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ANSYS INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Overview ANSYS, Inc.'s results for the year ended December 31, 2012 reflect growth in revenues of 15.4%, operating income of 10.8% and diluted earnings per share of 12.0% as compared to the year ended December 31, 2011. The Company experienced higher revenues in 2012 from growth in both license and maintenance revenue, and from the acquisition of Apache in 2011 and Esterel in 2012. The 2012 results of operations include the results of Esterel for the period from the date of acquisition (August 1, 2012) through December 31, 2012. The 2012 results of operations include a full year of Apache results, as compared to five months of activity in 2011. The growth in revenue was adversely impacted by the overall strengthening of the U.S. Dollar against the Company's primary foreign currencies. The net overall strengthening of the U.S. Dollar resulted in decreased revenue and operating income by $15.4 million and $7.4 million, respectively, for the year ended December 31, 2012 as compared to the year ended December 31, 2011. The growth in revenue was partially offset by increased operating expenses and additional amortization from intangible assets related to the Apache and Esterel acquisitions. The Company's non-GAAP results for the year ended December 31, 2012 reflect increases in revenue of 15.2%, operating income of 14.9% and diluted earnings per share of 15.0% as compared to the year ended December 31, 2011. The non-GAAP results exclude the income statement effects of the acquisition accounting adjustment to deferred revenue, stock-based compensation, acquisition-related amortization of intangible assets and transaction costs related to business combinations. For further disclosure regarding non-GAAP results, see the section titled "Non-GAAP Results" immediately preceding the section titled "Liquidity and Capital Resources". During the year ended December 31, 2012, the Company repurchased 1.5 million shares of treasury stock for $95.5 million at an average price of $63.65 per share and had net acquisition-related cash outlays of $45.1 million. The Company's financial position includes $577.2 million in cash and short-term investments, and working capital of $436.0 million as of December 31, 2012. As of December 31, 2012, remaining outstanding borrowings on the Company's term loan totaled $53.1 million. ANSYS develops and globally markets engineering simulation software and services widely used by engineers, designers, researchers and students across a broad spectrum of industries and academia, including aerospace, automotive, manufacturing, electronics, biomedical, energy and defense. Headquartered south of Pittsburgh, Pennsylvania, the Company and its subsidiaries employed approximately 2,400 people as of December 31, 2012 and focus on the development of open and flexible solutions that enable users to analyze designs directly on the desktop, providing a common platform for fast, efficient and cost-conscious product development, from design concept to final-stage testing and validation. The Company distributes its ANSYS suite of simulation technologies through a global network of independent channel partners and direct sales offices in strategic, global locations. It is the Company's intention to continue to maintain this hybrid sales and distribution model. The Company licenses its technology to businesses, educational institutions and governmental agencies. Growth in the Company's revenue is affected by the strength of global economies, general business conditions, currency exchange rate fluctuations, customer budgetary constraints and the competitive position of the Company's products. Please see the sub-sections entitled "Global Economic Conditions," "Decline in Customers' Business," "Risks Associated with International Activities," "Rapidly Changing Technology; New Products; Risk of Product Defects" and "Competition" under Item 1A. Risk Factors above for a complete discussion of how these factors might impact the Company's financial condition and operating results. The Company believes that the features, functionality and integrated multiphysics capabilities of its software products are as strong as they have ever been. However, the software business is generally characterized by long sales cycles. These long sales cycles increase the difficulty of predicting sales for any particular quarter. The Company makes many operational and strategic decisions based upon short- and long-term sales forecasts that are impacted not only by these long sales cycles but by current global economic conditions. As a result, the Company believes that its overall performance is best measured by fiscal year results rather than by quarterly results. Please see the sub-section entitled "Sales Forecasts" under Item 1A. Risk Factors above for a complete discussion of the potential impact of the Company's sales forecasts on the Company's financial condition, cash flows and operating results. The Company's management considers the competition and price pressure that it faces in the short- and long-term by focusing on expanding the breadth, depth, ease of use and quality of the technologies, features, functionality and integrated multiphysics capabilities of its software products as compared to its competitors; investing in research and development to develop new and innovative products and increase the capabilities of its existing products; supplying new products and services; focusing on customer needs, training, consulting and support; and enhancing its distribution channels. From time to time, the Company also considers acquisitions to supplement its global engineering talent, product offerings and distribution channels. 22-------------------------------------------------------------------------------- Table of Contents Geographic Trends: During the year ended December 31, 2012 North America contributed consistent and strong revenue growth. In addition, despite the ongoing macroeconomic concerns in Europe, the overall sales pipeline, renewal rates and customer engagements remained intact. Revenue growth for the year was particularly strong in Germany and the United Kingdom when compared to the prior year. While overall, the Company's General International Area, which includes all geographies other than North America and Europe, has continued to show improvement, the Company's growth in the Japan market has slowed due to the strength of the Japanese Yen and a general weakness in consumer electronics. Japan is the Company's second largest market and, as such, the Company is focused on and has made progress on its Japan organizational recovery plan. China, Korea and Taiwan were also notable areas of sales strength during the year. Industry Highlights: During the year ended December 31, 2012, the Company had growth from a combination of large accounts, multi-nationals, emerging markets and industry verticals with time-sensitive, complex, multiphysics challenges. The Company's revenue is derived from customers in many different industries, with no industry accounting for more than 20% of the Company's sales. Although customers from all industries contributed to the 2012 results, there were a few sectors where the activity was more notable than the others, as explained below. Automotive The Company experienced growth in the automotive industry, particularly in North America and its General International Area. A variety of factors positively affected the automotive sector from a simulation perspective, including rising gas prices and government regulations. These factors caused, and continue to cause, increased technology development with respect to higher mileage cars, including suppliers accelerating electric vehicle and hybrid electric vehicle component development. In addition, customers are making investments in high growth product areas such as wireless connectivity, smart products, systems design, engine and transmission efficiency improvements, emissions reductions and hydraulics, all of which are areas requiring the breadth and depth of the Company's product portfolio. Aerospace and Defense Despite uncertainty around the future size of the U.S. Department of Defense budget, aerospace and defense remained strong across most regions, including North America. Shrinking defense spending, volatile security environments, fuel cost spikes and increased regulations are driving systems engineering, green product development and operational cost reduction initiatives. Geopolitical drivers and non-state actors in the Middle East, Eastern Europe and Asia have changed the nature of warfare. This has led to a significant investment in the development of remote and lower-human-risk intelligence, surveillance and reconnaissance technologies such as unmanned military satellites and advanced sensors, along with supporting infrastructures. Commercial space exploration provided opportunities for the Company's portfolio of solutions. Key areas of investment in both commercial and military aerospace, including engine and aerodynamic efficiency, the development of bio-fuels, the validation of design processes for new lightweight materials, the development of electronic systems, noise control technologies and quality control all require the need for more robust simulation requiring the use of the Company's software. Electronics and Semiconductors The Company has seen some recovery in the electronics and semiconductor sectors, with a variety of market trends and initiatives driving the need for simulation. The exploding global demand for increased functionality, higher reliability and performance within ever-smaller, more portable devices is placing new demands on designers and is providing ANSYS with outstanding opportunities for growth well into the future. Engineers designing portable electronic devices like smart phones and tablets are driving an industry trend to integrate rich digital content with wireless connectivity and extended battery life. Modern systems integrate Radio Frequency ("RF")/Analog/Digital System on Chip solutions with memory, graphics, storage, Global System for Mobile Communications radio, Bluetooth, antenna, LCD, camera, MP3 and broadcast FM. Extreme integration creates new challenges for RF performance, system signal integrity, system-level electromagnetic interference, low power, and communications reliability. ANSYS's ability to combine multiphysics, circuit and embedded software simulation in a cohesive software offering is especially tailored to meet the exacting demands of electronic design. Note About Forward-Looking Statements The following discussion should be read in conjunction with the audited consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K. The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to fair value of stock, bad debts, contract revenue, valuation of goodwill, valuation of 23-------------------------------------------------------------------------------- Table of Contents intangible assets, income taxes, and contingencies and litigation. The Company bases its estimates on historical experience, market experience, estimated future cash flows and on various other assumptions that management believes are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, but not limited to, the following statements, as well as statements that contain such words as "anticipates," "intends," "believes," "plans" and other similar expressions: • The Company's expectation that it will continue to make targeted investments in its global sales and marketing organization and its global business infrastructure