from changes in foreign currency rates during 2007, software revenue decreased 33% in 2007 compared to 2006.
The 2006 period included conversions of leasing arrangements to paid-up transactions totaling $1.4 million that did not occur in 2007. The remaining decrease was due to the decision to discontinue certain products in 2006 and the transition to selling enterprise solutions. Maintenance revenue in 2007 was favorably impacted from changes in the Euro by $4.0 million. The remaining increase was due to a growing installed customer base coupled with high renewal rates. Services revenue in 2007 was favorably impacted from changes in the Euro by $1.1 million. The remaining decrease in services revenue reflects the decision to discontinue certain low valued services and the timing of revenue recognized upon the completion of consulting projects accounted for under the completed contract method.
Asia
The industries in Asia from which a significant portion of revenue is derived are automotive, manufacturing and electronics.
Total revenue in Asia for 2008 increased 3% compared to 2007 due primarily to favorable changes in the Yen totaling $9.4 million. Software revenue decreased 10% despite a favorable impact from changes in the Yen of $4.0 million. The decrease was due to non-renewals of lease arrangements, the absence of significant conversions of leases to token-based licenses that occurred in 2007 and lower sales from our indirect channel partners compared to 2007. Maintenance revenue increased 12% due to favorable changes in the Yen totaling $4.7 million. Services revenue increased 34% due to higher consulting revenue associated with MD and enterprise solutions and a favorable impact from changes in the Yen of $0.8 million.
Total revenue in Asia in 2007 decreased 6% compared to 2006 due to a decrease in services revenue of approximately $3.0 million, which resulted from the completion and non-replacement of larger consulting projects with major Japanese customers. In addition, changes in the Yen unfavorably impacted total revenue by $1.0 million during 2007.
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. We have taken actions in recent years 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. During 2005 we began to expand our software development activities in India through a third party solution provider to maintain our leadership in simulation software. In addition, we identified and commenced several cost reduction initiatives in 2006, 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. In 2007 and 2008, we initiated two separate restructuring plans designed to rationalize our costs and align our operations with our new enterprise products transition strategy that included (i) reductions in contracted services primarily impacting information technology and product development activities, (ii) closing and/or consolidation of facilities, (ii) workforce reductions, and (iii) reorganizations of various departments.
We allocate facility expenses among our income statement categories based on headcount. 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.
The changes in compensation and benefit costs in 2008 compared to 2007 reflect the impact from recent headcount reductions resulting from the cost reduction initiative implemented in 2008, and annual merit increases effective January 1, 2008 compared to similar increases effective July 1, 2007.
Cost of Revenue
Cost of Software Revenue
Cost of software revenue consists primarily of amortization of developed technology, third-party licenses and royalties for technology resold, embedded in or licensed with our software products, and other direct product costs, including those costs associated with software delivery, product packaging and documentation materials. As a percentage of software revenue, cost of software revenue for 2006, 2007 and 2008 was approximately 12%. We expect such percentage to be stable in the foreseeable future.
Cost of Maintenance and Services Revenue.
Cost of maintenance and services revenue consists primarily of personnel, outside consultancy costs and other direct costs required to provide post sales support, consulting and training services.
The following table sets forth major components of our cost of maintenance and services revenue in total dollars and the amounts expressed as a percentage of maintenance and services revenue for the years ended December 31, 2006, 2007 and 2008.
As a percentage of maintenance and services revenue, cost of maintenance and services revenue for 2006, 2007 and 2008 periods has improved. In 2008, gross margin was comparable to 2007. During 2007, the decrease in compensation and related benefits, third party and other direct costs of $9.9 million and the decrease in facility related costs of $1.0 million were directly attributable to our decision to restructure our technical and consulting service operations, including selling the PLM business in 2006 and discontinuing providing certain consulting services. The increase in incentive and stock-based compensation expense in 2007 reflects higher accruals for commissions and bonus and new equity grants awarded in 2007.
The impact from changes in foreign currency rates increased total cost of maintenance and services revenue by $1.0 million in 2007 and by $1.9 million in 2008.
Operating Expenses
Research and Development
Our research and development expenses consist primarily of salaries and benefits, facility costs (including depreciation and amortization), contracted services, incentive compensation and computer technology. Major research and development activities include developing our enterprise and MD solutions strategy, and enhancing the features and functionality of existing engineering tools.
The following table sets forth the significant components of research and development expenses in total dollars and the amounts expressed as a percentage of total revenue for the years ended December 31, 2006, 2007 and 2008.
The significant research and development activities during 2006, 2007 and 2008 included enhancements to our engineering products, including the integration of MD capabilities, and continuing development of our enterprise solutions. With the completion of major new releases of our products in June 2008, the rate of expenditures during the remainder of 2008 decreased, primarily with regard to contracted services. We expect this trend to continue in 2009.
Selling and Marketing
Our selling and marketing expenses consist primarily of salaries and benefits, sales commissions, facility costs (including depreciation and amortization), travel and entertainment, incentive compensation, product marketing and promotional materials, trade shows and customer conferences and professional services.
The following table sets forth the significant components of selling and marketing expenses in total dollars and the amounts expressed as a percentage of total revenue for the years ended December 31, 2006, 2007 and 2008.
Due to the significant number of sales and marketing personnel located outside of the U.S., the impact from changes in foreign currency rates between periods increased total selling and marketing expenses in 2007 and 2008 by $1.8 million and $4.9 million, respectively.
The increase in compensation and related benefits during 2008 was due to the impact of annual merit increases. The increase in incentive and stock-based compensation expense reflects higher accruals for sales commission and new equity awards granted in 2008. Travel and entertainment expenses increased due to higher business activities.
General and Administrative
Our general and administrative expenses consist primarily of salaries, benefits and incentive compensation, facility costs (including depreciation and amortization), outside consulting and other professional services and travel and entertainment.
The following table sets forth the general and administrative expenses in total dollars and the amounts expressed as a percentage of total revenue for the years ended December 31, 2006, 2007 and 2008:
* Not meaningful
The decrease in professional services during 2008 was attributable to the completion of various information technology, accounting and tax projects in 2007, including the implementation of our worldwide accounting and management system, and the adoption of FIN 48. These reductions were partially offset by increases in legal costs associated with various actions initiated against third parties, principally related to intellectual property matters. The increase in incentive and stock-based compensation expense during 2008 was attributable to higher accruals for incentive compensation based on operating performance in accordance with the 2008 bonus plan and recognition of stock-based compensation expense of new equity awards granted in 2008. In addition, increases in compensation due to annual merit increases were offset by lower accrued benefits resulting primarily from favorable trends in medical insurance claims.
The decrease in general and administrative expenses in 2007 of $8.4 million is primarily attributable to non-recurring items included in 2006. Included in 2006 were $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 and $0.7 million to settle previously disclosed claims, partially offset by a $4.6 million gain recognized on the sale of certain assets of our PLM business.
After consideration of these items totaling $8.1 million, the decrease in general and administrative expenses in 2007 was $0.3 million. Other factors affecting general and administrative expenses in 2007 primarily included lower salaries and related benefits totaling $2.8 million resulting from our 2007 restructuring plan and lower stock and incentive compensation totaling $0.6 million resulting from our operating performance. These items were offset by higher professional services and consulting fees of $1.4 million resulting from information technology, accounting and tax projects, facility related costs of $1.2 million and severance to management personnel totaling $0.7 million resulting from a reorganization of certain business functions.
The impact from changes in foreign currency rates increased total general and administrative expenses in 2007 and 2008 by $0.7 million and $1.4 million, respectively.
Amortization of Intangible Assets
The following table sets forth the amortization of intangible assets in total dollars and the amounts expressed as a percentage of total revenue for the years ended December 31, 2006, 2007 and 2008.
The increased amortization of intangibles during 2008 resulted from the acquisitions of Pioneer Solutions, Inc. in August 2007, Network Analysis, Inc. in January 2008 and the MacNeal Group, LLC in June 2008, and the reclassification of trademarks and trade names with a carrying value of $2.7 million from indefinite lived assets to other intangible assets at December 31, 2007.
Restructuring and Other Charges
The following table sets forth restructuring and other charges in total dollars and the amounts expressed as a percentage of total revenue for the years ended December 31, 2006, 2007 and 2008.
In June 2008, our management announced a cost reduction initiative that includes workforce reductions, significant reductions in contracted services primarily impacting information technology and product development activities and reorganizations of various departments. The workforce reductions will impact approximately 11% of our workforce throughout various departments and is projected to result in one-time termination benefits totaling approximately $2.6 million, of which we recognized approximately $2.0 million during 2008. We expect the remaining termination benefits related to this initiative will be incurred and paid in 2009.
In January 2007, our Board of Directors approved the implementation of a cost reduction program that included workforce reductions and facility closings and consolidations. As a result, we recognized restructuring charges totaling $8.5 million during 2007, including $1.2 million of expected sublease income that was not recognized during the period. During 2008, we recorded restructuring charges totaling $1.3 million related to unrecognized sublease income, net of adjustments of $0.2 million. Similar charges related to sublease income will be recorded in future periods to the extent we do not enter into sublease arrangements.
The impairment charges recognized in 2006, 2007 and 2008 were determined after an assessment of the recoverability of the carrying values. The recorded impairment charges for the indefinite-lived trademarks and trade names and developed technology were determined primarily during our annual impairment testing and represent the amount that the carrying values of the respective assets exceeded the discounted future net cash flows, which were adversely impacted by decreasing revenue.
Non-Operating Income and Expenses
Interest and Other (Income) Expense, Net
The following table sets forth interest and other (income) expense, net in total dollars and the amounts expressed as a percentage of total revenue for the years ended December 31, 2006, 2007 and 2008.
