ANSYS Inc

NASDAQ:ANSS

Earnings Call Transcript 2018-Q2

[Operator]

Ladies and gentlemen, thank you for standing by, and welcome to ANSYS' Second Quarter 2018 Earnings Conference Call. With us today are Ajei Gopal, Chief Executive Officer; Maria Shields, SVP and Chief Financial Officer; and Annette Arribas, Senior Director, Global Investor Relations.

At this time, I would like to turn the call over to Ms. Arribas for some opening remarks.

[Annette N. Arribas, ANSYS, Inc.]

Good morning, everyone. Our earnings release and the related prepared remarks documents have been posted on the homepage of our Investor Relations website this morning. They contain all of the key financial information and supporting data relative to our second quarter and our first half financial results and business update, as well as our initial Q3 and updated fiscal year 2018 outlook and the key underlying assumptions.

I'd like to remind everyone that in addition to any risks and uncertainties that we highlight during the course of this call, important factors that may affect our future results are discussed at length in our public filings with the SEC, all of which are also available via our website. Additionally, the company's reported results should not be considered an indication of future performance, as there are risks and uncertainties that could impact our business in the future. These statements are based upon our view of the business as of today and ANSYS undertakes no obligation to update any such information, unless we do so in a public forum.

During the course of this call and in the prepared remarks, we'll be making reference to non-GAAP financial measures and unless otherwise stated, for purposes of comparability, we'll be presenting results in accordance with ASC 605. A discussion of the various items that are excluded and a full reconciliation of GAAP to comparable non-GAAP financial measures under both ASC 605 and ASC 606 are included in this morning's earnings release materials and the related Form 8-K.

I would now like to turn the call over to our CEO, Ajei Gopal, for his opening remarks. Ajei?

[Ajei S. Gopal, ANSYS, Inc.]

Thank you, Annette, and good morning, everyone. Q2 was an excellent quarter across all key metrics, which has led to an outstanding first half of 2018. In Q2, we delivered constant currency revenue growth of 10%, and our operating margins and EPS exceeded the high end of our guidance under both ASC 605 and ASC 606.

Our Q2 ASC 605 revenue and EPS are both second quarter records for ANSYS. Our deferred revenue and backlog increased 24% year-over-year to $816 million. Annualized contract value or ACV grew 10% in constant currency for the first half of the year. Both of these metrics are leading indicators of the robust health of our business.

Given our strong performance to date in 2018 and the strength of our pipeline going into the second half of the year, we are increasing our EPS guidance for the full year. We're also adjusting our revenue guidance to reflect an increase in our constant currency revenue outlook, but in the context of an adverse currency impact of about $15 million since we last provided guidance. Maria will provide more details in a few minutes.

Large deals helped to drive our success in the quarter with 35 customers recording orders of over $1 million, an increase of 25% over the second quarter of 2017. These customers tend to buy multiple products from the ANSYS portfolio and consistent with last quarter, over 75% of these customers purchase products from at least three of our product lines. Our largest customer this quarter had combined orders of over $30 million across four product lines.

Our success in engineering services in the context of our momentum with enterprise and strategic accounts is another highlight of this quarter. We reported Q2 and first half constant currency services revenue growth of 40% and 30%, respectively, albeit up a smaller denominator. This is evidence that we are succeeding in leveraging our world-class engineering services talent to drive customer adoption of our portfolio. This is a direct result of the focused and incremental investments we have made in our field engineering team and in our go-to-market strategy around this important class of customers.

I'm delighted with the performance of our North American business and with the ongoing recovery of our European business. Europe grew 11% and 10% in constant currency in Q2 and in the first half respectively, continuing the significant turnaround for that region. As we had planned, sales in Asia-Pacific are back-end loaded this year and hence APJ had a relatively slower growth for the quarter and the first half.

I'm excited that our key regions of China and Japan delivered solid revenue growth for the quarter. However, the slower pace of implementation of go-to-market changes in South Korea impacted performance in that country and some centralized purchasing of enterprise deals muted results in India. With an expanded pipeline of larger deals, the ongoing addition of incremental enterprise sales resources in the region and the completion of our go-to-market changes, we are optimistic about our Asia-Pacific performance in the second half of the year.

Representing about 24% of total revenue, our indirect channel is a key area of focus. During the first half of 2018, we added 11 new channel partners, including 8 in Europe. We also increased our Elite channel partners to 20 from an initial group of 5. Our channel partners' certification levels across our product portfolio has also increased and they continue to add sales capacity and technical resources and enhance their capabilities. From an industry perspective, automotive and high-tech continue to perform strongly, with notable wins driven by the rise in electronics and the push to autonomy and electrification.

We saw a wonderful example of the power of our electrification solution recently when our partner, Volkswagen Motorsport, shattered the time record at the Pikes Peak International Hill Climb by nearly 16 seconds using an all-electric racecar. ANSYS was very proud to be selected as Volkswagen Motorsport's strategic technology partner of choice for simulating the mission-critical aspects of the electric propulsion system and the overall car design.

I'm also excited that we continue to make advances in our Startup Program. Today we have over 500 innovative young companies from around the world using the power of ANSYS solutions to build their next-generation products and services. Now last year we described our vision of Pervasive Simulation where simulation becomes critical across the entire product life cycle.

