In the days before software, if engineers wanted to know if an idea worked, they would first have to build a three-dimensional physical model.
But this method had one major flaws: not everything scales linearly. What worked fine on a smaller scale may turn into a disaster when made larger.
Thankfully, today, we have simulation software for engineers that allows them to correctly assess scaling, among other things. In fact, this is an $8 billion market globally.
Yet, the largest engineering simulation company in the world remains relatively unknown by investors. I know it because it is located not far from where I live, in western Pennsylvania…
Good Times for Ansys
The company is Ansys (ANSS), which was founded in 1970. Here’s how it describes its mission on its website: “For more than 50 years, Ansys software has enabled innovators across industries to push boundaries by using the predictive power of simulation. From sustainable transportation to advanced semiconductors, from satellite systems to life-saving medical devices, the next great leaps in human advancement will be powered by Ansys.”
Ansys’s leading cloud-based software product is sold to a wide range of industrial companies, including aerospace, automotive, energy, and semiconductors businesses. Customers license Ansys’s software on fixed contracts, providing annuity-like income for the company. Customers that require more complex computations, use more products, or need to add more users pay Ansys more.
Along with economic growth, the main macro indicator for whether Ansys is doing well or not is total research & development (R&D) spending across industrialized economies. That means the relatively recent passage the Inflation Reduction Act and the Chips and Science Act were great news for Ansys. Add in the reshoring of industries from China and the Russian invasion of Ukraine, and you have substantial increases in spending on the energy, military, and semiconductor industries in a bid to increase national security.
Ansys is already feeling the effects. In the second quarter, the company’s biggest revenue contributors by industry were semiconductors at 31%, aerospace at 23%, automotive at 17% and energy at 9%. The rest was split between industrial equipment, chemicals, and construction.
Most recently, Ansys has seen strong momentum in sales to the aerospace and defense industry, which is being boosted by increased travel demand following the pandemic.
While a lot of its business is domestic, Ansys is also very exposed to three other highly-industrialized countries: South Korea, Japan, and Germany. All three countries have announced large investments in their semiconductor industries.
In the second quarter, the U.S. accounted for 44% of Ansys’s revenue, with 8% coming from Germany and 13% from Japan. Around 10% was from South Korea, with the rest coming from the remaining European countries.
The Nvidia and AI effect is also positively affecting Ansys.
According to its management, the increased complexity of semiconductors has boosted demand for 3D simulation. For example, graphics processing units (GPUs) are designed on a nanometer (nm) scale, to accommodate as many cores as possible, but are then stacked together with memory chips to form a data center. This changing scale creates electromagnetic interference, which all needs to be simulated.
Ansys semiconductor customers include leading designers and foundries, such as Samsung and Taiwan Semiconductor (TSM). For example, Samsung certified Ansys’s Redhawk technology, which simulates thermal analysis to spot where there could be a voltage drop in the circuit, for its most advanced “2nm” process.
Ansys: Growing Steadily
Even before the boom in investments into semiconductors and other strategic sectors, Ansys had been growing consistently year on year. Between 2019 and 2022, sales increased 36% to $2 billion while operating profit was up 16% to $603 million. The company’s operating margin has hovered around 30% for the past decade, which is among the sector’s best.
And it continues to spend to remain on top of the sector.
Since 2017, the company has spent almost all of the $3 billion it generated in free cash flow towards acquisitions. This year, it acquired German automotive simulation software business DYNAmore and American semiconductor simulation company Diakopto, whose software spots bottlenecks and faults in semiconductor designs before they go into manufacturing.
Ansys’s own R&D spend is also ahead of the industry average. In the past year, R&D was $465 million, which was 21% of its $2.2 billion of revenue. This figure has consistently been above 20% for the past few years, while the software industry average is usually nearer 10%.
This spending is deepening the Buffett-type moat around Ansys’s business. As the market leader in 3D simulation software, Ansys has already built formidable barriers to would-be competitors. Like Microsoft’s Excel spreadsheet software, the ubiquity and quality of its software make it the default product for many businesses and engineers.
While the traditional simulation market is mature, Ansys’s total addressable market continues to grow at a healthy rate. Ansys’s core simulation total addressable market could double from 2022 to 2032, reaching $16 billion by 2032.
Ansys has made it a point to expose itself to new growth areas, including simulation needs for electrification of vehicles and 5G systems. In addition, simulation plays an integral part in “Internet of Things” predictive maintenance and digital twins, in which Ansys is positioning itself to meet future demand.
It should not come as a surprise, then, that Ansys stock has a premium—but not outrageous—valuation. Wall Street estimates are for revenue to rise to $2.53 billion in 2024, thanks to its strong and growing backlog of orders. Estimates are for earnings per share (EPS) to rise to $9.68 a share, a rise of 21% from 2022. That means Ansys’s 2025 price/earnings ratio is about 29. That is high, but its price to free cash flow is almost exactly the same, making it look a little more reasonable.
ANSS stock is a buy in the $300 to $320 range.