* Not meaningful
Interest expense primarily consists of interest on our long-term debt and the amortization of debt discounts and debt issue costs. The decrease in 2007 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. As discussed in the following Liquidity and Capital Resources section, we repaid our remaining outstanding long-term debt in December 2008 that will significantly our future interest expense.
The interest income is earned on our cash investments. The decrease in 2008 reflects the impact of transferring substantially all our cash to investments in lower yield, lower risk securities. The gain on sale of marketable equity securities in 2007 and 2008 resulted from the sale of the common stock of Geometric Limited, formerly Geometric Software Solutions Co. Ltd. (“GSSL”). At December 31, 2008, we do not own any shares in GSSL. The foreign currency transaction gains and losses result from the re-measurement of intercompany accounts denominated in the functional currency of the foreign subsidiary. The foreign currency transaction losses recognized in 2007 and 2008 were attributable to a stronger U.S. dollar associated with outstanding intercompany borrowings from certain foreign subsidiaries whose local currencies are other than the Euro or the Yen.
Provision (Benefit) for Income Taxes
The following table sets forth the provision (benefit) for income taxes in total dollars and the amounts expressed as a percentage of total revenue, as well as the effective tax rates for the years ended December 31, 2006, 2007 and 2008.
Principal differences between our recorded provision or benefit for income taxes and the amount determined by applying the U.S. federal statutory rate of 35% to pre-tax income or losses pertain to the effects of taxes associated with foreign operations, state taxes, changes in estimates from prior years, non-deductible compensation, changes in valuation allowances established for deferred tax assets and the recognition of uncertain tax benefits. Depending on the levels of consolidated pre-tax income or loss, the effects from the above can have a significant impact on our effective tax rate.
In 2008, we determined that it was “more likely than not” that we will not realize the benefit of the all of our federal U.S. and certain of our state deferred tax assets and certain of our foreign deferred tax assets existing as of December 31, 2008. As a result, we recorded a valuation allowance totaling $22.9 million. The valuation allowance was determined after considering all available evidence, both positive and negative, including recent taxable losses, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies.
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.
In January 2007, we reoccupied certain facilities previously considered as part of our Systems business that was discontinued in 2003. Accordingly, we reversed $0.3 million of restructuring reserve related to such operations and recorded it as income from discontinued operations in the accompanying consolidated financial statements. In June 2007, we reversed $1.4 million of accrued liabilities associated with potential contractual claims related to our Systems business because we believe such claims are time barred by the statute of limitations.
See Note 15-Discontinued Operations in Notes to Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 2008, our principal sources of liquidity included cash and cash equivalents of $152.6 million. We believe that cash on hand and cash generated from operations will provide sufficient funds for normal working capital needs and operating resource expenditures over the next twelve months. Our ability to generate cash flows from operations in future periods will largely depend on our ability to increase the sales of new software licenses while increasing existing cash flows through strong maintenance contract renewals, and effective cost and cash management. Cash from operations could be affected by various risks and uncertainties, including those resulting from the recent disruptions in the financial markets. See Part II, Item 1A entitled “Risk Factors.”
Our working capital (current assets minus current liabilities) at December 31, 2008 was $114.2 million compared to $107.3 million at December 31, 2007. In the past, working capital needed to finance our operations has been provided by cash on hand and by cash flow from operations.
Our primary source of cash is from selling product enhancements and support (maintenance), for which payments are generally received near the beginning of the contract term, which is typically one year in length. We also generate significant cash from new software license sales and, to a lesser extent, services. In addition, we also receive cash from employees in connection with the exercise of stock options. Our primary uses of cash are payments of employee-related expenses, such as compensation and benefits, as well as operating costs which consist primarily of professional or contracted services, marketing, facilities and overhead costs. In addition to operating expenses, we also use cash to fund our capital expenditures and business acquisitions, and to a lesser extent, to pay principal and interest on our outstanding debt and to repurchase stock. See further discussion of these items below.
Our cash investments are made according to policies approved by the Board of Directors. At December 31, 2008, approximately 36% of our cash was maintained outside the U.S. and invested primarily in guaranteed deposits with our banks. Within the U.S., our cash is invested primarily in U.S. Treasury securities and money market funds for working capital, which are not subject to any liquidity restrictions.
Cash Flows
The following data summarizes our consolidated statements of cash flows (in thousands).
Cash Flows from Operating Activities
Cash earnings, which represent net income (loss) adjusted for non-cash items, including depreciation and amortization and stock-based compensation, is the primary component of our operating cash flows. Depreciation and amortization expense related to fixed assets has been comparable for the periods presented as the amount and nature of capital expenditures during 2006, 2007 and 2008 have been relatively constant. We expect to closely monitor future capital expenditures and consequently expect our depreciation and amortization expense to remain stable or decrease slightly in future periods. We believe that our employees are incented by stock-based equity awards and expect to continue granting such awards, which will result in future non-cash compensation charges.
Our operating cash flows are also impacted by changes to operating assets and liabilities resulting from the timing of bookings of sales orders, collections on trade accounts receivable, and the timing of payments of accounts payable and other current liabilities relative to the recognition of the related revenue or expense. We closely monitor our trade accounts receivable and actively manage collections from our customers. Our days sales outstanding (computed after deducting deferred revenue remaining in accounts receivables as of December 31, 2008 and 2007 totaling $25.6 million and $30.1 million, respectively) was 33 days at December 31, 2008 and 37 days at December 31, 2007. We continue to take steps to improve our cash collection by reducing days sales outstanding. Since 2006, our total sales have been relatively consistent, although the mix of such sales have been different, which can and have impacted the balances of deferred revenue and trade accounts receivable. The timing and payment of trade payables and accruals is dependent on the level of expenditures during the year and can vary based upon business activity. Our vendors are paid within the terms of the purchase arrangement and accordingly the balance of trade payables and accruals vary only with the level of goods and services we procure.
The increase in cash generated from operations during 2008 of $15.6 million compared to 2007 resulted primarily from the following factors:
•
Higher cash earnings of $1.6 million.
•
Higher cash collections of trade receivables of $17.4 million. This amount represents proportionately higher collections of prior year billings (accounted for as deferred revenue as of December 31, 2007) than collections of sales transactions billed in 2008. In addition, our days sales outstanding improved 4 days during 2008, generating approximately $3 million in cash.
•
Net reductions of $1.6 million in accounts payable and accrued liabilities due to cost containment initiatives implemented during 2008.
•
Reductions in the restructuring reserve totaling $3.8 million due to timing of payments.
•
Increase in accrued and deferred income taxes, including changes in unrecognized tax benefits, of $4.0 million.
•
Other cash sources totaling $5.8 million due to timing of payments relative to recognition of related expenses.
•
Decrease from deferred revenue of $7.8 million attributable to the differences in revenue recognized compared to sales transactions billed. Deferred revenue was essentially unchanged from December 31, 2006 to December 31, 2007. Deferred revenue decreased in 2008 by $5.6 million due to more software and services revenue being recognized than booked. The primary factor driving this decrease was lower license and services bookings in 2008 due to the transition from selling tools to enterprise solutions, combined with the recent economic downturn. We did not change our revenue recognition policies or procedures nor did we alter our booking or payment practices from prior years.
The increase in cash provided from operations during 2007 of $21.0 million compared to 2006 resulted primarily from the following factors:
•
Lower cash earnings of $3.3 million.
•
Lower cash collections of trade receivables of $2.3 million, essentially unchanged.
•
Net increases in accounts payable and accrued liabilities of $1.1 million due primarily to higher accruals for incentive compensation.
•
Increase in restructuring reserves of $3.8 million related to cost reduction initiatives implemented in 2007.
•
Increase in accrued and deferred income taxes of $4.3 million.
•
Other cash uses totaling $1.0 million due to timing of payments relative to recognition of related expenses.
•
Increase from deferred revenue of $18.4 million attributable to the differences in revenue recognized compared to sales transactions billed. Deferred revenues increased $2.2 million in 2007 after decreasing $16.2 million in 2006. The decrease in 2006 was due to more software and services revenue being recognized than booked. The primary factor driving this decrease was lower license and services bookings in 2006 due to the transition from selling tools to enterprise solutions. Bookings were comparable in 2007 and 2006. We did not change our revenue recognition policies or procedures nor did we alter our booking or payment practices from prior years.
Our ability to increase cash generated from operations is impacted by higher sales of new software licenses each year while increasing existing cash flows through strong maintenance contract renewals. This is dependent upon our investment in new products, features and functionalities. Our research and development expenditures in 2008 totaled $51.1 million, which was comparable to 2007. Due to the short duration between technological feasibility and general availability of the new software to our customers, none of our research and development expenditures are capitalized. We estimate our expenditures for research and development activities in 2008 will total approximately $47 million. We expect to continue to invest a substantial portion of our revenues in the development of our engineering product suite, and MD and enterprise solutions.
Cash Flows from Investing Activities
Our principal investing activities during 2008 included expenditures for acquisitions of Network Analysis, Inc. and The MacNeal Group, LLC totaling $4.3 million, and capital expenditures totaling $3.0 million. Additionally, we received proceeds from the sale of marketable equity securities of GSSL totaling $2.7 million. During 2007 our principal investing activities included net capital expenditures of $8.1 million, the acquisition of Pioneer Solutions for $1.0 million, proceeds of $6.9 million received from the sale of marketable equity securities in GSSL and proceeds of $0.8 million from sales of long lived assets.
Our capital expenditures generally consist of the purchases of computer equipment and related software used in the development and support of our software products and business processes and totaled $3.0 million in 2008. Capital expenditures in 2007 were $8.1 million, including $4.0 million related to the upgrade of our worldwide financial and management information systems that were substantially completed in 2006 and $2.9 million for the purchase of a perpetual license for software source code to be used in future product development activities. We intend to continue to expand the capabilities of our computer equipment used in the development and support of our software products, as well as investing in our worldwide financial and management information systems. In 2009, we expect that our capital expenditures will be no greater than $5 million and will be primarily for the purchase of computer equipment and related software used in our development and business processes.