Our core business relies on driving innovation into our flagship solutions of mechanical, fluids, electromagnetics, semiconductors and systems. ANSYS 19.1 released during Q2 bolters our leadership across all of our key physics. This comprehensive release features advances across our portfolio to improve reliability, performance, speed and overall user experience. These dramatic improvements are driving high-value multiphysics sales across the regions and the industries we serve.

For example, Eldor Corporation, a global manufacturing leader for automotive systems, expanded their adoption of ANSYS electronics and HPC solutions to support next-generation electric powertrain development. Extending their adoption of a multiphysics platform based on ANSYS structural, CFD and electromagnetic products enables Eldor to further ensure the reliability of their designs, while increasing simulation efficiency or critical to responding to this rapidly evolving market.

Multiphysics was a critical topic at June's DAC, the major semiconductor industry conference. We were excited to have dozens of customers share their best practices on how they use ANSYS solutions beyond the traditional signoff area, leveraging the power of multiphysics simulations, big data analytics, and chip package system co-analyses to tackle the challenges of 7 nanometers and 3D IC design, just to name a few. This new functionality will help them to innovate by exceeding their power, performance and area goals.

A great example of our customers' success was outlined in a press release yesterday with HiSilicon Technologies, a subsidiary of Huawei. They are relying on ANSYS' suite of semiconductor and electronics simulation solutions for power integrity and reliability signoff to address complex multiphysics challenges. These include on-chip thermal effects, aging, thermal-aware statistical electromigration budgeting, electrostatic discharge, as well as the creation of chip power models for simulating the entire package and system.

HiSilicon is using ANSYS RedHawk-SC, our next-generation system-on-chip power noise and reliability signoff solution to enable design success for all advanced process nodes, including 7 nanometer and 5 nanometer. Our successes with RedHawk-SC was also showcased at DAC. I'm excited that all of our 7-nanometer RedHawk customers are using or deploying RedHawk-SC for signoff of their most complex products and design. These designs are at the heart of innovations in artificial intelligence, autonomous vehicles, 5G, mobile devices and so on.

Our successes with RedHawk-SC go beyond the Tier-1 chip makers. We're seeing rapid adoption by a number of hardware startups focused on chip development for artificial intelligence. But to become truly pervasive, simulation must move beyond the product design phase and move upstream into ideation and downstream into operations.

ANSYS Discovery Live, which we introduced in Q1, provides instantaneous 3D simulation and direct geometry modeling to enable interactive design exploration and rapid product innovation. We saw early success with ANSYS Discovery Live with China Southern Power Grid, which provides electricity to over 250 million people. This Fortune Global 100 company is using Discovery Live for digital exploration, resulting in a 3x improvement in tower design times.

The company also signed a contract in Q2 to expand its ANSYS usage across physics, including structures, fluids, electromagnetics, as well as high-performance computing. This expansion also enables their design teams to collaborate across engineering disciplines using an integrated workflow based on the ANSYS Workbench platform.

Also in Q2, we announced an exciting new partnership with PTC. They are developing a differentiated solution for their customers that embed Discovery Live's simulation engine into their Creo 3D CAD offering. With the combined solution which removes the boundaries between CAD and simulation, engineers will be able to see the real-time results of simulation during the modeling process. This will enable them to rapidly make tradeoffs and design changes in their models.

With PTC's significant presence in the designer space, our partnership broadens our reach to design engineers around the world. Although there's no impact on our 2018 revenue while the solution is in development, early customer feedback has been overwhelmingly positive.

Simulation can also play a critical role demonstrated in product operations through the use of digital twins. While digital twin adoption is still in its early stages, we're seeing significant interest from customers. Many companies have challenges in maintaining assets that are in remote or hostile locations. And so it's no surprise that companies in mining, energy as well as construction sites with heavy machinery are early adopters of the Internet of Things and digital twin technology.

In Q2, we released ANSYS Twin Builder, the only solution that offers a packaged approach for digital twins, enabling engineers to quickly build, validate and deploy these digital representations of physical products. The open solution integrates with any industrial IoT platform and contains run-time deployment capabilities for constant monitoring of every individual asset used during operations. The solution empowers customers to perform diagnostics and troubleshooting, determine the ideal maintenance programs, optimize the performance of each asset, and generate insightful data to improve the next generation of products.

Our longtime customer Regal is a great digital twin success story. Regal is a leading manufacturer of electric motors, power generation and power transmission products serving markets worldwide. Regal leveraged ANSYS simulation to build a digital twin, enabling them to iterate on the design, optimizing both software and hardware. Their digital twin helped them understand the performance impact of design changes within minutes and validate that the new design met market requirements. Likewise, Regal leveraged ANSYS' mechanical, fluids, embedded software and systems tools to reduce the design time from six weeks down to a few days.

I'm also delighted that in Q2, we announced an innovative partnership with software giant SAP. They're embedding ANSYS' technology for digital twins into their extensive digital supply chain, manufacturing and asset management portfolio, introducing a new product called SAP Predictive Engineering Insights enabled by ANSYS. This new solution, which introduces ANSYS simulation to operations and asset managers, ties together engineering models, manufacturing details and operational insights, including financial information.

Connecting these diverse data sets enables businesses to evaluate the real-time working conditions of physical objects and remotely monitor products and assets, empowering them to quickly detect and fix issues if something goes wrong, as well as to make design improvements to future releases. This relationship is particularly exciting for ANSYS because of SAP's enterprise product portfolio and extensive customer reach. Now while we're not expecting any revenue for ANSYS in 2018 while our engineering teams are working on the new product, initial customer feedback from customers has been very positive.

