Dassault Systèmes: Trading At A Price I’m Willing To Pay (OTCMKTS:DASTF)

I felt a bit hesitant about publishing this article, despite being convinced weeks ago that Dassault Systèmes [DSY] (OTCPK:DASTY, OTCPK:DASTF) was a buy and still maintaining that belief today. The hesitation persisted because, during additional research on the company, its stock continued to climb significantly, potentially diminishing future returns as I wrote this analysis until its publication. On the other hand, the skyrocketing DSY stock only validates my thesis of its potential. This is why I am still publishing my analysis of this high-quality company, which, based on my assumptions, could still be a buy.

I discovered this stock at the end of October 2023 as part of an article series for a German investment community where we highlight 3 stocks worth buying each month. Back then, Dassault Systèmes was trading over 24% lower than today, which already strongly supports our assessment, at least in the short term. This provides ample reason to delve even deeper – and the stock has gained almost 10% in the few days since I began crafting this analysis.

Furthermore, recent acquisition news of ANSYS by Synopsys has sparked additional industry interest. ANSYS (ANSS) experienced a surge in the stock price as reports indicated that Synopsys (SNPS) has finalized terms for acquiring the software company. Synopsys is set to pay approximately $35 billion for ANSYS, roughly $400 per share – a substantial premium compared to ANSYS’ previous trading price. Although the acquisition timeline extends up to 24 months for antitrust clearance, I will consider this high valuation as further external justification also for Dassault Systèmes [DSY] later on.

But to begin with, here is how my thesis is structured:

• A look into the past – why I perceive DSY as an exceptionally stable and high-quality player in its industry.
• What analysts are forecasting and why I find their projections reasonable.
• Valuation – why I consider it adequate, despite initial red flags.

I approach value with a dual perspective: in some analyses, I emphasize storytelling, while in others, especially in sectors where my expertise is limited, I prioritize a quantitative focus. In the latter case numbers, as a reflection of reality, guide my understanding, as seen in the subsequent Dassault Systèmes analysis, where I am not an industry expert. Your insights and comments, especially from specialists in DSY’s field, are therefore warmly welcomed!

Business Model – A Brief Overview

Over the last decade, Dassault Systèmes’ stock has demonstrated impressive performance, outpacing the market with an average annual price return of around 18% and multiplying more than thirteenfold over a 15-year period (in EUR). To give a quick business model introduction for US readers not so familiar with the French company, I am citing an earlier article of mine:

Dassault Systèmes gathers software experts to digitally depict reality in almost every aspect of life. Their software solutions are used in 11 different industries, including manufacturing, healthcare, infrastructure, and urban planning. They have 290,000 customers, ranging from big companies and startups to government institutions and individuals, totaling 25 million users for Dassault Systèmes’ software. On average, that’s about 86 users per customer. It’s hard to estimate how many end consumers around the world indirectly benefit from the company’s software solutions. Thanks to Dassault Systèmes, business clients can make their processes more efficient and cost-effective, while the safety of millions worldwide depends on the final products created through these processes. For example, the company’s software has already made detailed digital representations of the Boeing 777 and been used in complex crash-test simulations for vehicles before real cars hit the road. In the business world, their leading Enovia software allows for the complete digital tracking of product lifecycles. In healthcare, there are already digital twins of human hearts, used for testing medical procedures before actual surgeries. European retail giants like NKD, Carrefour in France, or Aldi Süd are among the over 770 companies utilizing CENTRIC as software for product lifecycle management.

High-Quality Operational Performance

In the past, Dassault Systèmes has proven itself to be a highly reliable and stable company operationally. Aktienfinder.net calculates stability indicators for revenue, earnings, cash flow, and dividend developments for lots of companies. These indicators range from -1 to a perfect score of +1, like a correlation coefficient, indicating perfectly reliable positive development in the latter case. DSY’s stability indicators stand at strong values of 0.97, 0.94, 0.94, and 0.93 for the mentioned metrics. Competitor Autodesk has not yet achieved such high indicators, with an earnings stability of only 0.58, just to provide an example. However, even though Dassault Systèmes doesn’t need to hide its growth, Autodesk is currently the faster-growing company that has outpaced Dassault Systèmes over the last five years, boasting average annual growth rates of 52 percent in profit and 16 percent in revenue. But, looking at the 10-year horizon, Dassault Systèmes is on par or sometimes stronger in growth, as its profit and revenue development has been more stable over an extended period. In summary, Autodesk’s stock provides a more dynamic growth story in the mid-term, while Dassault Systèmes’ is already established and exhibits long-term stability.