Cash Flows from Financing Activities
Our principal financing activities during 2008 included proceeds from the exercise of stock options totaling $3.1 million, excess tax benefits associated with stock-based compensation totaling $2.6 million, stock repurchases associated with shares withheld to satisfy employee tax obligations on restricted stock vested in 2007 totaling $1.5 million, a debt principal payment of $7.2 million and capital lease payments totaling $0.2 million. During 2007, our principal financing activities included proceeds from the exercise of stock options totaling $6.6 million, principal repayment on our 8% Subordinated Notes of $0.8 million, payments on capital lease obligations totaling $0.6 million, and the repurchase of 80,100 shares of common stock under the stock repurchase program and 176,192 shares of common stock withheld to cover restricted stock units exercised in 2007 for $3.5 million in aggregate.
In 2008, we repaid the outstanding principal balance on the 8% Subordinated Notes Payable due June 17, 2009 of $7.2 million. We may engage in additional financing methods that we believe are advantageous, particularly to finance potential acquisitions.
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.
On November 8, 2006, our Board of Directors authorized a stock repurchase program for up to 1,250,000 shares of MSC’s common stock from time to time in open market or private transactions. The stock repurchase program expired on November 7, 2007.
Contractual Obligations
The following summarizes our contractual obligations at December 31, 2008 (in thousands).
In addition, we recorded a liability for unrecognized tax benefits totaling $8.7 million as of December 31, 2008 in accordance with FIN 48. This amount has been excluded from the contractual obligations table above because a reasonably reliable estimate of the timing of future tax settlements cannot be determined.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to the impact of foreign currency fluctuations and interest rate changes.
Foreign Currency Risk
International revenue represented approximately 71%, 70% and 68%, of our total revenue for 2006, 2007 and 2008, 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 2008, a 5% change in both the Euro and the Yen would have impacted our revenue by approximately $8.3 million and our income from continuing operations by approximately $1.7 million. Since September 30, 2008, there has been a significant downturn in worldwide economic conditions. A prolonged economic downturn could adversely impact our customers and ultimately reduce our sales. In addition, the U.S. dollar has significantly strengthened against many currencies, including the Euro and the Yen. This has the effect of decreasing our revenue, expenses and net income when translated into U.S. dollars.
We do not currently hedge any of our foreign currencies.
Interest 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
After the May 2008 sale of our remaining marketable equity securities consisting entirely of stock in GSSL, we had no investments in marketable equity securities as of December 31, 2008.
Prior to such sale, we periodically evaluated whether any declines in fair value of our investments were other-than-temporary, which could have resulted in an impairment of such assets. This evaluation consisted of a review of qualitative and quantitative factors. We had no such impairments during 2006, 2007 or 2008.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Consolidated Balance Sheets as of December 31, 2007 and 2008
Consolidated Statements of Operations for the Years Ended December 31, 2006, 2007 and 2008
Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss) for the Years Ended December 31, 2006, 2007 and 2008
Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2007 and 2008
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
MSC.SOFTWARE CORPORATION
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2007 AND 2008
(in thousands except per share value amounts)
See accompanying notes to consolidated financial statements.
MSC.SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR YEARS ENDED DECEMBER 31, 2006, 2007 and 2008
(in thousands, except per share data)
See accompanying notes to consolidated financial statements.
MSC.SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 and 2008
(in thousands)
See accompanying notes to consolidated financial statements.
MSC.SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 and 2008
(in thousands)
MSC.SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 and 2008
(in thousands)
See accompanying notes to consolidated financial statements.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008
NOTE 1-NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations-MSC.Software Corporation (“MSC”) develops, markets and supports proprietary simulation solutions, including enterprise 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, computer and electronics manufacturers, biomedical, shipbuilding and rail.
Principles of Consolidation-The consolidated financial statements of MSC include the accounts of its subsidiaries. All intercompany accounts and transactions have been eliminated.
The results of the operations of businesses acquired 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 its software products and providing maintenance, consulting, and training services. Our standard software license agreement provides the end user with a perpetual license to use our products.
We record revenue from software licenses provided there is persuasive evidence of an arrangement, the license 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 contract period. VSOE of fair value for maintenance is measured by the stated renewal rate included in the license agreement or, when not stated in the license agreement, by analysis of actual maintenance renewal agreements, and has been between 20% and 23% of software license fees.
Customers may also enter into arrangements for consulting and training services. Consulting services are sold under fixed fee or on a time and material basis. Consulting revenue under a fixed fee arrangement 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”. When percentage-of-completion accounting is not possible we recognize the revenue using the completed-contract method. Consulting revenue under a time and material arrangement is recognized as services are provided. Training revenue is recognized as the related services are provided. These arrangements are not essential to the functionality of the software and are therefore accounted for separately from the license revenue because the arrangements qualify as “service transactions” as defined in SOP 97-2 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.
If the fair value of any undelivered element included in a multiple-element arrangement cannot be objectively determined, the entire amount of revenue from the arrangement is deferred. Depending upon the type of transaction and on which elements fair value cannot be determined, such deferred revenue will be recognized (1) after all elements have been delivered or fair value is objectively determined or (2) ratably over the period appropriate for that transaction.
License revenue from value-added resellers and other sales 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.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Our revenue is generated through a 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. We do not offer any rights of return, rebates, or price protection on our software products.
Deferred Revenue-Deferred revenue consists primarily of maintenance fees related to the remaining term of maintenance agreements in effect at those dates. Deferred license fees and services fees are also included in deferred revenue for those contracts that have been billed but not yet recognized.
As of December 31, 2007 and 2008, deferred revenue consisted of the following (in thousands):
Sales Commissions-Sales commissions earned by our employees are recognized in the period when eligible sales transactions are billed and totaled $7,504,000 in 2006, $9,175,000 in 2007 and $10,467,000 in 2008. The accrual for commissions earned is determined by applying specific commission rates on eligible billings based on estimated performance against annual targets. The commissions earned are paid quarterly after final determination of eligible billings and calculation of the commission expense in accordance with the related commission plans. Historically, differences in the commissions paid versus the amount accrued have not been significant and are accounted for as adjustments in commission expense in the period the change in estimate is made.
Under this compensation model, the amount of sales commission expense fully recognized during periods of increasing sales of new products and services relative to the amount of revenue recognized from such sales in those periods, could negatively impact income and earnings per share in a given period.
Discontinued Operations-In 2006, we completed the sale of our Japanese service subsidiary, ESTECH Corporation (“ESTECH”). In 2003, we ceased operations of its Systems business. Accordingly, all 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-We consider 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. Refer to Note 12 - Fair Value of Financial Instruments for further discussion of fair value.
In December 2007, we sold 3,100,000 shares of marketable equity securities of Geometric Limited, formerly Geometric Software Solutions Co. Ltd. (“GSSL”) resulting in a realized pre-tax gain of $6,818,000. As of December 31, 2007, MSC owned 2,100,000 shares in GSSL stock with an original cost of $27,000, which was subsequently sold in May 2008 for $2,656,000, resulting in a pre-tax gain of $2,629,000. As of December 31, 2008, we had no investments in marketable equity securities.
As of December 31, 2007 and 2008, our non-qualified supplemental retirement plan had investments in marketable equity securities classified as available-for-sale. Refer to Note 9-Pensions and Other Employee Benefits.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Available-for-sale securities held at December 31, 2007 and 2008 were as follows (in thousands):
We had no contractual maturities of any equity or debt securities as of December 31, 2007 and 2008.
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 collectability 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 was $1,855,000 and $1,375,000 at December 31, 2007 and 2008, respectively. Our provision for doubtful accounts totaled $625,000, $511,000 and $196,000 in 2006, 2007 and 2008, respectively, and were recorded in general and administrative expense in the consolidated statements of operations. Uncollectible trade accounts receivable written-off, net of recoveries, were $366,000, $211,000 and $676,000 in 2006, 2007 and 2008, respectively.
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 when we determine (1) that technology exists to achieve the performance requirements, (2) buy versus internal development decisions have been made and (3) our 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 such costs are amortized over an estimated useful life of three years using the straight-line method. Amounts capitalized during 2007 and 2008 totaled $4,464,000 and $1,304,000, respectively, and represent costs of purchased software. During 2007, we recorded an impairment charge of $343,000 related to capitalized software not being used. Amortization of capitalized software development costs totaled $1,578,000 in 2006, $3,012,000 in 2007, and $3,053,000 in 2008. Unamortized capitalized software costs totaled $5,326,000 at December 31, 2007, and $3,612,000 at December 31, 2008.
Goodwill and Other Intangible Assets-Goodwill represents the excess of cost over fair value of net assets of a business acquired. We account for goodwill and certain intangible assets acquired in accordance with FASB Statement No. 142, “Goodwill and Other Intangible Assets.” Goodwill and intangible assets determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually. Intangible assets with finite useful lives are amortized over their respective estimated useful lives and reviewed for impairment in accordance with FASB Statement No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.” Refer to Note 4-Goodwill and Other Intangible Assets.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Impairment or Disposal of Long-Lived Assets-In accordance with SFAS No. 144, long-lived assets, such as property, plant and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the 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 are presented separately in the appropriate asset and liability sections of the consolidated balance sheets, if material. In 2007, we sold long-lived assets held for sale with a net book value of $200,000 (after a write-down of $141,000 in 2006).
Goodwill is tested annually for impairment in the fourth quarter of each fiscal year, and will be tested more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, we determine the fair value of each reporting unit using discounted cash flow and market multiple methodologies and compare it to the carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with FASB Statement No. 141, “Business Combinations.” The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. No impairment charges for goodwill were recorded in 2006, 2007 or 2008 as a result of our impairment testing.