to enhance major account sales activities and to support its worldwide sales distribution and marketing strategies, and the business in general. • The Company's intentions related to investments in research and development, particularly as it relates to expanding the capabilities of its flagship products and other products within its broad portfolio of simulation software, evolution of its ANSYS® Workbench™ platform, HPC capabilities, robust design and ongoing integration. • The Company's plans related to future capital spending. • The Company's intentions regarding its hybrid sales and distribution model. • The sufficiency of existing cash and cash equivalent balances to meet future working capital, capital expenditure and debt service requirements. • The Company's assessment of the ultimate liabilities arising from various investigations, claims and legal proceedings. • The Company's statement regarding the competitive position and strength of its software products. • The Company's assessment of its ability to realize deferred tax assets. • The Company's expectation that it can renew existing leases as they expire, or find alternative facilities without difficulty as needed. • The Company's expectations regarding future claims related to indemnification obligations. • The Company's estimates regarding expected interest expense on its term loan. • The Company's statements regarding the impact of global economic conditions. • The Company's statement regarding increased exposure to volatility of foreign exchange rates. • The Company's intentions related to investments in complementary companies, products, services and technologies. • The Company's expectations regarding the impact of the merger of its Japan subsidiaries on future income tax expense and cash flows from operations. • The Company's estimates regarding the expected impact on reported revenue related to the acquisition accounting treatment of deferred revenue. • The Company's estimation that it is probable the key member of Apache's management will remain an employee of ANSYS on each of the first three anniversaries of the acquisition closing date. • The Company's anticipation that Apache will achieve certain revenue and operating income targets whereby it is probable that at least a portion of the performance-based restricted stock units will vest and that the recipients will continue employment through the measurement period. • The Company's expectations regarding the accelerated development and delivery of new and innovative products to the marketplace while lowering design and engineering costs for customers as a result of the Esterel acquisition. Forward-looking statements should not be unduly relied upon because they involve known and unknown risks, uncertainties and other factors, some of which are beyond the Company's control. The Company's actual results could differ materially from those set forth in the forward-looking statements. Certain factors that might cause such a difference include risks and uncertainties detailed in Item 1A. Risk Factors. 24-------------------------------------------------------------------------------- Table of Contents Acquisitions Esterel Technologies, S.A. On August 1, 2012, the Company completed its acquisition of Esterel. Under the terms of the acquisition agreement, ANSYS acquired 100% of Esterel for a purchase price of $58.2 million, which included $13.1 million in acquired cash. The acquisition agreement also includes retention provisions for key members of Esterel's management and employees, which are accounted for outside of the business combination. The Company funded the transaction entirely with existing cash balances. Esterel's software enables software and systems engineers to design, simulate and automatically produce certified embedded software, which is the control code built into the electronics in aircraft, rail transportation, automotive, energy systems, medical devices and other industrial products that have central processing units. The complementary combination is expected to accelerate development of new and innovative products to the marketplace while lowering design and engineering costs for customers. The operating results of Esterel have been included in the Company's consolidated financial statements since the date of acquisition, August 1, 2012. The assets and liabilities of Esterel have been recorded based upon management's estimates of their fair market values as of the acquisition date. The following tables summarize the fair value of consideration transferred and the fair values of identified assets acquired and liabilities assumed at the acquisition date: Fair Value of Consideration Transferred: (in thousands) Cash $ 58,150 Recognized Amounts of Identifiable Assets Acquired and Liabilities Assumed: (in thousands) Cash $ 13,075 Accounts receivable and other tangible assets 4,737 Customer relationships (12-year life) 21,421 Developed software (10-year life) 10,717 Platform trade name (indefinite life) 2,695 Accounts payable and other liabilities (4,936 ) Deferred revenue (1,139 ) Net deferred tax liabilities (9,286 ) Total identifiable net assets $ 37,284 Goodwill $ 20,866 Apache Design, Inc. On August 1, 2011, the Company completed its acquisition of Apache, a leading simulation software provider for advanced, low-power solutions in the electronics industry. Under the terms of the merger agreement, ANSYS acquired 100% of the outstanding shares of Apache for a purchase price of $314.0 million, which included $31.9 million in acquired cash and short-term investments on Apache's balance sheet, $3.2 million in ANSYS replacement stock options issued to holders of partially-vested Apache stock options and $9.5 million in contingent consideration that is based on the retention of a key member of Apache's management. The Company funded the transaction entirely with existing cash balances. The operating results of Apache have been included in the Company's consolidated financial statements since the date of acquisition, August 1, 2011. 25-------------------------------------------------------------------------------- Table of Contents The assets and liabilities of Apache have been recorded based on management's estimates of their fair market values as of the acquisition date. The following tables summarize the fair value of consideration transferred and the fair values of identifiable assets acquired and liabilities assumed at the acquisition date: Fair Value of Consideration Transferred: (in thousands) Cash $ 301,306 Contingent consideration 9,501 ANSYS replacement stock options 3,170 Total consideration transferred at fair value $ 313,977 Recognized Amounts of Identifiable Assets Acquired and Liabilities Assumed: (in thousands) Cash and short-term investments $ 31,948 Accounts receivable and other tangible assets 6,011 Developed software (7-year life) 82,500 Customer relationships (15-year life) 36,100 Contract backlog (3-year life) 13,500 Platform trade names (indefinite lives) 21,900 Apache trade name (6-year life) 2,100 Accounts payable and other liabilities (16,867 ) Deferred revenue (10,100 ) Net deferred tax liabilities (47,229 ) Total identifiable net assets $ 119,863 Goodwill $ 194,114 In valuing deferred revenue on the Apache and Esterel balance sheets as of their respective acquisition dates, the Company applied the fair value provisions applicable to the accounting for business combinations. Although this acquisition accounting requirement had no impact on the Company's business or cash flow, the Company's reported revenue under GAAP, primarily for the first 12 months post-acquisition, will be less than the sum of what would otherwise have been reported by Apache, Esterel and ANSYS absent the acquisitions. Acquired deferred revenue of $10.1 million and $1.1 million were recorded on the opening balance sheets of Apache and Esterel, respectively. Collectively, these amounts were $24.6 million lower than their historical carrying values. The impact on reported revenue for the year ended December 31, 2012 was $9.6 million. The expected impact on reported revenue is $1.8 million and $4.6 million for the quarter ending March 31, 2013 and the year ending December 31, 2013, respectively. 26-------------------------------------------------------------------------------- Table of Contents Results of Operations For purposes of the following discussion and analysis, the table below sets forth certain consolidated financial data for the years 2012, 2011 and 2010. The operating results of Esterel and Apache have been included in the results of operations since their respective acquisition dates of August 1, 2012 and 2011. Year Ended December 31, (in thousands) 2012 2011 2010 Revenue: Software licenses $ 501,870 $ 425,881 $ 351,033 Maintenance and service 296,148 265,568 229,203 Total revenue 798,018 691,449 580,236 Cost of sales: Software licenses 24,512 15,884 10,770 Amortization 40,889 33,728 32,757 Maintenance and service 74,115 69,402 57,352 Total cost of sales 139,516 119,014 100,879 Gross profit 658,502 572,435 479,357 Operating expenses: Selling, general and administrative 205,178 180,357 155,096 Research and development 132,628 108,530 88,990 Amortization 26,443 17,989 16,003 Total operating expenses 364,249 306,876 260,089 Operating income 294,253 265,559 219,268 Interest expense (2,661 ) (3,332 ) (4,488 ) Interest income 3,360 3,000 1,911 Other expense, net (1,405 ) (369 ) (297 ) Income before income tax provision 293,547 264,858 216,394 Income tax provision 90,064 84,183 63,262 Net income $ 203,483 $ 180,675 $ 153,132 27-------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2012 Compared to Year Ended December 31, 2011 Revenue: Year Ended December 31, Change (in thousands, except percentages) 2012 2011 Amount % Revenue: Lease licenses $ 279,283 $ 218,005 $ 61,278 28.1 Perpetual licenses 222,587 207,876 14,711 7.1 Software licenses 501,870 425,881 75,989 17.8 Maintenance 275,498 246,546 28,952 11.7 Service 20,650 19,022 1,628 8.6 Maintenance and service 296,148 265,568 30,580 11.5 Total revenue $ 798,018 $ 691,449 $ 106,569 15.4 The Company's revenue increased 15.4% in 2012 as compared to 2011, including increases in all major revenue categories. The Company's revenue included Apache operations for the full year in 2012 of $62.0 million as compared to five months in 2011 of $14.5 million. The growth was partially influenced by benefits from the Company's continued investment in its global sales and marketing organization. Revenue from lease licenses increased 28.1% as compared to the prior year due to an increase in Apache-related lease license revenue and growth in sales of other lease licenses. Annual maintenance contracts that were sold with new perpetual licenses, along with maintenance contracts sold with new perpetual licenses in previous years, contributed to maintenance revenue growth of 11.7%. Perpetual license revenue, which is derived entirely from new sales during the period, increased 7.1% as compared to the prior year. Esterel-related revenue for the period from the acquisition date (August 1, 2012) through December 31, 2012 was $3.3 million. Service revenue increased 8.6% as compared to the prior year, primarily from increased revenue associated with engineering consulting services. With respect to revenue, on average for the year ended December 31, 2012, the U.S. Dollar was 3.7% stronger, when measured against the Company's primary foreign currencies, than for the year ended December 31, 2011. The net overall strengthening of the U.S. Dollar resulted in decreased revenue and operating income during 2012, as compared to 2011, of $15.4 million and $7.4 