And finally, on the product side, we're seeing strong interest and increased opportunities from our recent acquisition of OPTIS. As you may remember, OPTIS is the leading provider of physics-based simulation software for light, human vision and visualization. This best-in-class technology helps to extend our industry leadership and drive full portfolio sales, particularly in the automotive vertical.

The $30 million Q2 deal I mentioned earlier was with one of the world's leading automotive companies. And like many of our automotive customers, this company is facing mounting pressures to bring new, autonomous and electric vehicle technology to market as quickly as possible. This industry leader who's also a customer of OPTIS realized that further investment in ANSYS' flagship solutions, including electromagnetics and functional safety, will increase their simulation efficiency which is crucial to rapid innovation.

Now before I close, I want to give you an update on our Board of Directors. First, I would like to thank two of our longstanding board members, Brad Morley and Pat Zilvitis who retired earlier this year, for their many years of dedicated service. And I'd like to welcome to our board two accomplished executives with extensive experience at leading technology companies; Nicole Anasenes and Glenda Dorchak. Along with Dr. Alec Gallimore who joined the board in December, they bring a wealth of thought leadership and experience to our outstanding Board of Directors and we are very much looking forward to the value they will bring to our growing enterprise.

I will now turn the call over to Maria to discuss our financial results in more detail. Maria?

[Maria T. Shields, ANSYS, Inc.]

Thank you, Ajei. Good morning, everyone. Ajei shared a few key highlights from our results. And now let me take a few minutes to add some additional commentary around our second quarter and first half financial performance. I will close my prepared remarks with an update on our outlook and key assumptions for Q3 and 2018.

Before I begin, I would like to remind everyone that during the first year of adoption of revenue recognition under ASC 606, we have been and will continue to provide financial results and outlook under both ASC 605 and ASC 606. Additionally, any comments that I make relative to growth rates will be comparing Q2 2018 to Q2 2017 results under ASC 605 and in constant currency. I will provide key financial metrics under both ASC 605 and ASC 606 and consistent with our standard practice, my comments will be in terms of non-GAAP, unless I state otherwise.

Our record Q2 results reflect continued strong momentum and execution across the business. Despite a stronger U.S. dollar that adversely affected our revenue by approximately $2 million as compared to our forecasted exchange rates, we posted revenue growth of 13% or 10% in constant currency. Operating margins and EPS were above the high end of our guidance under both ASC 605 and ASC 606. Our strong second quarter and first half performance give us confidence that we are on a path to continue to make progress against our strategic priorities and to deliver another year of record financial results in 2018.

Our key financial metrics for the quarter begin with Q2 constant currency ACV growth of 8% and 10% growth for the first half of the year. Second quarter revenue under ASC 605 and ASC 606 totaled $299 million and $309 million respectively, and include positive currency impacts of $6.8 million and $6.3 million as compared to last year.

The increase in software license sales combined with strong maintenance renewals contributed to our deferred revenue and backlog under ASC 605 of $816 million, representing a record Q2 high and a 24% increase over last year's comparable balance. Deferred revenue and backlog under ASC 606 totaled $587 million.

Recurring revenue for the quarter under ASC 605 grew 11% in constant currency to a total of $228 million or 76% of total revenue. Under ASC 606, recurring revenue totaled $225 million or 73% of total revenue. Under either method, our growing base of recurring revenue gives us good insight and predictability into our future performance.

The strong top line performance helped to drive a second quarter gross margin of 90% under both accounting methods and an operating margin of 45.5% under ASC 605 and 47.3% under ASC 606. The Q2 operating margin was above the high end of the guidance ranges that we had previously provided. Margins were positively impacted by revenue results finishing at the upper end of our revenue guidance when factoring in the strengthening of the U.S. dollar beyond the currency ranges provided with our previous guidance, particularly against the euro and the British pound.

The ASC 606 revenue and margins were favorably impacted by the timing of deliverables under a single contract that yielded $12.5 million of revenue in the second quarter. This revenue was originally anticipated to be recorded in Q3 of this year. This is a good example of contracts that can cause the increased volatility that we expect in our ASC 606 results. We also experienced a slightly slower pace of hiring than we had planned for the quarter. These delays were partially attributable to OPTIS integration activities that have been taking place across the teams since the closing of the deal in early May.

We reported second quarter EPS of $1.24 under ASC 605 and $1.35 under ASC 606. With respect to taxes, our effective tax rate in Q2 was 22%, which was at the lower end of the range that we had guided coming into the quarter. Going forward, we have updated our estimates and expect our effective tax rate to be in the range of 19% to 21% for Q3 and 21% to 22% for the full year. This includes an anticipated non-recurring net tax benefit of approximately $5 million or $0.06 that we expect to record in Q3. This net benefit relates to certain subsidiary activities, including entity structuring, that are currently underway.

Our cash flow from operations totaled $111 million for the quarter and $244 million for the first half. We closed the quarter with a total of $696 million in cash and short-term investments, of which 76% is held domestically.

Now let me turn to the topic of guidance. We are initiating guidance for the third quarter and expect non-GAAP revenue under ASC 605 in the range of $302 million to $312 million, and non-GAAP EPS in the range of $1.25 to $1.31. Non-GAAP revenue under ASC 606 is in the range of $265 million to $285 million, and non-GAAP EPS in the range of $0.93 to $1.07.