The fair value of indefinite lived intangibles, consisting primarily of trademarks and trade names of various software products, is determined using discounted cash flow and other methodologies under an income approach and after consideration of other factors that may exist. During 2007 and 2008, we recorded impairment charges totaling $4,435,000 and $9,951,000, respectively, related to trademarks and trade names for various software products. Refer to Note 4-Goodwill and Other Intangible Assets for further discussion.
Significant management judgment is required in determining the fair value of long-lived assets, including goodwill and intangible assets. Any changes in the assumptions used in determining fair value under the various valuation methodologies could impact the assessed value of an asset and result in an impairment charge equal to the amount by which its carrying value exceeds its actual or estimated fair value.
Software Development Costs-We account for development costs for software to be sold or otherwise marketed in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed.” SFAS No. 86 specifies that costs incurred internally in researching and developing a software product should be charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers and amortized on a straight-line basis over the estimated life of the software product Judgment is required in determining when technological feasibility of a product is established and assumptions are used that reflect our best estimates. 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 have not been capitalized.
Royalties to Third Parties-We have agreements with third parties requiring the payment of royalties for sales of third party products or inclusion of such products as a component of MSC’s products. Royalties are charged to cost of software revenue when incurred and totaled $5,578,000, $3,556,000 and $3,500,000 in 2006, 2007 and 2008, respectively.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Stock-Based Compensation-We account for stock-based compensation in accordance with SFAS No. 123(R), “Share-Based Payment.” 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. The amount of stock-based compensation expense recognized under SFAS No. 123(R) requires forfeitures to be estimated at the time of grant in order to estimate the amount of stock-based awards that will ultimately vest. The forfeiture rate is based on a review of historical rates and is updated each quarter as necessary.
The effect on net income of recording stock-based compensation for the years ended December 31, 2006, 2007 and 2008 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. No tax effect applies on stock-based compensation in 2008 as the result of valuation allowances being established on substantially all of our U.S. net deferred tax assets. Refer to Note 6-Income Taxes for additional information.
SFAS 123(R) requires the cash flows resulting from the tax benefits for tax deductions in excess of the stock-based compensation expense recorded for those options (excess tax benefits) to be classified as cash from financing activities. To calculate the excess tax benefits available for use in offsetting future tax shortfalls as of the date of implementation, we follow the alternative transition method discussed in FSP SFAS 123(R)-3. In 2006, 2007 and 2008 we recorded excess tax benefits of $1,341,000, none and $2,571,000, respectively.
Income Taxes-We use the asset and liability method of accounting for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” A tax provision is recognized in our 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. We record a valuation allowance to reduce deferred tax assets to an amount whose realization is more likely than not.
We are subject to tax audits in numerous jurisdictions in the U.S. and around the world. Tax audits by their very nature are often complex and can require several years to complete. In the normal course of business, we are subject to challenges from the IRS and other tax authorities regarding amounts of taxes due. These challenges may alter the timing or amount of taxable income or deductions, or the allocation of income among tax jurisdictions. Prior to 2007, we recognized income tax liabilities with respect to uncertain tax positions based upon SFAS No. 5, “Accounting for Contingencies.”
In 2007, we adopted Financial Accounting Standards Board (FASB) Interpretation No. (FIN) 48, “Accounting for Uncertainty in Income Taxes.” Under FIN 48, the benefits of tax positions that are more likely than not of being sustained upon audit based on the technical merits of the tax position are recognized in the consolidated financial statements; positions that do not meet this threshold are not recognized. For tax positions that are at least more likely than not of being sustained upon audit, the largest amount of the benefit, determined on a cumulative probability basis, which is more likely than not of being sustained is recognized in the consolidated financial statements. Refer to Note 6-Income Taxes.
Foreign Currency-We translate the assets and liabilities of our 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.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Our intercompany accounts are typically denominated in the functional currency of the foreign subsidiary. Gains and losses resulting from the remeasurement of intercompany receivables from those international subsidiaries for which settlements are anticipated 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 $(1,232,000), $637,000 and $4,013,000 for the years ended December 31, 2006, 2007 and 2008, respectively.
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 are 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 14-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. Cash equivalents and short-term investments are invested in instruments with investment grade credit ratings. Our investments are kept with high-credit-quality financial institutions and, by policy, limit the amount of credit exposure from any one issuer. At December 31, 2008, approximately 36% of our cash was maintained outside the U.S. and invested primarily in guaranteed deposits with our banks. Within the U.S., our cash is invested primarily in U.S. Treasury securities and money market funds for working capital, which are not subject to any liquidity restrictions.
We have historically derived a significant portion of our net revenue from selling simulation software products used 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, our business could be harmed by a decline in demand for, or in the prices of, these products as a result of many factors, including a maturation in the markets for these products, increased price competition or our failure to keep up with technological change.
In addition, we derive a significant portion of our revenue from the aerospace and automotive industries. As a result of this concentration, our business could be harmed if either one of these industries experienced economic difficulties.
For 2006, 2007, and 2008, we had no customers that accounted for 10% or more of total revenue. As of December 31, 2008, no customer accounted for 10% or more of our gross accounts receivable. As of December 31, 2007, one customer accounted for more than 10% of the our gross accounts receivable. We do not require collateral from our customers prior to granting credit.
Self-Insurance-We are self-insured for certain medical claims and benefits offered to our employees in the United States. Based on analysis of the historical data and actuarial estimates, the expected ultimate cost of future claims as of December 31, 2007 and 2008 was $841,000 and $632,000, respectively, which is included in accrued compensation and related costs in the accompanying consolidated balance sheets.
Fair Values of Financial Instruments-At December 31, 2007 and 2008, our financial instruments included cash and cash equivalents, trade receivables, marketable securities and accounts payable. Our subordinated notes outstanding at December 31, 2007 were repaid in December 2008. 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 values of financial assets were determined based on quoted market prices at year-end. The estimated fair value of the subordinated notes payable was determined based on the present value of its future cash flows using a discount rate that approximates our current borrowing rate.
Recently Issued Accounting Standards
In December 2008, the FASB issued Staff Position No. FAS 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets” (FSP FAS 132(R)-1). FSP FAS 132(R)-1 requires more detailed disclosures about employers’ plan assets in a defined benefit pension or other postretirement plan, including employers’ investment strategies, major categories of plan assets, concentrations of risk within plan assets, and inputs and valuation techniques used to measure the fair value of plan assets. FSP FAS 132(R)-1 also requires, for fair value measurements using significant unobservable inputs (Level 3), disclosure of the effect of the measurements on changes in plan assets for the period. The disclosures about plan assets required by FSP FAS 132(R)-1 must be provided for fiscal years ending after December 15, 2009. As this pronouncement is only disclosure-related, we do not expect it to have any impact on our consolidated financial statements.
In June 2008, the FASB issued FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” (“FSP EITF 03-6-1”). FSP EITF 03-6-1 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in computing earnings per share under the two-class method described in SFAS No. 128, “Earnings Per Share.” FSP EITF 03-6-1 is effective for fiscal years and interim periods beginning after December 15, 2008. Early adoption is prohibited. We do not expect FSP EITF 03-6-1 to have any impact on our consolidated financial statements.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
In April 2008, the FASB issued Staff Position No. 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP 142-3”). FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets.” FSP 142-3 is effective for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years, requiring prospective application to intangible assets acquired after the effective date. We will be required to adopt the principles of FSP 142-3 with respect to intangible assets acquired on or after January 1, 2009. Due to the prospective application requirement, we are unable to determine what effect, if any, the adoption of FSP 142-3 will have on our consolidated statement of financial position, results of operations or cash flows.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133.” SFAS No. 161 amends and expands the disclosure requirements of SFAS No. 133 with the intent to provide users of financial statements with an enhanced understanding of: (i) how and why an entity uses derivative instruments; (ii) how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations and (iii) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. We do not expect SFAS No. 161 to have a material impact on our future consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations.” SFAS No. 141(R) establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired. SFAS No. 141(R) also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS No. 141(R) is effective for fiscal years beginning after December 15, 2008, and will be adopted by us in the first quarter of 2009. We do not expect SFAS No. 141(R) to have a significant impact on our consolidated financial statements when effective, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the acquisitions we consummate after the effective date.
NOTE 2-BUSINESS ACQUISITIONS
On June 11, 2008, we acquired certain assets of The MacNeal Group, LLC (“TMG”), a developer of finite element analysis software. This acquisition allows us to develop and enhance our Nastran technology as part of a long-term strategy to provide customers superior and leading-edge simulation technology for the global enterprise environment. We paid $1,800,000 in cash at closing and paid an additional $200,000 in cash in July 2008 upon the delivery of certain source code and electronic media related to key technology purchased. The total purchase price of $2,000,000 was allocated to developed technology, an intangible asset.
On January 3, 2008, we acquired all the stock of Arizona-based Network Analysis, Inc. (“NAI”), a global innovator of thermal simulation software and the developers of the SINDA/G advanced thermal modeling software. We paid $2,450,000 in cash for the NAI stock at closing, and assumed $20,000 in net liabilities. The purchase price of $2,470,000 was allocated to goodwill totaling $1,428,000 (including $628,000 of deferred tax liabilities) and other intangible assets totaling $1,670,000, consisting primarily of developed technology and customer relationships. The pro forma effect of this acquisition was not material to our consolidated financial statements. We also recognized $300,000 in compensation expense pursuant to an Earn-out Agreement and upon retention of employees through December 31, 2008 and may recognize an additional $300,000 in compensation during 2009 under such arrangements.