million, respectively. A substantial portion of the Company's license and maintenance revenue is derived from annual lease and maintenance contracts. These contracts are generally renewed on an annual basis and typically have a high rate of customer renewal. In addition to the recurring revenue base associated with these contracts, a majority of customers purchasing new perpetual licenses also purchase related annual maintenance contracts. As a result of the significant recurring revenue base, the Company's license and maintenance revenue growth rate in any period does not necessarily correlate to the growth rate of new license and maintenance contracts sold during that period. To the extent the rate of customer renewal for lease and maintenance contracts is high, incremental lease contracts, and maintenance contracts sold with new perpetual licenses, will result in license and maintenance revenue growth. Conversely, if the rate of renewal for these contracts is adversely affected by economic or other factors, the Company's license and maintenance growth will be adversely affected over the term that the revenue for those contracts would have otherwise been recognized. The Company had a backlog of $55.2 million and $56.3 million of orders received but not invoiced as of December 31, 2012 and 2011, respectively. International and domestic revenues, as a percentage of total revenue, were 66.7% and 33.3%, respectively, during the year ended December 31, 2012, and 68.8% and 31.2%, respectively, during the year ended December 31, 2011. The Company derived 26.0% and 26.4% of its total revenue through the indirect sales channel for the years ended December 31, 2012 and 2011, respectively. In valuing deferred revenue on the Esterel and Apache balance sheets as of their respective acquisition dates, the Company applied the fair value provisions applicable to the accounting for business combinations resulting in lower amounts of revenue than Esterel and Apache would have recognized absent the acquisitions. The impact on reported revenue for the year ended December 31, 2012 was $9.6 million. 28-------------------------------------------------------------------------------- Table of Contents Cost of Sales and Gross Profit: Year Ended December 31, 2012 2011 Change (in thousands, except % of % of percentages) Amount Revenue Amount Revenue Amount % Cost of sales: Software licenses $ 24,512 3.1 $ 15,884 2.3 $ 8,628 54.3 Amortization 40,889 5.1 33,728 4.9 7,161 21.2 Maintenance and service 74,115 9.3 69,402 10.0 4,713 6.8 Total cost of sales 139,516 17.5 119,014 17.2 20,502 17.2 Gross profit $ 658,502 82.5 $ 572,435 82.8 $ 86,067 15.0 Software Licenses: The increase in software license costs was primarily due to the following: • Increased Apache-related costs of $7.3 million, primarily as a result of a full year of Apache activity in 2012 as compared to five months of activity in 2011. • A $900,000 increase in stock-based compensation. • Esterel-related cost of sales of $600,000 for the period from the acquisition (August 1, 2012) through December 31, 2012. Amortization: The increase in amortization expense was primarily due to the following: • An additional $9.5 million of amortization of acquired Apache software as a result of a full year of Apache activity in 2012 as compared to five months of activity in 2011. • A net $2.8 million decrease in amortization of other acquired software, including Esterel. Maintenance and Service: The increase in maintenance and service costs was primarily due to the following: • Increased salaries and headcount-related costs of $2.3 million. • Increased depreciation expense of $700,000. • Esterel-related maintenance and service expenses of $600,000 for the period from the acquisition (August 1, 2012) through December 31, 2012. The improvement in gross profit was a result of the increase in revenue offset by a smaller increase in related cost of sales. 29-------------------------------------------------------------------------------- Table of Contents Operating Expenses: Year Ended December 31, 2012 2011 Change (in thousands, except % of % of percentages) Amount Revenue Amount Revenue Amount % Operating expenses: Selling, general and administrative $ 205,178 25.7 $ 180,357 26.1 $ 24,821 13.8 Research and development 132,628 16.6 108,530 15.7 24,098 22.2 Amortization 26,443 3.3 17,989 2.6 8,454 47.0 Total operating expenses $ 364,249 45.6 $ 306,876 44.4 $ 57,373 18.7 Selling, General and Administrative: The increase in selling, general and administrative costs was primarily due to the following: • Increased salaries and headcount-related costs of $9.6 million. • Increased Apache-related expenses of $6.2 million, primarily as a result of a full year of Apache activity in 2012 as compared to five months of activity in 2011. • Esterel-related selling, general and administrative expenses of $5.5 million for the period from the acquisition (August 1, 2012) through December 31, 2012. • Increased stock-based compensation of $2.8 million. The Company anticipates that it will continue to make targeted investments in its global sales and marketing organization and its global business infrastructure to enhance major account sales activities and to support its worldwide sales distribution and marketing strategies, and the business in general. Research and Development: The increase in research and development costs was primarily due to the following: • Increased Apache-related expenses of $9.2 million, primarily as a result of a full year of Apache activity in 2012 as compared to five months of activity in 2011. • Increased salaries and headcount-related costs of $6.6 million. • Increased stock-based compensation expense of $5.3 million. • Increased depreciation expense of $1.5 million. • Esterel-related research and development expenses of $1.4 million for the period from the acquisition (August 1, 2012) through December 31, 2012. • Decreased incentive compensation of $1.7 million. The Company has traditionally invested significant resources in research and development activities and intends to continue to make investments in this area, particularly as it relates to expanding the capabilities of its flagship products and other products within its broad portfolio of simulation software, evolution of its ANSYS® Workbench™ platform, HPC capabilities, robust design and ongoing integration. Amortization: The increase in amortization expense was primarily due to the following: • An additional $9.1 million of amortization of acquired Apache intangible assets, including customer lists, contract backlog and a trade name, as a result of a full year of Apache activity in 2012 as compared to five months of activity in 2011. • A net $500,000 decrease in amortization of other acquired customer lists, including Esterel. 30-------------------------------------------------------------------------------- Table of Contents Interest Expense: The Company's interest expense consists of the following: Year Ended December 31, (in thousands) 2012 2011 Term loan $ 1,342 $ 1,605 Amortization of debt financing costs 698 953 Discounted obligations 546 462 Other 75 312 Total interest expense $ 2,661 $ 3,332 Interest Income: Interest income for the year ended December 31, 2012 was $3.4 million as compared to $3.0 million during the year ended December 31, 2011. Interest income increased as a result of both an increase in the average cash balances and the rate of return on those balances. Other Expense, net: The Company recorded other expense of $1.4 million during the year ended December 31, 2012 as compared to $369,000 during the year ended December 31, 2011. The activity for both years was primarily composed of net foreign currency transaction losses on transactions denominated in a currency other than the Company or its subsidiaries' functional currency. Income Tax Provision: The Company recorded income tax expense of $90.1 million and had income before income taxes of $293.5 million for the year ended December 31, 2012, representing an effective tax rate of 30.7%. During the year ended December 31, 2011, the Company recorded income tax expense of $84.2 million and had income before income taxes of $264.9 million, representing an effective tax rate of 31.8%. When compared to the federal and state combined statutory rate, these rates were favorably impacted by lower statutory tax rates in many of the Company's foreign jurisdictions, the domestic manufacturing deduction, research and experimentation credits and tax benefits associated with the merger of the Company's Japan subsidiaries in 2010. In the U.S., which is the largest jurisdiction where the Company receives such a tax credit, the availability of the research and development credit expired at the end of 2011. In January 2013, the U.S. Congress passed legislation that reinstated the research and development credit retroactive to 2012. These rates were also impacted by charges or benefits associated with the Company's uncertain tax positions. As a result of the 2010 subsidiary merger in Japan, the Company realized a reduction in its 2012 income tax expense of $9.0 million related to tax credits in the U.S. associated with foreign taxes paid in Japan. The Company also expects the 2010 Japan subsidiary merger to reduce future income tax expense by the following amounts: Estimated Reduction in Income Tax Expense Fiscal year 2013 $8.9 - $9.1 million Fiscal year 2014 $8.9 - $9.1 million Fiscal year 2015 $6.7 - $6.9 million Refer to the section titled, "Liquidity and Capital Resources" for the estimated impact of the Japan subsidiary merger on future cash flows. Net Income: The Company's net income for the year ended December 31, 2012 was $203.5 million as compared to net income of $180.7 million for the year ended December 31, 2011. Diluted earnings per share was $2.14 for the year ended December 31, 2012 and $1.91 for the year ended December 31, 2011. The weighted average shares used in computing diluted earnings per share were 95.0 million and 94.4 million during the years ended December 31, 2012 and 2011, respectively. 31-------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2011 Compared to Year Ended December 31, 2010 Revenue: Year Ended December 31, Change (in thousands, except percentages) 2011 2010 Amount % Revenue: Lease licenses $ 218,005 $ 184,539 $ 33,466 18.1 Perpetual licenses 207,876 166,494 41,382 24.9 Software licenses 425,881 351,033 74,848 21.3 Maintenance 246,546 211,465 35,081 16.6 Service 19,022 17,738 1,284 7.2 Maintenance and service 265,568 229,203 36,365 15.9 Total revenue $ 691,449 $ 580,236 $ 111,213 19.2 The Company's revenue increased 19.2% in 2011 as compared to 2010, including increases in license and maintenance revenue. This strong growth was partially influenced by a modest improvement in the global economy as compared to the prior year, including the effects of these economic improvements on year-end spending patterns in certain geographies, benefits from the Company's continued investment in its global sales and marketing organization and $14.5 million in revenue related to the acquisition of Apache for the period from the acquisition date (August 1, 2011) through December 31, 2011. Perpetual license revenue, which is derived entirely from new sales during the period, increased 24.9% as compared to the prior year. The annual maintenance contracts that were sold with the new perpetual licenses, along with the renewal of maintenance contracts sold with perpetual licenses in previous years, contributed to maintenance revenue growth of 16.6%. Revenue from lease licenses increased 18.1% as compared to the prior year, due to growth in sales of lease licenses and the addition of Apache-related lease license revenue of $14.0 million. Service revenue increased 7.2% as compared to the prior year. With respect to revenue, on average for the year ended December 31, 2011, the U.S. Dollar was 5.3% weaker, when measured against the Company's primary foreign currencies, than for the year ended December 31, 2010. The net overall weakening resulted in increased revenue and operating income during 2011, as compared with 2010, of $19.8 million and $12.6 million, respectively. International and domestic revenues, as a percentage of total revenue, were 68.8% and 31.2%, respectively, during the year ended December 31, 2011, and 67.5% and 32.5%, respectively, during the year ended December 31, 2010. The Company derived 26.4% and 26.7% of its total revenue through the indirect sales channel during the years ended December 31, 2011 and 2010, respectively. In accordance with the accounting requirements applicable to deferred revenue acquired in a business combination, acquired deferred revenue was recorded on the Apache opening balance sheet at an amount lower than the historical carrying value. The impact on reported revenue for the year ended December 31, 2011 was $9.6 million, primarily in lease license revenue. As of December 31, 2011, the Company had a backlog of $56.3 million of orders received but not invoiced. 