For the full year, we are increasing our constant currency revenue guidance. But due to the movements in currency rates that I mentioned earlier, we are also revising our outlook to reflect the estimated negative $15 million impact on revenue due to currency in the second half of the year. We are also increasing our EPS outlook for the full year. This increase reflects the strong performance in the second quarter combined with our confidence in continued positive business momentum for the remainder of the year.

This translates into our updated outlook for 2018 of non-GAAP revenue under ASC 605 in a range of $1.223 billion to $1.245 billion or constant currency growth of 10% to 11% at the midpoint, and EPS in the range of $4.97 to $5.09. Non-GAAP revenue under ASC 606 is in the range of $1.210 billion to $1.250 billion, and non-GAAP EPS in the range of $4.87 to $5.14.

With respect to the contribution from the OPTIS business, our outlook remains largely in line with what we had communicated last quarter or a range of $25 million to $26 million of revenue for 2018. We're also updating our ACV outlook for 2018 to factor in the negative impacts from changes in currency rates since we last provided guidance.

Our revised outlook for ACV is a range of $1.252 billion to $1.282 billion. This represents constant currency ACV growth of 9% to 12% over the 2017 baseline or approximately 10% to 11% at the midpoint. We are also maintaining our outlook for operating cash flows other than a slight currency adjustment and narrowing of the range to $435 million to $470 million.

I would like to remind everyone that our outlook for operating cash flow in 2018 includes our current estimated adverse impact of approximately $12 million to $15 million related to the acceleration of income tax payments under ASC 606 that is associated with deferred revenue and backlog credited to retained earnings that will never be recognized as revenue in the company's financial statements.

For modeling purposes, we are expecting third quarter operating margins of 44% to 45% under ASC 605 and 37% to 40% under ASC 606. And for the full year, we expect operating margins of 44% to 45% under ASC 605 and 43% to 45% under ASC 606. Further details around specific currency rates and other key assumptions that have been factored into our outlook for Q3 and 2018 are contained in the prepared remarks document.

In summary, we delivered another solid quarter with strength across our key financial metrics: ACV, top line growth, operating margins, EPS, operating cash flows, and deferred revenue and backlog. The strong second quarter and first half performance give us confidence that our continued focus on execution and investing in the business combined with the ongoing growth in our recurring business, our strong customer relationships and healthy sales pipelines provide a solid foundation to continue to deliver on our 2018 goals, as well as our longer-term 2020 financial targets.

Operator, we can now open the phone lines to take questions, please.

[Operator]

Thank you very much. We will now begin the question-and-answer session. Our first question is from Monika Garg of KeyBanc. Please go ahead.

[Monika Garg, KeyBanc Capital Markets, Inc.]

Hi. Thanks for taking my question. Maria, first question is your total revenue yearly guidance is unchanged in spite of currency impact of $15 million. But then you are reducing ACV guidance by $15 million due to FX, because I'm trying to understand if it's not impacting revenue, why it is impacting ACV.

[Maria T. Shields, ANSYS, Inc.]

So, Monika, relative to the outlook for the full year on revenue guidance, it is slightly modified up after factoring in the currency impact of $15 million. And from an ACV perspective, the same thing, really the only changes to ACV at this point are factoring in the negative impact from currency in the second half of the year because of what's transpired in rate changes since we gave guidance in May. There was no other changes to ACV other than for currency.

[Monika Garg, KeyBanc Capital Markets, Inc.]

Got it. I mean what I'm trying to understand is the upside you are seeing in the business in the revenue side, won't you also see in the ACV?

[Maria T. Shields, ANSYS, Inc.]

Yeah. The ACV range, Monika, we've given a wide enough range that we believe that some of the puts and takes that may happen, particularly in Q4 where some of those larger deals are heavily weighted towards. Sometimes, the reality is timing may move those into another quarter. So, we're trying to balance all the variables and factor in timing around large deals and the reality that as you get to the end of the year sometimes with holidays and things, you just run out of runway.

[Operator]

Thank you very much. The next question is from Gabriela Borges of Goldman Sachs. Please go ahead.

[Gabriela Borges, Goldman Sachs & Co. LLC]

Good morning. Congrats on the quarter. I wanted to follow up on a few of the go-to-market initiatives mentioned in the prepared remarks, specifically the build-out of the channel partners and the hiring of technical salespeople. Maybe for Ajei, at a higher level, where are you in the cadence of these investments and how long is it typically between when you add a technical salesperson or a new channel partner, and when do you expect to see a contribution to the pipeline and bookings? If I could ask you also to comment on the in-progress changes in APAC that are mentioned in the prepared remarks. Thank you.

[Ajei S. Gopal, ANSYS, Inc.]

Sure. So, when you think about the changes that we're making and what we announced last year, we said we were going to go through a change in our go-to-market strategy and that would include a greater focus on channel partners and would also include a clear understanding and segmentation of the market with an incremental focus on enterprise accounts and then with our direct sales organization also taking strategic accounts and sort of territory accounts and then working with the channel to make sure that we have a clear segmentation.

As part of that process, we clearly recruited a number of new channel partners who've come on-board and that work is ongoing. Obviously, the rate at which channel partners come up to speed depends on their level of background and the amount of work that they've done in our space in the past. We are very diligent in how we choose channel partners and it can take some time to screen them to come on-board. And obviously, they have to come up to speed on our products and so forth. But again, the speed at which they are able to sell depends on their experience in our space.