On August 8, 2007, we acquired Pioneer Solutions, Inc. (“Pioneer”), a provider of computational fluid dynamics technology, for $1,146,000 of which we paid $1,008,000 in cash and assumed liabilities of $138,000. As a result, we recorded other intangible assets totaling $663,000, consisting primarily of developed technology, and goodwill of $623,000 (including $240,000 of deferred tax liabilities). The pro forma effect of this acquisition was not material to our consolidated financial statements.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 3-PROPERTY AND EQUIPMENT
As of December 31, 2007 and 2008 property and equipment, at cost consisted of the following (in thousands):
Included in software, computers and other equipment are capital lease costs totaling $1,022,000 and $647,000, as of December 31, 2007 and 2008, respectively.
Depreciation and amortization expense of property and equipment for the years ended December 31, 2006, 2007 and 2008 totaled $6,967,000, $7,533,000 and $7,221,000, 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):
Our indefinite lived intangibles consist primarily of acquired trademarks and trade names and totaled $19,599,000 and $9,901,000 at December 31, 2007 and 2008, respectively. In 2007 and 2008, we recorded impairment charges of $4,435,000 and $9,698,000, respectively, related to trademarks and trade names as the result of our annual impairment testing. Such testing determined that the carrying value of the trademarks and trade names exceeded the discounted future net cash flows, which were adversely impacted by decreasing projected revenue. In addition, we determined that trademarks and trade names with carrying values totaling $2,734,000 had finite lives and were reclassified to other intangible assets at December 31, 2007.
As of December 31, 2007 and 2008, other intangible assets consisted of the following (in thousands):
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
During 2008, we also recorded an impairment charge of $253,000 related to developed technologies as the result of our annual impairment testing. Such testing determined that the carrying value of developed technology exceeded the discounted future net cash flows, which were adversely impacted by decreasing revenue.
Amortization expense of other intangibles for the years ended December 31, 2006, 2007 and 2008 totaled $5,917,000, $5,908,000 and $7,125,000, of which $5,168,000, $5,210,000 and $5,779,000, respectively, is related to developed technology and included in cost of software revenue in the accompanying consolidated statements of operations. The remaining amount of amortization expense related to customer lists and trademarks and trade names is shown separately in the accompanying consolidated statements of operations.
Estimated amortization expense of other intangible assets for each of the five succeeding fiscal years is as follows (in thousands):
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 5-RESTRUCTURING RESERVE
2008 Plan
In June 2008, we initiated a cost reduction program that includes workforce reductions, significant reductions in contracted services primarily impacting information technology and product development activities and reorganizations of various departments. When completed, the workforce reductions were expected to impact approximately 11% of our workforce throughout various departments and are projected to result in one-time termination benefits totaling approximately $2,600,000, of which we recognized approximately $2,000,000 during the year ended December 31, 2008. We expect the remaining termination benefits related to this initiative will be incurred and paid in 2009.
2007 Plan
In January 2007, we implemented a cost reduction program that included a 7% reduction of its workforce, and facility closings and consolidations in the United States and recorded. The cost reduction program was deemed necessary to better align global operating costs with our new enterprise sales strategy in an effort to improve operating profit.
As a result, we recorded restructuring charges totaling $7,357,000 during the first quarter of 2007. This amount included $3,697,000 for vacated facilities, which consists of the estimated net present value of remaining lease obligations for the vacated space totaling $11,397,000, less the estimated future sublease income of approximately $7,780,000, plus $80,000 of expected sublease income that was not recognized during the period ended March 31, 2007. After March 31, 2007, we recorded additional restructuring charges of $1,531,000, including $1,085,000 of expected sublease income that was not recognized through December 31, 2007. In addition, we wrote off deferred rent obligations related to the vacated facilities totaling $366,000 and credited the restructuring charge during 2007.
During 2008, we reversed $198,000 of the restructuring reserve related to the vacated facilities after an assessment of the remaining liabilities. In addition, we recognized $1,467,000 of expected sublease income relating to vacated facilities. Similar charges related to sublease income will be recorded in future periods to the extent we do not enter into sublease arrangements.
On a quarterly basis, we will review the assumptions used in estimating our restructuring charges, principally sublease income expectations for excess facilities and employee termination expenses, which may result in adjustments to established reserves.
The following is the activity in the restructuring reserve during the year ended December 31, 2007 and 2008 (in thousands):
The current portion of the reserve is reported separately while the long-term portion of the reserve is reported in other long-term liabilities in the accompanying consolidated balance sheets. Such long-term liabilities represent contractual lease obligations extending through 2013.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 6-INCOME TAXES
The provision for taxes based on income from continuing operations for the years ended December 31, 2006, 2007, and 2008 consists of the following (in thousands):
The foreign tax provision for 2006, 2007 and 2008 includes withholding taxes of approximately $623,000, $974,000, and $309,000 , respectively, assessed against MSC by foreign tax authorities on amounts remitted to the United States.
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 our deferred tax assets and liabilities as of December 31, 2007 and 2008 are as follows (in thousands):
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The balance sheet presentation of the net deferred tax assets as of December 31, 2007 and 2008 is as follows (in thousands):
In assessing the ability to realize deferred tax assets, our management considers whether it is “more likely than not” that some portion or all of the deferred tax assets will not be realized. We consider taxable income in carry back years, the scheduled reversal of deferred tax liabilities, tax planning strategies, and projected future taxable income in making this assessment. Based on our history of cumulative losses, our management believes it is “more likely than not” that we will not realize the benefit of the all of our federal U.S. and certain of our state deferred tax assets and certain of our foreign deferred tax assets existing as of the taxable year ended December 31, 2008. Accordingly, at December 31, 2008, we established a valuation allowance of $21,765,000 against our U.S. federal and certain state deferred tax assets, and increased by $1,088,000 the valuation allowance against our foreign deferred tax assets. If and when we release the valuation allowance, the entire amount released will reduce income tax expense.
In the year ended December 31, 2008, we realized unrecognized tax benefits through additional paid in capital of $2,571,000, representing the tax-effected portion of net operating losses (“NOLs”) pertaining to tax deductions from stock-based compensation.
We use the with-or-without method under SFAS No. 123(R) to determine when we will realize excess tax benefits from stock-based compensation. Under this method, we will realize excess tax benefits only after it realizes the tax benefits of NOL’s from operations.
At December 31, 2008, we had total foreign NOLs (net of FIN 48 effect) of $11,923,000, of which approximately $8,479,000 begin to expire in years 2009 through 2015; the remaining $3,444,000 of foreign NOLs carry forward indefinitely until used.
At December 31, 2008, we had federal, state, and foreign income tax credit carry forwards (net of FIN 48 effect) of approximately $6,061,000, $6,958,000 and $266,000, respectively. Federal income tax credits will expire at various dates from 2018 through 2028; state income tax credits have no expiration date; and foreign income tax credits expire in 2017.
The following table reconciles the U.S. federal statutory tax rate to the combined effective tax rate for years ended December 31, 2006, 2007 and 2008 (in thousands):
We have provided for no U.S. federal or state liability on approximately $25 million of undistributed foreign earnings at December 31, 2008. Determination of the potential amount of unrecognized deferred U.S. income tax liability and foreign withholding taxes is not practicable because of the complexities associated with its hypothetical calculation; however, unrecognized foreign tax credits would be available to reduce some portion of the U.S. liability.
The following table depicts our foreign and domestic operations realized combined income (loss) from continuing operations before taxes, including intercompany charges that eliminate in consolidation for the years ended December 31, 2006, 2007, and 2008 (in thousands):
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Our unrecognized tax benefits relate to various U.S. and foreign jurisdictions. The following table summarizes the changes to our unrecognized tax benefits during 2007 and 2008 (in thousands):
At December 31, 2008, $12,558,000 of our unrecognized tax benefit would reduce the annual effective tax rate, if recognized.
During the fiscal year 2008, we increased liabilities for interest of $128,000, and potential penalties of $365,000 related to unrecognized tax benefits. At December 31, 2008, we had a recorded liability for interest and potential penalties of $412,000 and $484,000, respectively.
We believe $1,193,000 of unrecognized tax benefits will likely be recognized in the next 12 months due to the expiration of the limitations period for deficiency assessments related to foreign tax matters.
We are subject to income taxation in the U.S., various states, and foreign countries, the most material of which are Germany and Japan. The tax returns filed in these jurisdictions for tax years after 2004 are subject to audit. The tax returns of our Japanese subsidiary for the year ended December 31, 2006 and 2007 are under audit. The principal issue involved in the audit is transfer pricing. The Japanese tax authority has asserted that the transfer pricing method between the U.S. parent company and its Japanese subsidiary attributed too little income to Japan. We have evaluated the position of the Japanese tax authority and believe our transfer pricing is supported by reliance on objective benchmarking against third party comparable results. As of December 31, 2008, we believe we have adequately reserved for the tax effects of any adjustments expected from these audits.
NOTE 7-LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
Long-Term Debt
Our long-term debt as of December 31, 2007 consisted of subordinated notes payable that were issued in connection with an acquisition in 1999. The subordinated notes payable were recorded at their estimated fair value at the time of issuance, net of a discount of $2,596,000 and were due June 2009. The subordinated notes payable bear interest at 8% with interest payments due semi-annually in January and July. The unamortized discount totaled $264,000 at December 31, 2007 and is being amortized to interest expense using the effective-interest method over the term of the notes payable. In June 2007 and 2008, we repaid $800,000 and $720,000 respectively, of principal on the notes payable. In December 2008, we repaid the remaining principal balance of $6,480,000 and wrote off $84,000 of unamortized discount, which is included in interest expense in the accompanying statements of operations.