32-------------------------------------------------------------------------------- Table of Contents Cost of Sales and Gross Profit: Year Ended December 31, 2011 2010 Change (in thousands, except % of % of percentages) Amount Revenue Amount Revenue Amount % Cost of sales: Software licenses $ 15,884 2.3 $ 10,770 1.9 $ 5,114 47.5 Amortization 33,728 4.9 32,757 5.6 971 3.0 Maintenance and service 69,402 10.0 57,352 9.9 12,050 21.0 Total cost of sales 119,014 17.2 100,879 17.4 18,135 18.0 Gross profit $ 572,435 82.8 $ 479,357 82.6 $ 93,078 19.4 Software Licenses: The increase in software license costs was primarily due to the following: • Apache-related cost of sales of $3.1 million for the period from the acquisition (August 1, 2011) through December 31, 2011. • Increased third-party royalties of $1.2 million. • Increased stock-based compensation of $400,000. • Increased salaries of $300,000. Amortization: The increase in amortization expense was primarily a result of the following: • Amortization of acquired Apache software of $3.8 million. • A $300,000 increase in amortization of a previously acquired trademark. • A $3.1 million decrease in amortization of other acquired software. Maintenance and Service: The increase in maintenance and service costs was primarily due to the following: • Increased salaries and headcount-related costs, including incentive compensation, of $9.5 million. • Increased business travel expenses of $1.1 million. • Decreased third-party technical support costs of $800,000. • Increased office and equipment lease expenses of $600,000. • Increased depreciation of $500,000. The improvement in the gross profit was a result of the increase in revenue offset by a smaller increase in related cost of sales. 33-------------------------------------------------------------------------------- Table of Contents Operating Expenses: Year Ended December 31, 2011 2010 Change (in thousands, except % of % of percentages) Amount Revenue Amount Revenue Amount % Operating expenses: Selling, general and administrative $ 180,357 26.1 $ 155,096 26.7 $ 25,261 16.3 Research and development 108,530 15.7 88,990 15.3 19,540 22.0 Amortization 17,989 2.6 16,003 2.8 1,986 12.4 Total operating expenses $ 306,876 44.4 $ 260,089 44.8 $ 46,787 18.0 Selling, General and Administrative: The increase in selling, general and administrative costs was primarily due to the following: • Increased salaries and headcount-related costs, including incentive compensation, of $9.0 million. • Apache-related selling, general and administrative expenses of $8.4 million. • Transaction costs totaling $2.1 million related to the Apache acquisition. • Increased third-party commissions of $1.8 million. • Increased discretionary marketing costs of $1.5 million. • Increased depreciation of $900,000. • Increased business travel expenses and maintenance-related costs, each of $800,000. • Increased stock-based compensation expense of $700,000. • Decreased franchise tax expenses of $1.8 million. • Decreased bad debt expense of $1.4 million. Research and Development: The increase in research and development expenses was primarily due to the following: • Increased salaries and headcount-related costs, including incentive compensation, of $8.0 million. • Apache-related research and development expenses of $6.0 million. • Increased stock-based compensation expense of $2.5 million. • Increased depreciation of $700,000. • Increased facilities and information technology maintenance costs of $600,000. • Increased consulting expenses of $500,000. Amortization: The increase in amortization expense was primarily the result of $1.8 million of acquired Apache intangible assets, including a trademark, customer lists and contract backlog. 34-------------------------------------------------------------------------------- Table of Contents Interest Expense: The Company's interest expense consisted of the following: Year Ended December 31, (in thousands) 2011 2010 Bank interest on term loans $ 1,605 $ 2,096 Amortization of debt financing costs 953 1,107 Discounted obligations 462 334 Realized loss on interest rate swap agreement - 864 Other 312 87 Total interest expense $ 3,332 $ 4,488 The decreased interest expense shown above for 2011 is primarily a result of the June 30, 2010 expiration of the interest rate swap and a lower average outstanding debt balance. Interest Income: Interest income for the year ended December 31, 2011 was $3.0 million as compared to $1.9 million for the year ended December 31, 2010. Interest income increased as a result of both an increase in the average cash balances and the rate of return on those balances. Other Expense, net: The Company recorded other expense of $369,000 during the year ended December 31, 2011 as compared to other expense of $297,000 during the year ended December 31, 2010. The activity for both years was primarily composed of net foreign currency transaction losses. Income Tax Provision: The Company recorded income tax expense of $84.2 million and had income before income taxes of $264.9 million for the year ended December 31, 2011. This represents an effective tax rate of 31.8%. During the year ended December 31, 2010, the Company recorded income tax expense of $63.3 million and had income before income taxes of $216.4 million, representing an effective tax rate of 29.2%. As a result of a 2010 subsidiary merger in Japan, the Company realized a reduction in its 2011 income tax expense of $9.0 million related to tax credits in the U.S. associated with foreign taxes paid in Japan. In addition, the Company's tax expense in the year ended December 31, 2011 was unfavorably impacted by reductions to the Japanese corporate tax rate, beginning with the 2013 tax year. This legislation, enacted on November 30, 2011, resulted in an additional $4.8 million in deferred tax expense due to the reduction in the value of certain net deferred tax assets of the Company's Japanese subsidiaries. The effect of this adjustment increased the 2011 effective tax rate from 30.0% to 31.8%. Net Income: The Company's net income for the year ended December 31, 2011 was $180.7 million as compared to net income of $153.1 million for the year ended December 31, 2010. Diluted earnings per share was $1.91 for the year ended December 31, 2011 and $1.64 for the year ended December 31, 2010. The weighted average shares used in computing diluted earnings per share were 94.4 million and 93.2 million during the years ended December 31, 2011 and 2010, respectively. 35-------------------------------------------------------------------------------- Table of Contents Non-GAAP Results The Company provides non-GAAP revenue, non-GAAP operating income, non-GAAP operating profit margin, non-GAAP net income and non-GAAP diluted earnings per share as supplemental measures to GAAP measures regarding the Company's operational performance. These financial measures exclude the impact of certain items and, therefore, have not been calculated in accordance with GAAP. A detailed explanation and a reconciliation of each non-GAAP financial measure to its most comparable GAAP financial measure are described below. Year Ended December 31, 2012 2011 (in thousands, except percentages and per As Non-GAAP As Non-GAAP share data) Reported Adjustments Results Reported Adjustments Results Total revenue $ 798,018 $ 9,636 (1) $ 807,654 $ 691,449 $ 9,621 (4) $ 701,070 Operating income 294,253 110,290 (2) 404,543 265,559 86,550 (5) 352,109 Operating profit margin 36.9 % 50.1 % 38.4 % 50.2 % Net income $ 203,483 $ 73,304 (3) $ 276,787 $ 180,675 $ 58,301 (6) $ 238,976 Earnings per share - diluted: Diluted earnings per share $ 2.14 $ 2.91 $ 1.91 $ 2.53 Weighted average shares - diluted 94,954 94,954 94,381 94,381 (1) Amount represents the revenue not reported during the period as a result of the acquisition accounting adjustment associated with accounting for deferred revenue in business combinations. (2) Amount represents $67.3 million of amortization expense associated with intangible assets acquired in business combinations, $32.4 million of stock-based compensation expense, the $9.6 million adjustment to revenue as reflected in (1) above and $0.9 million of transaction expenses related to the Esterel acquisition. (3) Amount represents the impact of the adjustments to operating income referred to in (2) above, adjusted for the related income tax impact of $37.0 million. (4) Amount represents the revenue not reported during the period as a result of the acquisition accounting adjustment associated with accounting for deferred revenue in business combinations. (5) Amount represents $51.7 million of amortization expense associated with intangible assets acquired in business combinations, $23.1 million of stock-based compensation expense, the $9.6 million adjustment to revenue as reflected in (4) above and $2.1 million of transaction expenses related to the Apache acquisition. (6) Amount represents the impact of the adjustments to operating income referred to in (5) above, adjusted for the related income tax impact of $28.2 million. Note: The 2011 GAAP and non-GAAP net income and earnings per share data reflected above include $4.8 million, or $0.05 per share, related to income tax expense associated with reductions to the Japanese corporate tax rate, beginning with the 2013 tax year. This legislation, enacted on November 30, 2011, resulted in an additional $4.8 million in deferred tax expense due to the reduction in the value of certain net deferred tax assets of the Company's Japanese subsidiaries. 