As far as the technical resources are concerned, we continue to recruit and we have been able to add to our technical salespeople or our ACE organization. The pace is not exactly what we would have wanted because obviously we're looking for very, very high skilled people. And so, we're a little bit behind on that, but we still continue to be able to add to our ranks. I think those were the questions. Was there anything that I missed?

[Gabriela Borges, Goldman Sachs & Co. LLC]

Just on the in-progress changes in APAC and then I have a follow-up on Discovery Live, if I may.

[Ajei S. Gopal, ANSYS, Inc.]

Oh, yes. In APAC, so essentially the point about APAC was, as I mentioned in the script, we have a year that's more – a little bit back-end loaded. And that obviously, the timing of deals obviously then has an overall impact on quarter performance versus year performance. That's number one. Point number two, I would say we were a little bit slower in implementing some of the go-to-market changes that I just talked about in South Korea and that had an impact, I would say, on our performance in that country.

And then, the other point I mentioned was around the centralization of some large enterprise deals. Essentially what happens is we serve customers obviously who are global in nature, they have workforces around the world. And we had a few deals where even with workforces in India, the customers chose to purchase at a different country and centralize the purchasing. So, that's the situation over there. It's obviously a multiphysics solution that these customers are going after as opposed to a historical kind of single physics deal. So, that's really the changes that are highlighted in the script.

[Gabriela Borges, Goldman Sachs & Co. LLC]

That's very helpful. Thank you. A follow-up is on Discovery Live, what can you share at this point about unit economics? I think we've talked about a $2,000, $4,000, $6,000 price point before. With the PTC agreement, any color you can tell us on the gross margin line and the contribution that could have.

And one of the questions that we have is when you look at the price points of CAD solutions, historically they've also been in that same sort of range, the $2,000, $4,000, $5,000 range. When you've gotten customer feedback, has there been any concerns or pushback around while the price of adding on Discovery Live is almost equal or perhaps more than the price of the base CAD solution? And sometimes when you're upselling at that kind of price point, meaning double, that can be a little bit of an uphill battle. So, I would love to hear if any of the feedback from customers has touched on that at all and maybe been positive in spite of that. Thanks.

[Ajei S. Gopal, ANSYS, Inc.]

So, firstly, this was our first full quarter of Discovery in the marketplace and we've seen trials increase. We have conducted or we've sold Discovery Live in every single geo, we've sold Discovery through multiple channels and the feedback has been very positive. We're seeing customer traction. I gave you an example in the script of China Southern Power Grid. So, there is clearly market demand for the product. There's validation that the product hits a sweet spot and there's validation that we have it right. So, I'm excited about that.

With respect to PTC, that's a royalty arrangement with PTC. So, to your point about margins, it's a royalty arrangement. As far as the revenue impact from the PTC relationship, at this point of time we don't have product in market and we don't expect to see any impact in 2018. We're expecting this to have an impact on the following year.

As far as customers' interests are concerned, they don't view this as a – this is not sort of a small add-on to a CAD solution. The Discovery Live, the simulation aspects of Discovery Live are extremely powerful and this is brand-new industry leading capability. So, we're seeing a lot of excitement from customers, especially in the PTC installed base as they think about their Creo users, for them to be able to get CAD we don't see any problem in maintaining the price point at all. So, we don't see that as a problem right now. Obviously, we'll have product in market later on and we'll have hands-on evidence later on, but right now we don't see the price point as a problem at all. And I think I addressed all the questions.

[Operator]

Thank you very much. Thank you. The next question is from Gal Munda of Berenberg. Please go ahead.

[Gal Munda, Berenberg Capital Markets LLC]

Hi, guys. Thanks for taking my question. I'd like to ask one in terms of the large deals. Now you guys have done three large deals over $30 million over the last three quarters or so. Can you just give us a bit of a color about the opportunity, the way you see in terms of your existing installed base, how many of those customers are starting to look at a overall portfolio, maybe consolidate some of the vendors that are using simulation and what that means for the opportunity in the pipeline of your large deals? Just trying to get an idea, is that out of your customers, is that 20, is it 100s, just kind of if you can ballpark it for us. Thank you.

[Ajei S. Gopal, ANSYS, Inc.]

So, one of the important metrics to consider as you think about our evolution for large deals is to think about the journey that we've been on. And if you look back at the history of ANSYS, we were historically selling single physics and our sales motions were around being able to sell an incremental solver at a time and we were operating very much at the lower levels of the organization.

We've obviously moved up over the years and certainly with the changes that Rick – in the go-to-market that I spoke about earlier, the changes that Rick has made, we have a very clear and thoughtful approach to being able to address the needs of our customers. We use channel partners where appropriate, we use inside sales where appropriate, and certainly we have also strategic accounts and enterprise accounts. These are accounts that we believe will be driving significant multi-portfolio sales and as I mentioned in my script, we have – something like 75% of these large million-dollar deals include three or more physics.

And so, what you're seeing in the evolution is customers who were previously single physics customers are now expanding their footprint and moving to multiphysics customers. No one shows up on day one as a non-customer of ANSYS and then buys multiple millions of dollars of software across multiple physics. Usually what happens is they'll come in and they'll grow. And so, many of our existing customers and many of these large deals come from customers who've had years of success with ANSYS who are now expanding their use of simulation.