Looking at the balance sheet, Dassault Systèmes has significantly reduced its interest-bearing debt in recent years and has even built a net cash position to date. The interest-bearing debt could theoretically be paid off from the free cash flow in just 2-3 years, even after paying dividends.

The quarterly results reported at the end of October for the third quarter exceeded the management’s goals despite currency-related headwinds, also leading to a sharp increase in the stock price. The targets were primarily surpassed in the software segment rather than DSY’s less significant service segment. A key driver of growth is the 3DEXPERIENCE platform, exhibiting high double-digit growth rates on a quarterly basis as well as for the first three quarters of the fiscal year. Renowned clients like Jaguar Land Rover and AbbVie have extended or intensified their partnerships. Constant-currency revenue growth reached 12 percent compared to the same quarter of the previous year, accompanied by an improvement in operational margins. Encouraged by the positive business development, the management confirmed the outlook for the full year 2023, expecting revenue growth between 8 and 9 percent, and slightly raised the targeted EPS range.

Robust Forecasts

For Dassault Systèmes’ upcoming 2 to 3 fiscal years, there are 2 to 15 analyst estimates available from my source depicted below – a coverage I consider sufficient to derive a valid median. Accordingly, the adjusted profit is expected to grow between 7 and 12% annually, accompanied by a robust annual revenue growth of 9%.

For validation, I compared the much-discussed competitor Autodesk concerning estimates for adjusted EPS, as well as Synopsys (acquirer) and ANSYS (target), influenced by their recent acquisition announcements. ANSYS seems to show slightly weaker adjusted EPS growth, being on par with DSY – an interesting fact given its high valuation based on the acquisition price, which we will compare to DSY later. Overall, analysts’ ambitious earnings estimates for DSY do not appear unrealistic in the peer comparison. On the contrary, they seem quite moderate.

Valuation Requires A Deeper Look

DSY stands out negatively in the Seeking Alpha Quant Rating, primarily due to its poor valuation score. This seems obvious at first glance, without further research, given the extraordinarily high P/E of 60 based on GAAP earnings. However, my thesis is that savvy investors familiar with DSY don’t rely on GAAP earnings as their valuation basis, but rather on Non-GAAP or adjusted EPS.

GAAP earnings at DSY typically include significant ongoing depreciation on intangible assets such as software or customer relationships, which, however, no longer lead to a cash outflow. Therefore, adjusted earnings are close to operational and free cash flow – the more relevant valuation metrics. The free cash flow is only marginally lower than the operational cash flow, as Dassault Systèmes makes no significant investments outside its operational business and instead grows through research and development. These expenses are already considered in the operational domain. Thus, cash flows and adjusted earnings best reflect the value creation of Dassault Systèmes.

And based on adjusted EPS, the story looks quite different, as the adjusted P/E is below 40 – comparable to that of the acquisition target ANSYS, which has not even fully priced in the potential takeover price yet. At the same time, the adjusted P/E is slightly higher than that of Autodesk – which at first seems counterintuitive given Autodesk’s higher expected growth rates. However, my derivation of the capital cost parameters shortly will clarify why the high adjusted P/E for DSY, in my view, is still justified.

To derive DSY’s fair value through a simplified Discounted Cash Flow model, I utilize free cash flow projections sourced from Aktienfinder.net that highly correlate with adjusted EPS forecasts, as depicted and validated earlier. These projections are drawing on median analyst estimates until the fiscal year’s end in 2026, based on FactSet’s database. I successfully cross-verified the actual figures from the last five years for this metric (free cash flow) with those from Seeking Alpha. To approximate a simplified Terminal Value, I am using an average of all free cash flows from 2022 (last available actuals) till 2026e (all forecasts), which is 26% higher than the last actual value in 2022 – all of this visualized below.

My research on DSY’s WACC (Weighted Average Cost of Capital) settles at a value of 6%. This figure reflects current levels of risk-free alternatives that are denominated in Euro, as DSY reports and plans its financials in Euro. Additionally, current Equity Risk Premia per country, as last published in January 2024 by the renowned Prof. Damodaran, are factored in. Considering that DSY’s revenue primarily comes from mature markets like the USA, France, Japan, or Germany (altogether accounting for 81% of revenues in 2022), there are only marginal country risks on top of the Equity Risk Premium for mature markets.