36-------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2011 2010 (in thousands, except percentages and per As Non-GAAP As Non-GAAP share data) Reported Adjustments Results Reported Adjustments Results Total revenue $ 691,449 $ 9,621 (1) $ 701,070 $ 580,236 $ 580,236 Operating income 265,559 86,550 (2) 352,109 219,268 $ 67,749 (4) 287,017 Operating profit margin 38.4 % 50.2 % 37.8 % 49.5 % Net income $ 180,675 $ 58,301 (3) $ 238,976 $ 153,132 $ 44,977 (5) $ 198,109 Earnings per share-diluted: Diluted earnings per share $ 1.91 $ 2.53 $ 1.64 $ 2.13 Weighted average shares-diluted 94,381 94,381 93,209 93,209 (1) Amount represents the revenue not reported during the period as a result of the acquisition accounting adjustment associated with accounting for deferred revenue in business combinations. (2) Amount represents $51.7 million of amortization expense associated with intangible assets acquired in business combinations, $23.1 million of stock-based compensation expense, the $9.6 million adjustment to revenue as reflected in (1) above and $2.1 million of transaction expenses related to the Apache acquisition. (3) Amount represents the impact of the adjustments to operating income referred to in (2) above, adjusted for the related income tax impact of $28.2 million. (4) Amount represents $48.7 million of amortization expense associated with intangible assets acquired in business combinations and a $19.0 million charge for stock-based compensation. (5) Amount represents the impact of the adjustments to operating income referred to in (4) above, adjusted for the related income tax impact of $22.8 million. Note: The 2011 GAAP and non-GAAP net income and earnings per share data reflected above include $4.8 million, or $0.05 per share, related to income tax expense associated with reductions to the Japanese corporate tax rate, beginning with the 2013 tax year. This legislation, enacted on November 30, 2011, resulted in an additional $4.8 million in deferred tax expense due to the reduction in the value of certain net deferred tax assets of the Company's Japanese subsidiaries. 37-------------------------------------------------------------------------------- Table of Contents Non-GAAP Measures Management uses non-GAAP financial measures (a) to evaluate the Company's historical and prospective financial performance as well as its performance relative to its competitors, (b) to set internal sales targets and spending budgets, (c) to allocate resources, (d) to measure operational profitability and the accuracy of forecasting, (e) to assess financial discipline over operational expenditures and (f) as an important factor in determining variable compensation for management and its employees. In addition, many financial analysts that follow the Company focus on and publish both historical results and future projections based on non-GAAP financial measures. The Company believes that it is in the best interest of its investors to provide this information to analysts so that they accurately report the non-GAAP financial information. Moreover, investors have historically requested and the Company has historically reported these non-GAAP financial measures as a means of providing consistent and comparable information with past reports of financial results. While management believes that these non-GAAP financial measures provide useful supplemental information to investors, there are limitations associated with the use of these non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with GAAP, are not reported by all of the Company's competitors and may not be directly comparable to similarly titled measures of the Company's competitors due to potential differences in the exact method of calculation. The Company compensates for these limitations by using these non-GAAP financial measures as supplements to GAAP financial measures and by reviewing the reconciliations of the non-GAAP financial measures to their most comparable GAAP financial measures. The adjustments to these non-GAAP financial measures, and the basis for such adjustments, are outlined below: Acquisition accounting for deferred revenue and its related tax impact. Historically, the Company has consummated acquisitions in order to support its strategic and other business objectives. In accordance with the fair value provisions applicable to the accounting for business combinations, acquired deferred revenue is often recorded on the opening balance sheet at an amount that is lower than the historical carrying value. Although this purchase accounting requirement has no impact on the Company's business or cash flow, it adversely impacts the Company's reported GAAP revenue in the reporting periods following an acquisition. In order to provide investors with financial information that facilitates comparison of both historical and future results, the Company provides non-GAAP financial measures which exclude the impact of the acquisition accounting adjustment. The Company believes that this non-GAAP financial adjustment is useful to investors because it allows investors to (a) evaluate the effectiveness of the methodology and information used by management in its financial and operational decision-making and (b) compare past and future reports of financial results of the Company as the revenue reduction related to acquired deferred revenue will not recur when related annual lease licenses and software maintenance contracts are renewed in future periods. Amortization of intangibles from acquisitions and its related tax impact. The Company incurs amortization of intangibles, included in its GAAP presentation of amortization expense, related to various acquisitions it has made in recent years. Management excludes these expenses and their related tax impact for the purpose of calculating non-GAAP operating income, non-GAAP operating profit margin, non-GAAP net income and non-GAAP diluted earnings per share when it evaluates the continuing operational performance of the Company because these costs are fixed at the time of an acquisition, are then amortized over a period of several years after the acquisition and generally cannot be changed or influenced by management after the acquisition. Accordingly, management does not consider these expenses for purposes of evaluating the performance of the Company during the applicable time period after the acquisition, and it excludes such expenses when making decisions to allocate resources. The Company believes that these non-GAAP financial measures are useful to investors because they allow investors to (a) evaluate the effectiveness of the methodology and information used by management in its financial and operational decision-making and (b) compare past reports of financial results of the Company as the Company has historically reported these non-GAAP financial measures. Stock-based compensation expense and its related tax impact. The Company incurs expense related to stock-based compensation included in its GAAP presentation of cost of software licenses; cost of maintenance and service; research and development expense and selling, general and administrative expense. Although stock-based compensation is an expense of the Company and viewed as a form of compensation, management excludes these expenses for the purpose of calculating non-GAAP operating income, non-GAAP operating profit margin, non-GAAP net income and non-GAAP diluted earnings per share when it evaluates the continuing operational performance of the Company. Specifically, the Company excludes stock-based compensation during its annual budgeting process and its quarterly and annual assessments of the Company's and management's performance. The annual budgeting process is the primary mechanism whereby the Company allocates resources to various initiatives and operational requirements. Additionally, the annual review by the board of directors during which it compares the Company's historical business model and profitability to the planned business model and profitability for the forthcoming year excludes the impact of stock-based compensation. In evaluating the performance of senior management and department managers, charges related to stock-based compensation are excluded from expenditure and profitability results. 38-------------------------------------------------------------------------------- Table of Contents In fact, the Company records stock-based compensation expense into a stand-alone cost center for which no single operational manager is responsible or accountable. In this way, management is able to review, on a period-to-period basis, each manager's performance and assess financial discipline over operational expenditures without the effect of stock-based compensation. The Company believes that these non-GAAP financial measures are useful to investors because they allow investors to (a) evaluate the Company's operating results and the effectiveness of the methodology used by management to review the Company's operating results, and (b) review historical comparability in its financial reporting as well as comparability with competitors' operating results. Transaction costs related to business combinations. The Company incurs expenses for professional services rendered in connection with business combinations, which are included in its GAAP presentation of selling, general and administrative expense. These expenses are generally not tax-deductible. Management excludes these acquisition-related transaction costs for the purpose of calculating non-GAAP operating income, non-GAAP operating profit margin, non-GAAP net income and non-GAAP diluted earnings per share when it evaluates the continuing operational performance of the Company, as it generally would not have otherwise incurred these expenses in the periods presented as a part of its continuing operations. The Company believes that these non-GAAP financial measures are useful to investors because they allow investors to (a) evaluate the Company's operating results and the effectiveness of the methodology used by management to review the Company's operating results, and (b) review historical comparability in its financial reporting as well as comparability with competitors' operating results. Non-GAAP financial measures are not in accordance with, or an alternative for, GAAP. The Company's non-GAAP financial measures are not meant to be considered in isolation or as a substitute for comparable GAAP financial measures, and should be read only in conjunction with the Company's consolidated financial statements prepared in accordance with GAAP. The Company has provided a reconciliation of the non-GAAP financial measures to the most directly comparable GAAP financial measures as listed below: GAAP Reporting Measure Non-GAAP Reporting Measure Revenue Non-GAAP Revenue Operating Income Non-GAAP Operating Income Operating Profit Margin Non-GAAP Operating Profit Margin Net Income Non-GAAP Net IncomeDiluted Earnings Per Share Non-GAAP Diluted Earnings Per Share 39-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Cash, cash equivalents and short-term investments: As of December 31, 2012, the Company had cash, cash equivalents and short-term investments totaling $577.2 million and working capital of $436.0 million as compared to cash, cash equivalents and short-term investments of $472.4 million and working capital of $301.3 million at December 31, 2011. Cash and cash equivalents consist primarily of highly liquid investments such as money market mutual funds and deposits held at major banks. Short-term investments consist primarily of deposits held by certain foreign subsidiaries of the Company with original maturities of three months to one year. Cash, cash equivalents and short-term investments include $177.9 million held by the Company's foreign subsidiaries as of December 31, 2012. If these foreign balances were repatriated to the U.S., they would be subject to domestic tax, resulting in a tax obligation in the period of repatriation. The amount of cash, cash equivalents and short-term investments held by these subsidiaries is subject to translation adjustments caused by changes in foreign currency exchange rates as of the end of each respective reporting period, the offset to which is recorded in accumulated other comprehensive income on the Company's consolidated balance sheet. Cash flows from operating activities: The Company's operating activities provided