The reason they're expanding their use of simulation is not just because we're building, we're reaching them in the best possible way we are. We're trying to meet the customers where they are. We're trying to adjust our go-to-market to address the needs of the customers. So, that's one. But it's also the case that the products that they're dealing with are becoming significantly more complicated.

So, if you take, for example, automotive and I mentioned an automotive sale whereas years ago we may have had a conversation with customers about structures or fluids or air flow. Today, the conversation is about electrification. I mentioned the example of Volkswagen Motorsport, it's about electrification, it's about electric drive trains. The conversation is about autonomous and these are all intrinsically multiphysics solutions that include our electronic solutions, our embedded software, optical solutions, we have OPTIS in the case of autonomous and so forth.

And so, the nature of the customer problems have changed. We're in the right place at the right time of the right portfolio. We have the right go-to-market and we're in a position to get to the customers as they need to, which is essentially driving the growth of our portfolio. The other point I made in the script is we've made investments in our engineering services organization and we're able to monetize that investment and that also drives adoption and it drives customer success. So, we're very excited about this movement towards larger deals, towards satisfying customer needs at a higher level and we're very optimistic.

[Gal Munda, Berenberg Capital Markets LLC]

Thank you. And just as a follow-up, when I look at your ACV growth around 8% constant currencies, deferred revenue and backlog still even in constant currencies must be growing above 20%. Can you just talk a bit about that mix shift that's going on still between the perpetual licenses and leases? How does that compare kind of year-on-year? Even, Maria, if you can comment on that. And how does that compare with your expectations that you had? Do you still see more and more leases coming in and are those large contracts mostly, likely to be leases in the future as well? Thank you.

[Maria T. Shields, ANSYS, Inc.]

Yeah. So, Gal, what I'd say is, I commented in the script, I called out the fact that the recurring revenue streams are growing double digits in constant currency and, no doubt, perpetual licenses are single-digit growth this year. That being said, certain geographies particularly in Asia, as Ajei had alluded to, that are slated for second half tend to be paid up in nature. But no, Gal, as the enterprise and strategic accounts become a larger part of the quarterly business flow, they are choosing leases as opposed to traditional.

When they were more single physics customers, they tended to be paid up and now they are migrating. We will continue to have a flexible business model that enables customers to choose because that's the most important element, we believe, as customers migrate to truly broadening the use of multiphysics across the enterprise and adding new products to their portfolio of usage. We need to allow them to license the software under whatever model makes sense for them. And currently a number of those are choosing multiyear leases and we're okay with that.

[Operator]

Thank you very much. The next question is from Ken Talanian of Evercore ISI. Please go ahead.

[Kenneth Talanian, Evercore ISI]

Hi, guys. Thanks for taking the question. So, first for a bit of housekeeping, could you tell us the inorganic contribution to ACV in the quarter and a rough estimate of what you now expect for the year?

[Maria T. Shields, ANSYS, Inc.]

Yeah, it's about 4% to 5% for the quarter, and 25% to 30% for the year.

[Kenneth Talanian, Evercore ISI]

Okay, great. And I guess for Ajei, sort of bigger picture question, but given the big deal activity, I was wondering if you could help us understand what level of upsell you're starting to see on some of these deals as you expand the physics.

[Ajei S. Gopal, ANSYS, Inc.]

What do you mean what level of upsell? Are you talking about expansion across physics or use cases? Could you clarify, please?

[Kenneth Talanian, Evercore ISI]

Well, simply, if you are revisiting a renewal with a customer and say they are paying $1 million, on average how much upsell are you getting above the prior run rate?

[Ajei S. Gopal, ANSYS, Inc.]

It's very hard to give you a formulaic response, because the fact remains that each of these deals, it depends on the industry that the customer happens to be in, it depends on the geos and it depends on the specific initiatives that they have underway. And so, there's no standardized answer. The broad trends though that I've mentioned several times, the broad trends that we're seeing of smarter products, that's driving a lot of this conversation. And so, you'd get and I gave you the example of how we are having these broader conversations with a number of customers in the automotive space.

If I think about telecommunications, we're having conversations about 5G and those happen to be strategic initiatives and so on. I can pick the industry and whatever the strategic area is, that's the area that we're focused on to try to help them be successful using our technology. And that's what drives the incremental use of technology. And oftentimes you'll find customers starting to take a step away from some of their core areas of competence as they start to move into some of these new physics.

And in particular, customers have historically not used electronics heavily in the building of their products. When they recognize that you now need to build smarter products, they need more support for electronics. That depends on the level of staffing they can get and that depends a little bit on the broader support they're able to get together for themselves and, of course, we're in a position to help there, too. So, a lot of it really depends on where the customer is, industry, geo and so on.

[Operator]

Thank you very much. The next question is from Rob Oliver of Robert W. Baird & Co. Please go ahead.

[Rob Oliver, Robert W. Baird & Co., Inc.]

Hi, guys. Thanks for taking my question, and apologize for the bad connection here if I have one. Just given the push into indirect channels and partnerships and the success you guys are having there, I mean how should we think about kind of the longer-term mix of direct versus indirect business? I think traditionally it's been about three-quarters direct. And do you guys see that changing at all?

And then, I'll put my follow-up in now in case I get cut off again. This is the second quarter in a row where you guys mentioned it's been challenging to hire and that hiring would be back-end loaded. I was just wondering, is that a field technical sales issue and what gives you guys the confidence that you'll be able to hire in the second half of the year? Thanks a lot.