In June 2006, we completed the redemption of our 2 1/2% Senior Subordinated Convertible Notes (the “Notes”) at a redemption price of 100% of principal outstanding, plus accrued interest. Holders of the Notes converted their Notes to shares of MSC’s common stock, at a conversion rate of 117.4398 shares of common stock per $1,000 principal amount of the Notes.
In connection with the redemption, we wrote off $1,404,000 of unamortized debt issue costs related to the Notes, which is included in interest expense in the accompanying statements of operations. In addition, debt securities that were pledged to a trustee for the payment of all scheduled interest payments on the Notes were sold in June 2006. At the time of the sale, the amortized cost of these pledged securities totaled $4,893,000 resulting in a pre-tax loss of $71,000, which is included in other expense in the accompanying statements of operations.
Capital Lease Obligations
We have capital lease obligations covering primarily computer equipment. As of December 31, 2007 and 2008, such obligations totaled $331,000 and $125,000, of which $184,000 and $73,000, respectively, are included in other accrued liabilities based on their maturities. The remaining portion of the obligations is due in 2010 and is included in other long-term liabilities.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 8-SEGMENT INFORMATION
We apply SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” to determine our operating segments. Operating segments, as defined by SFAS No. 131, are components of an enterprise for which separate financial information is available and is evaluated regularly by key decision makers in deciding how to allocate resources and in assessing performance. SFAS No. 131 also requires disclosure about products and services, geographic areas and major customers. We currently operate in two business segments-software and services, as determined under SFAS No. 131.
Our senior management reviews financial information to manage the business consistent with the presentation in the consolidated financial statements, focusing on the revenue and gross profit for each segment. We do not allocate research and development, selling, or general and administrative expenses to each segment, as management does not use this information to measure the performance of the operating segments. Our senior management does not review assets by operating segment. Consequently, such information is not provided herein. Maintenance and services revenue is derived from software upgrades, technical support, consulting and training. The revenue and gross margins attributable to these segments for the years ended December 31, 2006, 2007 and 2008 are included in the following table (in thousands):
Our international operations consist primarily of foreign sales offices selling our software products developed in the United States and related services provided locally. Revenue is attributed to the country in which the customer is located. No customer accounted for 10% or more of total consolidated revenue. The following tables summarize by geographic location consolidated revenue of our operations for the years ended December 31, 2006, 2007 and 2008 and identifiable assets at December 31, 2007 and 2008 (in thousands):
The net assets of our foreign subsidiaries totaled $46,038,000 and $45,087,000 as of December 31, 2007 and 2008, respectively, excluding intercompany items. Included in these amounts were long-lived assets totaling $5,885,000 and $4,627,000 as of December 31, 2007 and 2008 respectively. The revenue and net assets of discontinued operations are not included in the above. Refer to Note 15 - Discontinued Operations. The income (loss) before taxes of our foreign subsidiaries is shown in Note 6-Income Taxes.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 9-PENSIONS AND OTHER EMPLOYEE BENEFITS
Defined Benefit Pension Plans
We have four defined benefit pension plans (the “Plans”) covering substantially all of our full-time employees in Japan, Korea, Taiwan and Germany. The Plans typically provide for a lump sum payment upon retirement, which is generally based upon years of service and compensation. The Plans do not provide continuing salary or benefits upon retirement. As of December 31, 2007 and 2008, the Plans had 166 and 151 active participants, respectively. During the years ended December 31, 2006, 2007 and 2008, we recognized expense of $973,000, $1,433,000 and $1,067,000, respectively.
On December 31, 2006, we adopted the recognition and disclosure provisions of SFAS No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of SFAS Nos. 87, 88, 106 and 132(R)” (“SFAS No. 158”). SFAS No. 158 required us to recognize the funded status of our defined benefit pension plans on our consolidated balance sheet as of December 31, 2006, with a corresponding adjustment to accumulated other comprehensive income, net of tax. The resulting 2006 adjustment to accumulated other comprehensive income totaled $1,070,000 and resulted from the recognition of the transition asset, prior service cost and actuarial gain not included in the net periodic benefit cost during 2006. This amount is being amortized and recognized as part of the net period benefit cost beginning in 2007. Actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic benefit cost in the same periods are recognized as a component of other comprehensive income. These gains and losses are subsequently recognized as a component of net periodic benefit cost on the same basis as the amounts recognized in accumulated other comprehensive loss at adoption of SFAS No. 158.
We use a December 31 measurement date for all of our pension plans. The fair value of plan assets is determined by market value. Contributions to the Plans totaled $472,000 in 2007 and $631,000 in 2008 and we expect to contribute approximately $622,000 to the Plans in 2009, but such amount is subject to change.
Information on benefit obligations, funded status and plan assets as of and for the years ended December 31, 2006, 2007 and 2008 is as follows (in thousands):
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
We have plan assets in only two of our pension plans. The most significant plan has its assets invested solely in a general account with an insurance company, which is an investment vehicle that complies with pension fund requirements of the corresponding country. The insurance company manages the funds invested and guarantees a return of 0.75% per annum. The rate of return may be revised and dividends may also be declared on funds invested in this general account based on current economic conditions and investment performance. Investment in this general account bears minimal risk as the rate of return is fixed and the insurance company bears risk of loss on the investment of funds that it manages. We do not currently have specific investment policies or an investment committee in place to oversee the investment of its pension fund.
There are no contributions paid into an external plan and no asset of MSC identified, segregated or invested specifically to fund the remaining pension plans. The estimated future benefit payments of these plans are expected to be paid directly by MSC. The following benefit payments, which reflect expected future service, as appropriate, are projected to be paid as follows (in thousands):
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Employee Savings Plan
We contribute an amount to a defined contribution plan, covering substantially all North American full-time employees who have completed a specified term of service. For the years ended December 31, 2006, 2007 and 2008, contributions charged to expense in connection with this plan were $2,728,000, $2,473,000 and $2,755,000, respectively. The plan has a 401(k) feature to permit voluntary employee contributions, which does not affect our expenses. Our contributions vest over a three year period.
Non-Qualified Supplemental Retirement Plan
In 1995, we adopted a non-qualified supplemental retirement plan covering certain key employees who have completed a specified term of service. For the years ended December 31, 2006, 2007 and 2008, contributions charged to expense in connection with this plan were $209,000, $120,000 and $135,000, respectively. As of December 31, 2007 and 2008, the fair value of plan assets and obligations was $1,869,000 and $1,341,000, respectively, and are classified in other assets and other long-term liabilities in the accompanying consolidated balance sheets.
NOTE 10-STOCK-BASED COMPENSATION
Under our 2006 Performance Incentive Plan (the “2006 Plan”), MSC’s common stock may be issued to employees, directors and other eligible persons under a broad range of potential equity grants including stock options, stock appreciation rights, restricted stock, performance stock, stock units, phantom stock and dividend equivalents. Shares issued for option exercises and vested restricted stock, restricted stock unit awards and performance stock unit awards may be either authorized but unissued shares, or shares of treasury stock acquired in the open market or otherwise.
As of December 31, 2008, there were approximately 5,928,000 shares reserved for future grants under the 2006 Plan. We expect to continue granting new equity grants from the reserved shares under the 2006 Plan.
The following table summarizes total stock-based compensation expense recognized by type of equity award during 2006, 2007 and 2008 (amounts in thousands):
In addition, we modified the stock options of one departing executive in 2007 to extend the life of his options. The modification was determined using the Black-Scholes valuation model in accordance with SFAS No. 123(R). As a result, we recorded a non-cash charge of $674,000 in 2007 which is included in general and administrative expenses in the accompanying consolidated statement of operations.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following table summarizes total stock-based compensation as recorded in the same expense captions as would be required for cash compensation for the years ended December 31, 2006, 2007 and 2008, respectively (amounts in thousands):
Stock Options
We grant stock options for a fixed number of shares to key employees and non-employee directors with an exercise price equal to the fair value of the shares at the date of grant. Options are exercisable up to ten years from the date of grant, subject to transfer restrictions and vesting provisions outlined at the grant date. Generally, options vest ratably in four annual installments for employees and on the first anniversary following the grant date for non-employee directors. The stock plans and plan agreements provide that vesting may be accelerated in certain events related to changes in control of MSC. Similarly, the stock plans provide that the Compensation Committee of our Board of Directors has discretion, subject to certain limitations, to modify the terms of outstanding options. No amendment or cancellation and re-grant, subject to permitted adjustments, shall reduce the per share exercise price to a price less than 100% of the fair market value of our common stock on the option date of the initial option. Unless approved by our shareholders, no repricing of a stock option under the 2006 Plan is permitted.
A summary of stock option activity under all the stock option plans for the years ended December 31, 2006, 2007 and 2008 is as follows:
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Using the Black-Scholes option-pricing model, the estimated per share weighted-average fair value of stock options granted in 2006, 2007 and 2008 was $8.58, $7.11 and $6.03, respectively. 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 years ended December 31, 2006, 2007 and 2008, the average expected life was determined using the simplified approach described under Staff Accounting Bulletin No. 107 due to the lack of sufficient historical exercise data for options granted since September 2006, when MSC’s common stock began trading on NASDAQ.
In addition, we estimate forfeitures when recognizing compensation expense, and will adjust such estimates 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.
The aggregate intrinsic values of options outstanding at December 31, 2007 and 2008 were $8,804,000 and $316,000, respectively, which is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 3,147,000 shares and 199,000 shares that had exercise prices lower than $12.99 and $6.68, the market price of our common stock at December 31, 2007 and 2008, respectively. The aggregate intrinsic values of options exercised during 2007 and 2008 were $2,869,000 and $1,375,000, respectively, determined as of the date of exercise. Cash proceeds from the exercise of stock options in 2006, 2007 and 2008 totaled $9,513,000, $6,598,000 and $3,131,000, respectively. The aggregate intrinsic value of options exercisable at December 31, 2007 and 2008 was $7,536,000 and $316,000 respectively.