cash of $298.4 million in 2012, $307.7 million in 2011 and $166.9 million in 2010. The net $9.2 million decrease in operating cash flows for the year ended December 31, 2012 as compared to the year ended December 31, 2011 was primarily related to: • A $41.6 million decrease in cash flows from operating assets and liabilities whereby these fluctuations produced a net cash inflow of $8.9 million during the year ended December 31, 2012 as compared to $50.4 million during the year ended December 31, 2011. Included in the $8.9 million net cash inflow in 2012 was a reduction of $9.3 million in the amount of income tax payments that otherwise would have been made in 2012 as a result of the tax impact associated with the merger of the Company's Japan subsidiaries, as compared to a reduction of $18.0 million in 2011. Please see below for a complete discussion of the expected future cash flow benefits associated with the merger of the Company's Japan subsidiaries. • An increase in net income of $22.8 million from $180.7 million for the year ended December 31, 2011 to $203.5 million for the year ended December 31, 2012. • An increase in other non-cash operating adjustments of $9.5 million from $76.6 million for the year ended December 31, 2011 to $86.1 million for the year ended December 31, 2012. The net $140.8 million increase in the Company's cash flow from operating activities in 2011 as compared to 2010 was primarily the result of a $79.9 million increase in cash flows from operating assets and liabilities, a $33.3 million increase in other non-cash operating adjustments and a $27.5 million increase in net income. The 2010 operating cash flows were adversely impacted by increased tax payments of $55.1 million related to the merger of the Company's Japan subsidiaries. Cash flows from investing activities: The Company's investing activities used net cash of $69.0 million and $291.6 million for the years ended December 31, 2012 and December 31, 2011, respectively. The Company had net acquisition-related cash outlays of $45.1 million and $269.5 million during the years ended December 31, 2012 and December 31, 2011, respectively. Total capital spending was $24.0 million and $22.1 million for the years ended December 31, 2012 and 2011, respectively. In May 2012, the Company acquired an office building adjacent to its Canonsburg headquarters for $4.8 million. This building will serve primarily as a data center and customer training space, and will provide flexibility for future expansion and the growing employee population. The Company currently plans capital spending of $35 million to $45 million during fiscal year 2013, including spending on the Company's new headquarters facilities that are expected to be completed in 2014. The Company has occupied its current headquarters facility since 1997. The overall level of capital spending in 2013 will be dependent upon various factors, including growth of the business and general economic conditions. The Company's investing activities used net cash of $291.6 million and $6.6 million in 2011 and 2010, respectively. The change in cash used was primarily driven by the $269.5 million net cash outlay for the acquisition of Apache in August 2011. Cash flows used in financing activities: Financing activities used cash of $124.8 million and $9.7 million for the years ended December 31, 2012 and 2011, respectively. This change of $115.2 million was primarily the result of an increase in cash used for treasury stock repurchases of $82.8 million and a $42.5 million increase in required principal payments on long-term debt in 2012 as compared to 2011. Financing activities used cash of $9.7 million and $29.6 million in 2011 and 2010, respectively. This change of $20.0 million was primarily driven by a $33.7 million decrease in principal payments on long-term debt, partially offset by $12.7 million in treasury stock repurchases in 2011. There were no treasury stock repurchases in 2010. 40-------------------------------------------------------------------------------- Table of Contents The Company's term loan includes covenants related to the consolidated leverage ratio and the consolidated fixed charge coverage ratio, as well as certain restrictions on additional investments and indebtedness. As of December 31, 2012, the Company is in compliance with all financial covenants as stated in the credit agreement. The Company's term loan matures on July 31, 2013. The Company believes that existing cash and cash equivalent balances of $576.7 million, together with cash generated from operations, will be sufficient to meet the Company's working capital, capital expenditure and debt service requirements through the next twelve months. The Company's cash requirements in the future may also be financed through additional equity or debt financings. There can be no assurance that such financings can be obtained on favorable terms, if at all. As of December 31, 2012, 1.5 million shares remain authorized for repurchase under the Company's stock repurchase program. The Company continues to generate positive cash flows from operating activities and believes that the best use of its excess cash is to repay its long-term debt, to invest in the business and, under certain favorable conditions, to repurchase stock. Additionally, the Company has in the past, and expects in the future, to acquire or make investments in complementary companies, products, services and technologies. Any future acquisitions may be funded by available cash and investments, cash generated from operations, existing or additional credit facilities, or from the issuance of additional securities. On August 1, 2012, the Company completed its acquisition of Esterel, a leading provider of embedded software simulation and automatic generation of certified code solutions for mission critical applications. Under the terms of the acquisition agreement, ANSYS acquired 100% of Esterel for a purchase price of $58.2 million, which included $13.1 million in acquired cash. The acquisition agreement also includes retention provisions for key members of Esterel's management and employees. The Company funded the transaction entirely with existing cash balances. The Company's operating cash flow has been favorably impacted by the 2010 merger of the Company's Japan subsidiaries. The Company saw a reduction in these cash flow savings of $16.8 million for the year ended December 31, 2012 when compared to the year ended December 31, 2011. This merger is expected to favorably impact the Company's cash flow from operations in future periods as follows: Estimated Future Cash Flow Savings Fiscal year 2013 $8 - $9 million Fiscal year 2014 - 2015 $9 - $10 million per year Fiscal year 2016 - 2017 $10 - $11 million per year Fiscal year 2018 $4 - $5 million Uncertain timing $21 million Total future benefits $71 - $77 million With respect to the amounts in the preceding table whereby the timing is listed as "uncertain," the realization of these benefits is affected by the resolution of an audit of the Company's amended tax return refund claims, which the Internal Revenue Service ("IRS") began in the second quarter of 2012. The Company continues to expect that it will realize these cash flow benefits. Off-Balance Sheet Arrangements The Company does not have any special purpose entities or off-balance sheet financing. 41-------------------------------------------------------------------------------- Table of Contents Contractual Obligations The Company's significant contractual obligations as of December 31, 2012 are summarized below: Payments Due by Period (in thousands) Total Within 1 year 2 - 3 years 4 - 5 years After 5 years Long-term debt Principal payments $ 53,149 $ 53,149 $ - $ - $ - Interest payments(1) 215 215 - - - Capital lease obligations - - - - - Global headquarters operating leases(2) 69,818 1,429 5,707 8,556 54,126 Other operating leases(3) 44,155 12,177 16,581 7,150 8,247 Unconditional purchase obligations(4) 3,502 3,313 189 - - Obligations related to uncertain tax positions, including interest and penalties(5) - - - - - Other long-term obligations(6) 34,198 9,676 16,776 5,364 2,382 Total contractual obligations $ 205,037 $ 79,959 $ 39,253 $ 21,070 $ 64,755 (1) See Note 8 to the consolidated financial statements in Part IV, Item 15 of this Annual Report on Form 10-K. The interest rate on the outstanding term loan balance of $53.1 million is set for the quarter ending March 31, 2013 at 1.06%, which is based on LIBOR + 0.75%. The estimated payments assume an interest rate of 1.06% on the remaining loan balance, and are calculated assuming contractual quarterly principal payments are made with no additional prepayments. (2) On September 14, 2012, the Company entered into a lease agreement for a to-be-built office facility in Canonsburg, Pennsylvania, which will serve as the Company's new headquarters. The lease was effective as of September 14, 2012, but because the premises are to-be-built, the Company will not be obligated to pay rent until January 1, 2015 (the "Commencement Date"). The term of the lease is 183 months, beginning on the Commencement Date. The Company shall have a one-time right to terminate the lease effective upon the last day of the tenth full year following the Commencement Date (anticipated to be December 31, 2025), by providing the landlord with at least 18 months' prior written notice of such termination. The Company's lease for its existing headquarters expires on December 31, 2014. (3) Other operating leases primarily include noncancellable lease commitments for the Company's other domestic and international offices as well as certain operating equipment. (4) Unconditional purchase obligations primarily include software licenses and long-term purchase contracts for network, communication and office maintenance services, which are unrecorded as of December 31, 2012. (5) The Company has $36.9 million of unrecognized tax benefits, including estimated interest and penalties, that have been recorded as liabilities in accordance with income tax accounting guidance for which the Company is uncertain as to if or when such amounts may be settled. As a result, such amounts are excluded from the table above. (6) Includes long-term retention bonus and Apache-related deferred compensation of $21.8 million (including estimated imputed interest of $520,000 within 1 year, $550,000 within 2-3 years and $210,000 within 4-5 years), contingent consideration of $6.6 million (including estimated imputed interest of $110,000 within 1 year and $200,000 within 2-3 years) and pension obligations of $3.7 million for certain foreign locations of the Company. 