DSY’s statistically slightly lower-than-market-average volatility – expressed in its Beta factor – contributes to keeping DSY’s WACC relatively low. I am relying on an average of the 2 and 5 year Beta factor from Seeking Alpha, conservatively adjusted using the Blume method. This calculation yielded a Beta factor slightly above 0.8. This is exactly what makes the difference between DSY and Autodesk. Whereas due to Autodesk’s higher growth one would intuitively expect higher P/Es, this is counteracted by way higher risk associated with Autodesk (Beta of 1.4 applying the same systematics). This translates the P/E downwards. Or from the other side, it is DSY’s stability and reliability over many years that give the stock the bonus of a high valuation – expressed in a high P/E or relatively low cost of equity. Lower Debt financing costs contribute to further slightly lower DSY’s WACC.

I am applying a terminal growth rate of 4% into perpetuity, based on the convergence assumption. Within this assumption, I presume that newly invested capital yields neither more nor less than its required cost of capital of 6%. Furthermore, I assume that two-thirds of DSY’s free cash flow is reinvested, aligning with DSY’s recent only 20-40% dividend payouts in recent years and the easily manageable debt burden. So, 4% eternal growth is calculated as 6% WACC times the assumption of 67% of retained and reinvested earnings.

Using these parameters, I’ve calculated the present value of free cash flows for Dassault Systèmes at approximately 59 EUR per share (equivalent to 64 USD at current rates). When factoring in net cash, the total equity value is only slightly higher at 60 EUR per share (equivalent to 65 USD at current rates), significantly surpassing the current share price of approximately 46 EUR. While this valuation depends on my assumptions, the stock movement since first considering it a buying opportunity is impressively moving towards the target of my valuation result. Historically, DSY has even seen much higher valuations on an adjusted EPS basis.

Weak Spots of This Thesis

The additional upside potential, from my perspective, largely stems from my valuation considerations that aim to apply as objective methods as possible. Nevertheless, other market participants may subjectively evaluate these parameters differently. This constitutes one of the key risks of my bullish thesis, which relies on below-market-average capital costs of 6% for DSY.

Another SA analyst points out that Dassault’s products are perceived as less innovative compared to Autodesk. Therefore, Dassault faces critical decisions for its long-term future, especially regarding the improvement of its 3D modeling programs and the integration of AI and new features. On an operational level, a shift in consumer preferences and the introduction of new features could support the demand for Autodesk, potentially harming Dassault Systèmes.

Additionally, I am citing my own risk assessment from my earlier DSY analysis:

Generally speaking, competition appears to pose a significant risk, with – besides Autodesk – further major players like Siemens, SAP and Microsoft competing in certain niches. Additionally, open-source software adds another layer of competition, potentially challenging paid products. Personally, I don’t perceive the competitive risk as overly concerning. On one hand, the market appears large enough for multiple providers, and on the other hand, I deem customer lock-in effects substantial, given the complexity and investment in switching software. This is especially the case because employees need thorough training to operate specific programs. Free software, in contrast to commercial services like those offered by Dassault Systèmes, I deem generally not reliable enough. Furthermore, Dassault Systèmes recently reported a pleasingly high proportion of 81% recurring revenues through subscriptions.

From a US perspective, the exchange rate between USD and EUR poses an exchange rate risk for the primarily EUR-listed stock.

Why I Stay Bullish Despite Recent Surge

Despite initial hesitation due to the surging stock price of Dassault Systèmes, I decided to publish my analysis, reaffirming it as a buy. Discovered in October 2023 when trading over 24% lower, DSY has once again demonstrated strong performance, gaining almost 10% since I began my research for this Seeking Alpha analysis about a week ago. The recent Synopsys-ANSYS acquisition has sparked industry interest, valuing ANSYS even higher than DSY based on the planned acquisition price. In my analysis, I was convinced by DSY’s past stability operationally and statistically when compared to its peers and the overall market. I argue that GAAP P/E multiples are not of as much importance as adjusted P/E, more realistically reflecting free cash flow developments. Analyst forecasts appear realistic given its past performance and in the light of forecasts of DSY’s peers. Therefore, not only do I justify a high valuation for DSY based on its stability, but also due to its robust growth, despite being relatively low within its sector. Risks include potentially ongoing shifts between competitors in the sector, these being big and mighty players. I once again emphasize that insights from tech-savvy industry experts are highly welcomed in the comment section.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.