At December 31, 2008, the number of options outstanding and exercisable under the stock plans, by range of exercise prices, was as follows:
The number of options vested or expected to vest at December 31, 2007 and 2008 was 5,380,000 and 4,464,000, with a weighted average exercise price of $11.90 and $12.32, a weighted-average remaining contractual life of 6.5 years and 6.18 years; and an aggregate intrinsic value of $8,054,000 and $316,000 respectively.
As of December 31, 2007 and 2008, total unamortized stock-based compensation cost related to unvested stock options was $14,848,000 and $9,036,000, with a weighted average recognition period of 3.1 years and 2.3 years, respectively.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
At December 31, 2006, 2007 and 2008, the number of options exercisable, the per-share weighted-average exercise prices of the stock options exercisable and the number of options available for future grant under all of the stock plans were as follows:
Restricted Stock, Restricted Stock Unit and Performance Stock Unit Awards
We grant time-based and performance-based restricted stock units to selected employees pursuant to the 2006 Plan. The time-based restricted stock units vest ratably over the requisite service periods. The performance-based restricted stock units vest equally over the requisite service periods upon achievement of specified performance criteria established by the Compensation Committee of our Board of Directors. The award agreements for restricted stock units generally provide that vesting will be accelerated in certain events related to changes in control of MSC. Total compensation cost for these awards is based on the fair market value of MSC’s common stock at the date of grant. The portion of the total compensation cost related to the performance-based awards is subject to adjustment each quarter based on management’s assessment of the likelihood of achieving the annual performance criteria. During the years ended December 31, 2006, 2007 and 2008, we recognized stock compensation expense of $720,000, $3,335,000 and $5,047,000, respectively, related to these restricted stock units.
The fair value of restricted stock unit awards is determined based on our stock price as of the measurement date, which is the date of grant. As of December 31, 2007 and 2008, deferred compensation cost related to the restricted stock unit awards totaled $11,527,000 and $11,734,000, which had weighted average remaining contractual lives of 1.8 years and 1.1 years, respectively.
During 2005, in connection with the employment of certain executive officers, we granted the right to purchase in aggregate 225,000 shares of restricted common stock, of which 75,000 of restricted shares were purchased. Upon the purchase of the restricted shares, those executive officers received in aggregate 239,000 restricted stock unit awards which vest over four years. During 2006, 2007 and 2008, we recognized stock-based compensation charges totaling $1,307,000, $122,000 and none, respectively, related to these transactions.
The following table presents a summary of restricted stock unit awards activity for the years ended December 31, 2006, 2007 and 2008:
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
During 2005 and 2006, in connection with the employment of executive officers and other key employees, we granted performance stock unit awards that vest and are payable in shares if the per share price of the MSC’s common stock exceeds a pre-established per share price for thirty consecutive trading days on a national stock exchange within two years from the date of grant. On September 5, 2006, MSC’s common stock began trading on the NASDAQ stock exchange thus satisfying the performance condition on its performance stock unit awards pursuant to FAS 123(R). As a result, we recognized $1,907,000 in stock-based compensation expense, representing the vested portion of the estimated fair value through December 31, 2006. The pre-established share price was determined based on the price of our common stock at the date of grant. The fair value of performance stock unit awards granted was estimated using the Monte Carlo simulation valuation model. As of December 31, 2007 all compensation cost related to these performance stock unit awards has been recognized over the expected vesting period, although adjustments have been recorded during the year ended December 31, 2007 for forfeitures of unvested shares.
The following table presents a summary of performance stock unit activity during the years ended December 31, 2006, 2007 and 2008:
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 11-STOCKHOLDERS’ EQUITY
Preferred Stock
We have 10,000,000 shares of authorized undesignated preferred stock, which may be issued in more than one series. Our Board of Directors is authorized to determine or alter the rights, preferences, privileges or restrictions granted to or imposed upon any un-issued series of preferred stock. As of December 2007 and 2008, no preferred shares were issued or outstanding.
Common Stock Repurchase Program
On November 8, 2006, our Board of Directors authorized a stock repurchase program for up to 1,250,000 shares of common stock, which expired on November 7, 2007. During 2006 and 2007, we purchased 183,400 shares and 80,100 shares for $2,581,000 and $1,120,000, respectively. Such amounts have been recorded in treasury stock in the accompanying consolidated balance sheet.
In addition, during 2007 and 2008 we withheld 176,192 shares and 141,069 shares of restricted stock as settlement of income taxes paid by MSC on behalf of employees totaling $2,432,000 and $1,479,000, respectively. Such amounts have been recorded in treasury stock in the accompanying consolidated balance sheet.
Shareholder Rights Plan
On October 6, 2008, our Board of Directors adopted a Rights Agreement (the “Rights Agreement”). As part of the Rights Agreement, the Board declared a dividend of one preferred stock purchase right (a “Right”) for each outstanding share of our common stock, payable to stockholders of record as of the close of business on October 16, 2008. These rights, which do not have any shareholder rights, including any voting or dividend rights will expire on October 16, 2018, unless we earlier redeem such rights prior to expiration at a price of $0.01 per right. The rights automatically transfer with a transfer of common stock until the time they become exercisable, which happens when certain specified events occur. If the rights become exercisable, they entitle the holders thereof to purchase for $55.00 (the “Purchase Price”), one one-hundreth of a share of Junior Participating Preferred Stock, and, if a party becomes an Acquiring person (as defined in the Rights Agreement), each right will entitle the holder thereof to purchase shares of common stock of the other party to such business combination or sale having a market value twice the Purchase Price, all subject to other provisions of the Rights Agreement.
Our Board of Directors adopted the Rights Agreement and declared the distribution of Rights in connection with the expiration of the previous stockholders rights plan that was in effect from October 16, 1998 until October 16, 2008.
NOTE 12- FAIR VALUE OF FINANCIAL INSTRUMENTS
On January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements”, except for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis pursuant to FSP 157-2. SFAS No. 157 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, SFAS No. 157 establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which requires us to develop our own assumptions. This hierarchy requires us to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value.
The carrying value of cash and cash equivalents, accounts receivable and trade payables approximates the fair value due to their short-term maturities
For recognition purposes, we measure our marketable equity securities at fair value on a recurring basis, as determined using quoted prices in active markets (Level 1) and/or significant unobservable inputs (Level 3) as presented in the table below. In May 2008, we sold our remaining investments in marketable equity securities of GSSL.
For disclosure purposes only, we are required to measure the fair value of outstanding debt on a recurring basis. The fair value of our subordinated notes payable represents the net present value of discounted cash flows. Our subordinated notes payable is reported at amortized cost in accordance with SFAS No. 107, “Disclosure about Fair Value of Financial Instruments,” and was $6,936,000 at December 31, 2007. The fair value of our subordinated notes payable was $7,455,000 at December 31, 2007. In December 2008, we repaid the remaining principal balance of the subordinated notes payable.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2007 and 2008 are summarized below (in thousands):
The fair values of the recurring financial assets and liabilities measured using Level 3 inputs changed during the year ended December 31, 2008 as follows (in thousands):
On a nonrecurring basis, we use fair value measures when analyzing asset impairment. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If it is determined such indicators are present and the review indicates that the assets will not be fully recoverable, based on undiscounted estimated cash flows over the remaining amortization periods, their carrying values are reduced to estimated fair value. During 2008, we recorded an impairment charge of $253,000 related to developed technologies. Refer to Note 4-Goodwill and Other Intangible Assets for further discussion.
Goodwill and indefinite-lived intangibles are tested for impairment annually or whenever events or circumstances make it more likely than not that impairment may have occurred. During 2008, we recorded an impairment charge of $9,698,000 of related to trademarks and trade names. Refer to Note 4-Goodwill and Other Intangible Assets for further discussion.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 13-COMMITMENTS AND CONTINGENCIES
Leases
We lease facilities and equipment under various lease agreements, which require the following minimum annual commitments (in thousands):
For the years ended December 31, 2006, 2007 and 2008, the cost for various facilities and equipment under operating leases was $16,910,000, $17,034,000 and $17,196,000, respectively. Although the above table reflects our obligation on leases until the end of its term, management expects that, in the normal course of business, most leases will be renewed or replaced by others.
We sublease all or part of some of our facilities to third parties. In 2006, 2007 and 2008, we recognized sublease income of $2,111,000, $1,785,000 and $1,594,000, respectively, which is included in our general and administrative expenses. Annual minimum rental commitments on these subleases are as follows (in thousands):
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Litigation
We are subject to and have initiated various claims and legal proceedings that arise in the ordinary course of our business. We are vigorously defending claims brought against us, and believe that we have adequately reserved for potential costs that may result from these matters, which are not considered material at December 31, 2008. Further, we are vigorously prosecuting actions brought by us. No assurance can be given, however, that the ultimate outcome of these claims will not have a material adverse effect on our financial condition or results of operations.
We are periodically audited by various taxing authorities in the United States of America and in other countries in which we do business. In August 2008, we were notified by tax auditors in Germany that we may not have withheld and remitted approximately $550,000 of VAT on sales to certain customers during the years 2004 through 2006. We have evaluated the merits of the tax authority’s position and believe we have adequately reserved for any payment that may result from this matter, which is not considered material at December 31, 2008.
Indemnifications
In the normal course of business, we provide indemnifications of varying scopes, including product warranties as well as indemnification of customers against claims of intellectual property infringement made by third parties arising from the use of its products or services. We accrue for known indemnification issues if a loss is probable and can be reasonably estimated. Historically, costs related to these indemnifications have been insignificant. But because potential future costs are highly variable, we are unable to estimate the maximum potential impact of these indemnifications on its future results of operations.