42 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates The Company believes that the following critical accounting policies affect the more significant judgments and estimates used in the preparation of its consolidated financial statements. Revenue is derived principally from the licensing of computer software products and from related maintenance contracts. Revenue from perpetual licenses is classified as license revenue and is recognized upon delivery of the licensed product and the utility that enables the customer to access authorization keys, provided that acceptance has occurred and a signed contractual obligation has been received, the price is fixed and determinable, and collectibility of the receivable is probable. The Company determines the fair value of post-contract customer support ("PCS") sold together with perpetual licenses based on the rate charged for PCS when sold separately. Revenue from PCS contracts is classified as maintenance and service revenue and is recognized ratably over the term of the contract. Revenue for software lease licenses is classified as license revenue and is recognized over the period of the lease contract. Typically, the Company's software leases include PCS which, due to the short term (principally one year or less) of the Company's software lease licenses, cannot be separated from lease revenue for accounting purposes. As a result, both the lease license and PCS are recognized ratably over the lease period. Due to the short-term nature of the software lease licenses and the frequency with which the Company provides major product upgrades (typically every 12-18 months), the Company does not believe that a significant portion of the fee paid under the arrangement is attributable to the PCS component of the arrangement and, as a result, includes the revenue for the entire arrangement within software license revenue in the consolidated statements of income. The Company's Apache products are typically licensed via longer term leases of 24-36 months. The Company recognizes revenue for these licenses over the term of the lease contract. Because the Company does not have vendor-specific objective evidence of the fair value of these leases, the Company also recognizes revenue from perpetual licenses over the term of the lease contract during the infrequent occurrence of these licenses being sold with Apache leases in multiple-element arrangements. Revenue from training, support and other services is recognized as the services are performed. The Company applies the specific performance method to contracts in which the service consists of a single act, such as providing a training class to a customer, and the proportional performance method to other service contracts that are longer in duration and often include multiple acts (for example, both training and consulting). In applying the proportional performance method, the Company typically utilizes output-based estimates for services with contractual billing arrangements that are not based on time and materials, and estimates output based on the total tasks completed as compared to the total tasks required for each work contract. Input-based estimates are utilized for services that involve general consultations with contractual billing arrangements based on time and materials, utilizing direct labor as the input measure. The Company also executes arrangements through independent channel partners in which the channel partners are authorized to market and distribute the Company's software products to end-users of the Company's products and services in specified territories. In sales facilitated by channel partners, the channel partner bears the risk of collection from the end-user customer. The Company recognizes revenue from transactions with channel partners when the channel partner submits a written purchase commitment, collectibility from the channel partner is probable, a signed license agreement is received from the end-user customer and delivery has occurred, provided that all other revenue recognition criteria are satisfied. Revenue from channel partner transactions is the amount remitted to the Company by the channel partners. This amount includes a fee for PCS that is compensation for providing technical enhancements and the second level of technical support to the end-user, which is based on the rate charged for PCS when sold separately, and is recognized over the period that PCS is to be provided. The Company does not offer right of return, product rotation or price protection to any of its channel partners. Non-income related taxes collected from customers and remitted to governmental authorities are recorded on the consolidated balance sheet as accounts receivable and accrued expenses. The collection and payment of these amounts are reported on a net basis in the consolidated statements of income and do not impact reported revenues or expenses. The Company warrants to its customers that its software will substantially perform as specified in the Company's most current user manuals. The Company has not experienced significant claims related to software warranties beyond the scope of maintenance support, which the Company is already obligated to provide, and consequently, the Company has not established reserves for warranty obligations. The Company's agreements with its customers generally require it to indemnify the customer against claims that the Company's software infringes third-party patent, copyright, trademark or other proprietary rights. Such indemnification obligations are generally limited in a variety of industry-standard respects, including the Company's right to replace an infringing product. As of December 31, 2012, the Company had not experienced any losses related to these indemnification obligations and no claims with respect thereto were outstanding. The Company does not expect significant claims related to these indemnification obligations, and consequently, the Company has not established any related reserves. 43-------------------------------------------------------------------------------- Table of Contents The Company makes judgments as to its ability to collect outstanding receivables and provides allowances for a portion of receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding invoices from both value and delinquency perspectives. For those invoices not specifically reviewed, provisions are provided at differing rates based upon the age of the receivable and the geographic area of origin. In determining these percentages, the Company considers its historical collection experience and current economic trends in the customer's industry and geographic region. If the historical data used to calculate the allowance for doubtful accounts does not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and future results of operations could be materially affected. The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period of the enactment date. The Company records net deferred tax assets to the extent it believes these assets will more likely than not be realized. In making such determination, the Company considers all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and recent financial operations. In the event the Company determines that it will be able to realize deferred income tax assets in the future in excess of their net recorded amount, an adjustment to the valuation allowance would be recorded that would reduce the provision for income taxes. Tax benefits related to uncertain tax positions taken or expected to be taken on a tax return are recorded when such benefits meet a more likely than not threshold. Otherwise, these tax benefits are recorded when a tax position has been effectively settled, which means that the statute of limitations has expired or the appropriate taxing authority has completed their examination even though the statute of limitations remains open. The Company recognizes interest and penalties related to unrecognized tax benefits within the income tax expense line in the consolidated statements of income. Accrued interest and penalties are included within the related tax liability line in the consolidated balance sheets. The Company tests goodwill for impairment at least annually by performing a qualitative assessment of whether there is sufficient evidence that it is more likely than not that the fair value of each reporting unit exceeds its carrying amount. The application of a qualitative assessment requires the Company to assess and make judgments regarding a variety of factors which potentially impact the fair value of a reporting unit, including general economic conditions, industry and market-specific conditions, customer behavior, cost factors, the Company's financial performance and trends, the Company's strategies and business plans, capital requirements, management and personnel issues, and the Company's stock price, among others. The Company then considers the totality of these and other factors, placing more weight on the events and circumstances that are judged to most affect a reporting unit's fair value or the carrying amount of its net assets, to reach a qualitative conclusion regarding whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If it is determined that it is more likely than not that the reporting unit's fair value is less than its carrying amount, then the fair value of the reporting unit is estimated and an impairment loss is measured (if any). Fair value is estimated using discounted cash flow and other valuation methodologies. In preparing the estimate of fair value, the Company relies on a number of factors, including historical operating results, business plans, anticipated future cash flows, economic projections and other market data. Because there are inherent uncertainties involved in these factors, the Company's estimates of fair value are imprecise and the resulting carrying value of goodwill and intangible assets may be misstated. The Company tests indefinite-lived intangible assets for impairment at least annually by comparing the estimated fair value of each asset to its carrying value. Fair value is estimated using a discounted cash flow valuation methodology. In preparing the estimate of fair value, the Company relies on a number of factors, including historical operating results, business plans, anticipated future cash flows, economic projections and other market data. Because there are inherent uncertainties involved in these factors, the Company's estimates of fair value are imprecise and the resulting carrying value of indefinite-lived intangible assets may be misstated. When the Company assigns fair value to a trademark, it also estimates whether it has a finite or indefinite life, thus impacting whether the value is amortized or not. Events such as product and naming strategy changes can occur whereby the Company may reconsider the life (whether finite or indefinite), resulting in changes to amortization expense. Amortization periods may also be reconsidered for identifiable intangible assets with finite lives. On January 1, 2012, the Company completed the annual impairment tests for goodwill and indefinite-lived intangible assets and determined that these assets had not been impaired as of the test date. For goodwill, the Company performed a qualitative assessment, and as of the test date, there was sufficient evidence that it was more likely than not that the fair values of its two reporting units exceeded their carrying amounts. Due to the August 1, 2012 acquisition of Esterel, the Company now has three reporting units. The fair value of the Company's indefinite-lived intangible assets substantially exceeded their carrying values as of the test date. The key assumptions utilized in determining the fair value of the indefinite-lived intangible assets are 44-------------------------------------------------------------------------------- Table of Contents revenue growth rates, growth rates of cash expenditures and related operating margin percentages, income tax rates, and factors that influence the Company's weighted average cost of capital, including interest rates, the ratio of the Company's debt capital to its total capital and the Company's systematic risk or beta. Of the preceding factors, fair value estimates are most sensitive to changes in revenue growth rate assumptions. Factors that could adversely affect the Company's revenue growth rates include adverse economic conditions in certain geographies or industries, especially key industrial and electronics industries; enhanced competition and related pricing pressures; integration issues associated with acquisitions; strengthening of the