[Ajei S. Gopal, ANSYS, Inc.]

So, in first as far as your question about the volume of business to the channel partners, we are not seeing – we don't fundamentally expect the numbers to change dramatically in the short term and it's been, as you rightly say, about a quarter – three-quarters and that's what we certainly see in the short term going forward.

As far your – about your question about hiring people, this year as you know we increased our hiring aperture and we were looking for significantly more people than historically have been in the position to hire. And it takes a certain amount of time to rev up the recruiting engines and that obviously adds latency to the process. And it's also the case that we're looking for very skilled individuals and some of these individuals are a little bit harder to find. So, we're building our recruiting pipeline which is, of course, both our internal pipeline as well as some recruiting partners and we have a key focus on making sure we can address and bring more people on-board. Maria, anything to add?

[Maria T. Shields, ANSYS, Inc.]

Yeah. Rob, I just wanted to add one thing. As with any time that we acquire businesses, it just has a natural slowdown, as we think through the integration, as we think through what talent do they bring to the table that may be able to fulfill roles that we had originally thought in the plan that we were going to go to market to fill. So, that combined with, no doubt, a more challenging hiring environment has slowed things down. But that being said, we continue to have an aggressive recruiting engine, in fact, we just recently hired a couple more additional people on that team to help us as we head into the second half, so that we are well prepared as we head into 2019.

[Operator]

Thank you very much. The next question is from Rich Valera of Needham & Co. Please go ahead.

[Richard Valera, Needham & Co. LLC]

Thank you. Ajei, auto featured very prominently in your prepared remarks and I know that's historically been the large customers of your products. And just wondering, is there something going on specifically in the auto industry that's leading to kind of more activity, bigger deals that's somewhat unique to auto? Or is that something you expect to sort of see pervasively amongst your other verticals that you quote (00:48:23)?

[Ajei S. Gopal, ANSYS, Inc.]

Well, one of the reasons I've mentioned auto is really they epitomize this change that's taking place towards smart connected products. The big trends in automotive which are autonomous vehicles, electrification and sort of connected, if you will, all of those trends, we have great technologies that support our customers through that transition. So, we have, for example, with the OPTIS acquisition that we just recently concluded, we have now an end-to-end simulation that allows our customers to be able to simulate driven miles.

And so, one of the big challenges with autonomous is you can't – it's very difficult to test autonomous vehicles and we can now with this integration across the OPTIS portfolio and the traditional ANSYS portfolio, we now have an integrated view of virtual miles driven as well as an integrated view of all of the sensors, including camera, lidar and radar as well as, of course, ultrasound for short distance. And we can kind of close the loop on the simulation process. So, that's a very exciting solution. It's completely relevant to what the car companies are dealing with right now and not just on road, but also off road. Similarly for electrification and I gave a couple of examples, and similarly for connected and we're talking about 5G and antenna design and so forth.

So, that's clearly making a difference for the end customer and then, of course, those changes reverberate through the supply chain. And so, we're having conversations and we're working with customers, for example, around the integration of our safety technology into semiconductors. And so, in fact, in Q2 a major automotive chip provider, they expanded their use of simulation – and who's the chip provider, they expanded the use of simulation to include ANSYS medini, which is our safety solution to get ISO 26262 functional – for ISO 26262 functional safety analysis, which is appropriate for the auto industry.

So, there's an enormous amount of reverberation through the supply chain from the automotive sector that you're seeing. So, I think that's one area. But these broad trends, I think, are applicable across industries. As I said, industries are at different levels of maturity and we expect to see these trends repeating themselves across other industries as well.

[Richard Valera, Needham & Co. LLC]

Thank you. And then just a quick follow-up for Maria. Can you reiterate what you said on taxes for 2018, what it was in the pipeline, too (00:51:13)? Thanks.

[Maria T. Shields, ANSYS, Inc.]

Yeah. So, what I said was for Q3, we're looking at a range of 19% to 21% because we will have a non-recurring benefit of about $5 million or $0.06. And then for the full year, we are looking at a rate of 21% to 22%.

[Richard Valera, Needham & Co. LLC]

Thank you very much.

[Operator]

The next question is from Jay Vleeschhouwer of Griffin Securities. Please go ahead.

[Jay Vleeschhouwer, Griffin Securities, Inc.]

Yeah. Thank you. Good morning. For Ajei, first, with respect to making the simulation more pervasive via partnerships, in particular, if in the case of the PTC relationship you penetrate, let's say, the majority of the active Creo base, that would add about 100,000 licenses to the ANSYS space, perhaps more. When you consider your other partner opportunities, particularly in operations such as with SAP or ARRIS, are you thinking in terms of potentially tens of thousands or hundreds of thousands of additional licenses added to your base, albeit at possibly substantially lower than usual ARPUs with the solvers?

And then relatedly, I'll ask you a question I asked PTC which is how are you managing or implementing the partnerships more deeply into the ANSYS organization, not just at the highest levels of the company. And then just for my follow-up in for Maria, your ASC 605 non-GAAP operating margin guidance suggests about a 200 basis point decline at the midpoint from 2017. Is the margin antimatter for the year mostly due to higher R&D, including the OPTIS acquisition? Or is it mostly SG&A as you add sales in AEs plus variable comp on the bookings growth? Thanks.