As permitted under Delaware law, MSC is authorized to provide for indemnification of its officers and directors for certain events or occurrences while the officer or director is, or was, serving at MSC’s request in such capacity. The term of the indemnification period is for the officer’s or director’s term in such capacity. The maximum potential amount of future payments we could be required to make for such indemnification is the fullest extent permitted by law; however, we have a director and officer insurance policy that limits our exposure and enables recovery of a portion of any future amounts paid in certain circumstances. As a result of the insurance policy coverage, we believe the estimated fair value of these indemnifications is minimal.
In connection with the issuance of our Convertible Notes, we agreed to indemnify the initial purchasers of the Convertible Notes against certain liabilities, including liabilities under the Securities Act, or to contribute to payments the initial purchasers may be required to make in respect of those liabilities. We believe the estimated fair value of this indemnification is minimal. Accordingly, there are no liabilities recorded for these types of liabilities as of December 31, 2006, 2007 and 2008.
Severance Compensation Agreements
As of December 31, 2008, we have Severance Compensation agreements (“Agreements”) with eighteen employees. These Agreements, subject to annual review by our Board of Directors, are automatically extended in one year increments unless canceled by us 60 days prior to the end of the calendar year. These Agreements provide for specified benefits in the event of a Change in Control, as defined in the Agreements. Mr. Weyand also has a change in control provision in his employment contract. For Messrs. Weyand, Wienkoop, Mongelluzzo, Auriemma, Gorrell and Mobayen, these Agreements and employment contract provide 2.5 times annual salary and bonus in the event of termination for other than Cause (as defined) or by the executive for other than Good Reason (as defined) within two years following a Change in Control (as defined). In addition, these individuals would receive a “gross-up-payment” for any excise tax imposed by Section 4999 of the Internal Revenue Code. In addition, one employee would be entitled to a 2.0 multiple under the Agreements but are not subject to a gross-up-payment. Twelve other employees would be entitled to a 1.0 multiple under the Agreements but are not subject to a gross-up-payment. The Agreements also provide for additional benefits including continued health care benefits. In accordance with his employment contract, Mr. Weyand would be entitled to one time his annual salary and one year of health care benefits if terminated for other than cause when there has been no change in control.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 14-EARNINGS (LOSS) PER SHARE
The following table sets forth the computation of basic and diluted earnings (loss) per share for the years ended December 31, 2006, 2007 and 2008 (in thousands, except per share data):
Refer to Note 7-Long-Term Debt for additional disclosures regarding the subordinated convertible notes, and Note 10-Stock Compensation for discussion of employee stock options and restricted stock units.
Options to purchase 960,550 shares, 3,640,470 shares and 3,353,369 shares of the our common stock for 2006, 2007 and 2008, respectively, were not included in the computation of diluted earnings (loss) per share as the exercise prices of the options were greater than the average market price of the common stock for each respective year and, as a result, the effect on earnings per share would be anti-dilutive.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 15-DISCONTINUED OPERATIONS AND SALE OF LONG-LIVED ASSETS
ESTECH Corporation
In the fourth quarter of 2005, we approved a plan to sell our wholly owned Japanese service subsidiary, ESTECH Corporation (“ESTECH”). Accordingly, ESTECH has been presented as a discontinued operation within the consolidated financial statements in accordance with SFAS No. 144, “ Accounting for the Impairment or Disposal of Long-Lived Assets “. 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.
In January 2006, we entered into a Stock Sale and Purchase Agreement to sell ESTECH to Information Services International-Dentsu, Ltd. (ISID), a reseller of our product. In March 2006, the sale was consummated and we received 1.2 billion Yen, or approximately $10.2 million, resulting in an estimated loss of $1,110,000, which was accrued as of December 31, 2005 and recorded as a loss from disposal of discontinued operations.
The results of the discontinued operations of ESTECH included in the accompanying consolidated statements of operations for the year ended December 31, 2006 are as follows (in thousands):
There were no assets or liabilities of ESTECH included in the consolidated balance sheets as of December 31, 2007.
Systems Business
In 2003, we discontinued our Systems business and recorded restructuring charges of $3,548,000, including $2,027,000 for workforce reductions and $1,521,000 related to closing or consolidating facilities. As of December 31, 2007 and 2008, the restructuring reserve totaled $149,000 and $92,000 respectively, and relates to remaining lease obligations that will terminate in 2010.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following is the activity in the restructuring reserve related to discontinued operations of the Systems business during 2006, 2007 and 2008 (in thousands):
The adjustment of $276,000 in 2007 represents a reversal of the restructuring reserve related to a facility that we re-occupied in January 2007. Accordingly, such amount, net of tax is reflected in the results of discontinued operations in the accompanying consolidated statements of operations.
In June 2007, we reversed a previously established accrued liability of $1,383,000 related to a contractual claim pursuant to the statute of limitation applicable to such potential claim. Accordingly, such amount, net of tax is reflected in the results of discontinued operations in the accompanying consolidated statements of operations
PLM Assets
In March and October 2006, we completed the sales of certain assets of our PLM business in North America and Europe, respectively, and recorded an aggregate pre-tax gain of approximately $4,640,000, which is included in general and administrative expenses in the accompanying consolidated statements of operations. The PLM business primarily included reselling PLM software, including CATIA, ENOVIA, and SMARTEAM software and providing implementation services to efficiently and effectively deploy such software.
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 16-SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is selected unaudited quarterly financial data for the years ended December 31, 2008 and 2007 (in thousands, except per share data).
MSC.SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
MSC.Software Corporation
Santa Ana, CA
We have audited the accompanying consolidated balance sheets of MSC.Software Corporation and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2008. Our audits also included the financial statement schedule listed in the Index at Item 15. We also have audited the Company’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and financial statement schedule and an opinion on the Company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of MSC.Software Corporation and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
As discussed in Note 12 to the consolidated financial statements, in 2008, the Company adopted Financial Accounting Standards Board (“FASB”) Statement No. 157, Fair Value Measurements. Further, as discussed in Note 1 to the consolidated financial statements, in 2007, the Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FAS 109, Accounting for Income Taxes and as discussed in Note 9 to the consolidated financial statements, in 2006, the Company adopted FASB Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statement No. 87, 88, 106 and 132(R).
/s/ DELOITTE & TOUCHE LLP
Costa Mesa, California
March 13, 2009
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our interim Chief Executive Officer and Chief Financial Officer have evaluated our disclosure controls and procedures as of December 31, 2008 and have concluded that these disclosure controls and procedures were effective as of December 31, 2008 to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (ii) accumulated and communicated to management, including the interim Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2008.
Deloitte & Touche LLP, the independent registered public accounting firm that audited the financial statements included herein, has issued an attestation report on our internal control over financial reporting, as stated in their report which is included on page 78 herein.
Changes in Internal Controls
There were no changes in our internal control over financial reporting that occurred during the fourth quarter of 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
Not Applicable
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Directors of MSC
Information about our Directors is incorporated by reference from the section entitled “Election of Directors” in our Proxy Statement for the 2009 Annual Meeting of Stockholders to be filed with the SEC within 120 days of December 31, 2008 (the “Proxy Statement”).
The information to be included in the section entitled “Corporate Governance-Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement is incorporated herein by reference.
The information to be included in the section entitled “Corporate Governance-Code of Ethics” in the Proxy Statement is incorporated herein by reference.
The information to be included in the section entitled “Corporate Governance-Board Meetings, Committees and Committee Composition-Audit Committee” in the Proxy Statement is incorporated herein by reference.
Executive Officers of MSC
For information required by this Item regarding our executive officers, see Item 1 of Part I of this report entitled “Business,” which is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information to be included in the sections entitled “Executive Compensation,” “Corporate Governance-Director Compensation,” “Corporate Governance-Compensation Committee Interlocks and Insider Participation” and “Executive Compensation-Report of the Compensation Committee” in the Proxy Statement is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information to be included in the section entitled “Security Ownership of Certain Beneficial Owners and Management” in the Proxy Statement is incorporated herein by reference.
The information to be included in the section entitled “Equity Compensation Plan Information” in the Proxy Statement is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information to be included in the section entitled “Certain Relationships and Related Transactions” in the Proxy Statement is incorporated herein by reference.
The information to be included in the section entitled “Corporate Governance-Board Independence and Meetings” in the Proxy Statement is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information to be included in the section entitled “Proposal Two. Ratification of the Appointment of Deloitte & Touche LLP, as the Company’s Independent Registered Public Accounting Firm-Fees Paid to Independent Registered Public Accounting Firm” in the Proxy Statement is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
Item 15(a) 1. Financial Statements
The following consolidated financial statements of MSC.Software Corporation, as included in this Report, are included in Item 8.
Consolidated Balance Sheets as of December 31, 2007 and 2008
Consolidated Statements of Operations for the Years Ended December 31, 2006, 2007 and 2008
Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2006, 2007 and 2008
Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2007 and 2008
Notes to Consolidated Financial Statements
Independent Registered Public Accounting Firms’ Reports
Item 15(a) 2. Financial Statement Schedules
Schedule II-Consolidated Valuation and Qualifying Accounts and Reserves
All other schedules have been omitted because the information either has been shown in the consolidated financial statements or notes thereto, or is not applicable or required under the instructions.
Item 15(a) 3. Exhibits
* Denotes management contract or compensatory plan.
** Indicates filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
MSC.SOFTWARE CORPORATION
(Registrant)
Dated: March 13, 2009
By:
/s/ ASHFAQ A. MUNSHI
ASHFAQ A. MUNSHI
Interim Chief Executive Officer & President
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
Dated: March 13, 2009
By:
WILLIAM J. WEYAND
Director
Schedule II-Consolidated Valuation and Qualifying Accounts and Reserves
For the Years Ended December 31, 2006, 2007 and 2008
(in thousands)