U.S. Dollar or other adverse foreign currency fluctuations; reduced renewal rates for the Company's annual lease and maintenance contracts; and the Company's ability to attract and retain key personnel. Any of these factors individually or in combination could cause the Company's growth rates to decline over a defined period of time. The Company has demonstrated an ability in the past to adjust its cost structure through reductions in discretionary spending, delayed hiring or workforce reductions when faced with periods of reduced revenue growth. If adverse conditions would persist over a longer period of time and would cause a revision to the Company's long-term revenue growth rate projections without a similar cost reduction response, or if other factors would occur that would result in a similar growth rate revision or a material revision to the other inputs to reporting unit fair value, it could cause the fair value of the Company's reporting unit to fall below its carrying value, potentially resulting in an impairment. The Company is involved in various investigations, claims and legal proceedings that arise in the ordinary course of business including alleged infringement of intellectual property rights, commercial disputes, labor and employment matters, tax audits and other matters. The Company reviews the status of these matters, assesses its financial exposure and records a related accrual if the potential loss from an investigation, claim or legal proceeding is probable and the amount is reasonably estimable. Significant judgment is involved in the determination of probability and in the determination of whether an exposure is reasonably estimable. As a result of the uncertainties involved in making these estimates, the Company may have to revise its estimates as facts and circumstances change. The revision of these estimates could have a material impact on the Company's financial position and results of operations. The Company grants options and stock awards to employees and directors under the Company's stock option and grant plan. Eligible employees can also purchase shares of the Company's common stock at a discount under the Company's employee stock purchase plan. The benefits provided under these plans are share-based payments subject to the provisions of share-based payment accounting guidance. The Company uses the fair value method to apply the provisions of share-based payment accounting guidance. Share-based compensation expense for 2012, 2011 and 2010 was $32.4 million, $23.1 million and $19.0 million, respectively. As of December 31, 2012, total unrecognized estimated compensation expense related to unvested stock options granted prior to that date was $61.9 million, which is expected to be recognized over a weighted average period of 2.0 years. The value of each share-based award was estimated on the date of grant or date of acquisition for options issued in a business combination using the Black-Scholes option pricing model ("Black-Scholes model"). The determination of the fair value of share-based payment awards using an option pricing model is affected by the Company's stock price as well as assumptions regarding a number of complex and subjective variables. These variables include the Company's expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rates and expected dividends. The table below presents the weighted average input assumptions used and resulting fair values for options granted or issued in business combinations during each respective year. The stock-based compensation expense for options is recorded ratably over their requisite service period. The interest rates used were determined by using the five-year U.S. Treasury Note yield on the date of grant or date of acquisition. Year Ended December 31, 2012 2011 2010 Risk-free interest rate 0.59% to 1.04% 0.91% to 2.11% 1.27% to 2.34% Expected dividend yield 0% 0% 0% Expected volatility 38% 39% 39% Expected term 6.0 years 5.8 years 6.1 years Weighted average fair value per share $24.82 $25.84 $19.41 Prior to 2012, the Company issued both non-qualified and incentive stock options; however, the Company no longer issues incentive stock options. The tax benefits associated with the outstanding incentive stock options are unpredictable, as they are predicated upon an award recipient triggering an event that disqualifies the award and that then results in a tax deduction to the Company. Share-based payment accounting guidance requires that these tax benefits be recorded at the time of the triggering event. The triggering events for each option holder are not easily projected. In order to estimate the tax benefits related to incentive stock options, the Company makes many assumptions and estimates, including the number of incentive stock options that will be exercised during the period by U.S. employees, the number of incentive stock options that will be disqualified 45-------------------------------------------------------------------------------- Table of Contents during the period and the fair market value of the Company's stock price on the exercise dates. Each of these items is subject to significant uncertainty. Additionally, a significant portion of the tax benefits related to disqualified incentive stock options is accounted for as an increase to equity (additional paid-in capital) rather than as a reduction in income tax expense. Although all such benefits continue to be realized through the Company's tax filings, this accounting treatment has the effect of increasing tax expense and reducing net income. For example, the Company realized a tax benefit of $7.6 million during the year ended December 31, 2012 related to disqualified dispositions of incentive stock options; however, only $1.7 million of such amount was recorded as a reduction in income tax expense. Under the terms of the ANSYS, Inc. Long-Term Incentive Plan, in the first quarter of 2012, 2011 and 2010, the Company granted 100,000, 92,500 and 80,500 performance-based restricted stock units, respectively. Vesting of the full award or a portion thereof is based on the Company's performance as measured by total shareholder return relative to the median percentage appreciation of the NASDAQ Composite Index over a specified measurement period, subject to each participant's continued employment with the Company through the conclusion of the measurement period. The measurement period for the restricted stock units granted pursuant to the Long-Term Incentive Plan is a three-year period beginning January 1 of the year of the grant. Each restricted stock unit relates to one share of the Company's common stock. The estimated grant-date value of each restricted stock unit granted in 2012, 2011 and 2010 was $33.16, $32.05 and $25.00, respectively. The estimate of the grant-date value of the restricted stock units was made using a Monte Carlo simulation model. The determination of the fair value of the awards was affected by the grant date and a number of variables, each of which has been identified in the chart below. Share-based compensation expense based on the fair value of the award is being recorded from the grant date through the conclusion of the three-year measurement period. On December 31, 2012, employees earned 76,500 restricted stock units, which will be issued in the first quarter of 2013. Year Ended December 31, 2012 2011 and 2010 Risk-free interest rate 0.16% 1.35% Expected dividend yield 0% 0% Expected volatility-ANSYS Stock Price 28% 40% Expected volatility-NASDAQ Composite Index 20% 25% Expected term 2.8 years 2.9 years Correlation factor 0.75 0.70 In addition, the Company grants deferred stock units to non-affiliate Independent Directors, which are rights to receive shares of common stock upon termination of service as a Director. The deferred stock units are issued in arrears and vest immediately. As of December 31, 2012, 95,227 deferred stock units have been earned with the underlying shares remaining unissued until the service termination of the respective Director owners. Of this amount, 28,523 units were earned during the year ended December 31, 2012. In accordance with the Apache merger agreement, the Company granted performance-based restricted stock units to key members of Apache management and employees, with a maximum of $13.0 million to be earned annually over a three-fiscal-year period beginning January 1, 2012. Vesting of the full award or a portion thereof is determined discretely for each of the three fiscal years based on the achievement of certain revenue and operating income targets by the Apache subsidiary, and the recipient's continued employment through the measurement period. The value of each restricted stock unit on the August 1, 2011 grant date was $50.30, the closing price of ANSYS stock as of that date. On December 31, 2012, employees earned 76,658 restricted stock units, which will be issued in the first quarter of 2013. If factors change and the Company employs different assumptions in the application of share-based payment accounting guidance in future periods, the compensation expense that the Company will record may differ significantly from what the Company has recorded in the current period. Therefore, it is important for investors to be aware of the high degree of subjectivity involved when using option pricing models to estimate share-based compensation. Option pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions, are fully transferable and do not cause dilution. Because the Company's share-based payments have characteristics significantly different from those of freely-traded options and because changes in the input assumptions can materially affect the Company's estimates of fair values, in the Company's opinion, existing valuation models may not provide reliable measures of the fair values of the Company's share-based compensation. Consequently, there is a risk that the Company's estimates of the fair values of the Company's share-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those share-based payments in the future. Certain share-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in the Company's financial statements. Alternatively, value may be realized from these instruments that is significantly in excess of the fair values originally estimated on the grant date and 46-------------------------------------------------------------------------------- Table of Contents reported in the Company's financial statements. There is currently no market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor is there a means to compare and adjust the estimates to actual values. Although the fair value of employee share-based awards is determined in accordance with share-based payment accounting guidance using an option pricing model, that value may not be indicative of the fair value observed in a willing buyer/seller market transaction. Estimates of share-based compensation expenses are significant to the Company's financial statements, but these expenses are based on the aforementioned option valuation models and will never result in the payment of cash by the Company. For this reason, and because the Company does not view share-based compensation as related to its operational performance, the Board of Directors and management exclude estimated share-based compensation expense when evaluating the Company's underlying business performance. Recent Accounting Guidance For information regarding recent accounting guidance and the impact of this guidance on the Company's consolidated financial statements, see Note 2 to the consolidated financial statements in Part IV, Item 15 of this Annual Report on Form 10-K. |