[Ajei S. Gopal, ANSYS, Inc.]

So, Jay, let me try to address that multipart question. I'm not sure I have all of the – let me look at Maria's notes here. So, the first was around the number of users. So, look, it's much too soon for us to give you a revenue projection of where we'll be with some of those partnerships. It's obviously the case that we will be expanding the number of users to others who have just traditionally not been using ANSYS solutions. That's certainly the case, as you start to think about going downstream into operations and, of course, as you start to think about the designer community. And we believe that there's an opportunity to monetize that relationship going forward. Obviously, it'll depend on the kind of user and the industry they're in.

You're also absolutely right to suggest that the cost that we would charge or pricing for run-time licenses with digital twins will be different from our pricing for our traditional solvers. And that's obviously going to be the case because the use cases are different and the nature of usage across those two cases will drive a different level of complexity and solver need.

As far as investing in the relationship is concerned, I think that the relationship has multiple touch points. We have project management in place. We have multiple touch points up and down both from an R&D perspective as well as from a go-to-market perspective. From an R&D perspective, obviously, the teams are working together to make sure that we can sync up on deliverables and we get everything in place for product release by PTC, but our teams are working closely together.

And from a go-to-market perspective, obviously there's some planning involved to make sure that we understand what we're doing together. So, I think that that's well underway and obviously this is a working partnership with people rolling up their sleeves and getting the job done. So, I'm excited about that relationship and I'm excited about frankly the mobilization on both companies; both PTC and us to move things forward. Maria, there was another question, right?

[Maria T. Shields, ANSYS, Inc.]

Yeah, around margins, I'll take that one. Jay, if you look at our guidance for full year under ASC 605, we're saying 44% to 45%, which was pretty much in line with what we had communicated as we came into the year relative to our perspective for the full year. We are building in the impact of OPTIS, which is slightly negative as we had communicated last quarter.

And, no doubt, we are continuing to add investments across the business, particularly on the people front, R&D, field engineering, as Ajei mentioned. On the partnerships, we have added incremental people whose full-time job now is to focus on the success of those partnerships. So, we're investing across all the functions of the business to prepare ourselves to be able to continue to take advantage of the tremendous market opportunity that we see ahead

[Ajei S. Gopal, ANSYS, Inc.]

Chris, do we have another question? Operator?

[Operator]

My apologies, sir. Ladies and gentlemen, our next question is from Ross MacMillan of RBC Capital Markets. Please go ahead.

[Ross MacMillan, RBC Capital Markets LLC]

Thanks so much. Ajei, I know it's early on Discovery Live, but the example of China Southern Power Grid suggests that it may be a way to engage with customers and then actually drive adoption of the broader portfolio into those accounts. I was just curious, is that a secondary effect, a trend that you think is going to be more pervasive. And then my follow-up for Maria, on the ACV growth that you've given us for both Q2 and first half in constant currency, I wondered if you had the comparable growth rates for ACV in 2Q 2017 and 1H 2017. Thanks.

[Ajei S. Gopal, ANSYS, Inc.]

So, to answer your question, there are actually, I would say, a couple of important use cases for Discovery Live. And one as we've discussed is, of course, the – is the use of Discovery Live by individuals who have not necessarily been using simulation and those individuals could be at companies who historically have not bought ANSYS solutions. And so, that's clearly a use case.

But there's a really exciting use case which the Discovery Live, Southern China experience does bring to focus and that is that many of our customers who are historical users of ANSYS recognize the opportunity to be able to broaden the deployment of simulation through their engineering base by making Discovery Live available to their designers. And so, we'll go from the flagship into the designers.

But equally, we can go in from the designers into the flagships, because we have now the ability to provide this end-to-end coverage across the organization for people of different levels of skills and capabilities and understanding of simulation with the ability to be able to move and migrate work across the different product lines. And so, that's a dynamic that we're very excited about.

And we see this pattern continuing with customers and that's something that we're encouraging and, certainly, our enterprise sales force is excited about that because that g them an opportunity to engage with some of these large customers and they're seeing large opportunities for Discovery Live, but then they're seeing that driving further flagship sales. So, that's a symbiotic effect that we're very excited about.

[Maria T. Shields, ANSYS, Inc.]

And, Ross, to your question on ACV growth, ACV is a new metric that we just started reporting in 2017. So, we have not gone back to recreate ACV under historical data. So, I don't have the comparisons for last year to the same periods.

[Operator]

Thank you very much. Ladies and gentlemen, that concludes our Q&A session. And I would like to turn the conference back to Ajei Gopal for any closing remarks.

[Ajei S. Gopal, ANSYS, Inc.]

Thanks, Chris. I'm delighted by the excellent quarter and the progress that we've made. Our Pervasive Simulation strategy is clearly resonating with customers. And as I think about the rest of the year, our focus remains on execution. We will continue to strengthen our flagship products with ANSYS 19.2 that's coming out soon and we will continue to expand our ecosystem through additional partnerships. And, of course, we will continue to support and grow our customer base.

In closing, I would like to express my sincere gratitude to our customers and to our partners and a shout out to my ANSYS colleagues, thank you for all your efforts and thank you for another great quarter. Thank you all for joining me on the call today. I look forward to our next discussions. Enjoy the rest of your day.

[Operator]

Thank you very much, sir. Ladies and gentlemen, that concludes this conference call and you may now disconnect your lines.