##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

| |  |                                                                                         
| |  | ----------------------------------------------------------------------------------------
| |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
| |  | For the fiscal period ended: September 30, 2001                                         
|
| |  | OR                                                                                      
|
| |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
| |  | For the transition period from
          
to                                            

Commission file number: 0-20679

MECHANICAL DYNAMICS, INC.
(Exact name of registrant as specified in its charter)

|                                  |  |                                                
|--------------------------------- |  | -----------------------------------------------
|Michigan
(State of incorporation) |  | 38-2163045
(I.R.S. Employer Identification No.)

2300 Traverwood Drive
Ann Arbor, Michigan 48105
(734) 994-3800
(Address of principal executive offices, including zip
code, and telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

Yes               No

The number of outstanding shares of the Registrants common stock, as of
November 9, 2001, was 6,097,124.





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TABLE OF CONTENTS



|                               |                                                                                               |                                                                                                     |  |  |  |  |  | 
|------------------------------ | --------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------- |  |  |  |  |  | 
|PART I  FINANCIAL INFORMATION
|                               | Item 1. Financial Statements                                                                 
|                               |                                                                                               | Condensed Consolidated Balance Sheets September 30, 2001 and December 31, 2000                     
|                               |                                                                                               | Condensed Consolidated Statements of Income Three and Nine Months Ended September 30, 2001 and 2000
|                               |                                                                                               | Condensed Consolidated Statements of Cash Flows Nine Months Ended September 30, 2001 and 2000      
|                               |                                                                                               | Notes to Condensed Consolidated Financial Statements                                               
|                               | Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
|                               | Item 3. Quantitative and Qualitative Disclosures about Market Risk                           
|PART II  OTHER INFORMATION   
|                               | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                    
|INDEX TO EXHIBITS             
|Line Credit Document          



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##### Table of Contents



MECHANICAL DYNAMICS, INC.

FORM 10-Q
TABLE OF CONTENTS

|                               |  |                                                                                                     |  |     
|------------------------------ |  | --------------------------------------------------------------------------------------------------- |  | ----
|                               |  |                                                                                                     |  | Page
|                               |  |                                                                                                     |  |     
|PART I  FINANCIAL INFORMATION |  |                                                                                                    
|                              
|Item 1.                        |  | Financial Statements                                                                                |  |     
|                              
|                               |  | Condensed Consolidated Balance Sheets
September 30, 2001 and December 31, 2000.                     |  | 3   
|                              
|                               |  | Condensed Consolidated Statements of Income
Three and Nine Months Ended September 30, 2001 and 2000 |  | 4   
|                              
|                               |  | Condensed Consolidated Statements of Cash Flows
Nine Months Ended September 30, 2001 and 2000.      |  | 5   
|                              
|                               |  | Notes to Condensed Consolidated Financial Statements                                                |  | 6   
|                              
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition
and Results of Operations               |  | 8   
|                              
|Item 3.                        |  | Quantitative and Qualitative Disclosures about Market Risk                                          |  | 13  
|                              
|PART II  OTHER INFORMATION    |  |                                                                                                    
|                              
|Item 6.                        |  | Exhibits and Reports on Form 8-K                                                                    |  | 14  
|                              
|SIGNATURES                     |  | 15                                                                                                 
|                              
|INDEX TO EXHIBITS              |  | 16                                                                                                 

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PART I  FINANCIAL INFORMATION




Item 1. Financial Statements




MECHANICAL DYNAMICS, INC. AND
SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS

|                                               |                                        |                            |        |               |        |   |              |        |        | 
|---------------------------------------------- | -------------------------------------- | -------------------------- | ------ | ------------- | ------ | - | ------------ | ------ | ------ | 
|                                               |                                        |                            |        | September 30, |        |   | December 31, |       
|in thousands                                   |                                        | 2001                       |        |               | 2000   |  
|                                               |                                        |                            |        |               |        |  
|                                               |                                        |                            |        | (Unaudited)   |        |   |              |        |       
|Assets:                                        |                                        |                            |        |               |        |   |              |       
|Current assets:                                |                                        |                            |        |               |        |   |              |       
|                                               | Cash and cash equivalents              |                            | $      | 17,850        |        |   | $            | 17,961 |       
|                                               | Accounts receivable, net               |                            |        | 11,670        |        |   |              | 11,442 |       
|                                               | Prepaid and deferred expenses          |                            |        | 3,136         |        |   |              | 3,255  |       
|                                               |                                        |                            |        |               |        |  
|                                               | Total current assets                   |                            |        | 32,656        |        |   |              | 32,658 |       
|                                               |                                        |                            |        |               |        |  
|Property and equipment, net                    |                                        |                            | 4,808  |               |        |   | 4,462        |       
|Goodwill, net                                  |                                        |                            | 6,327  |               |        |   | 6,768        |       
|Other assets                                   |                                        |                            | 2,239  |               |        |   | 1,981        |       
|                                               |                                        |                            |        |               |        |  
|Total assets                                   |                                        | $                          | 46,030 |               |        | $ | 45,869       |       
|                                               |                                        |                            |        |               |        |  
|Liabilities and Shareholders Equity:          |                                        |                            |        |               |        |   |              |       
|Current liabilities:                           |                                        |                            |        |               |        |   |              |       
|                                               | Borrowings under lines of credit       |                            | $      |              |        |   | $            | 49     |       
|                                               | Current portion of capital leases      |                            |        | 432           |        |   |              | 406    |       
|                                               | Accounts payable                       |                            |        | 2,163         |        |   |              | 2,466  |       
|                                               | Accrued expenses                       |                            |        | 5,102         |        |   |              | 7,152  |       
|                                               | Deferred revenue                       |                            |        | 7,898         |        |   |              | 6,936  |       
|                                               |                                        |                            |        |               |        |  
|                                               |                                        | Total current liabilities  |        |               | 15,595 |   |              |        | 17,009 | 
|                                               |                                        |                            |        |               |        |  
|Capital lease obligation, less current portion |                                        |                            | 525    |               |        |   | 658          |       
|Minority interest                              |                                        |                            | 679    |               |        |   | 539          |       
|Shareholders equity:                          |                                        |                            |        |               |        |   |              |       
|                                               | Common stock                           |                            |        | 22,090        |        |   |              | 21,998 |       
|                                               | Preferred stock                        |                            |        |              |        |   |              |       |       
|                                               | Retained earnings                      |                            |        | 7,533         |        |   |              | 5,819  |       
|                                               | Accumulated other comprehensive income |                            |        | (392          | )      |   |              | (154   | )     
|                                               |                                        |                            |        |               |        |  
|                                               |                                        | Total shareholders equity |        |               | 29,231 |   |              |        | 27,663 | 
|                                               |                                        |                            |        |               |        |  
|Total liabilities and shareholders equity     |                                        | $                          | 46,030 |               |        | $ | 45,869       |       
|                                               |                                        |                            |        |               |        |  

The accompanying notes are an integral part of these condensed consolidated financial statements.

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MECHANICAL DYNAMICS, INC. AND
SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)

|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |        |        |   |           |        |        | 
|---------------------------------------------------- | ------------------------------- | ------------------------ | --------- | ------------------ | ------ | - | ----------------- | ----- | ------ | - | --------- | ------ | ------ | - | --------- | ------ | ------ | 
|                                                     |                                 |                          |           | Three Months Ended |        |   | Nine Months Ended |      
|                                                     |                                 |                          |           | September 30,      |        |   | September 30,     |      
|                                                     |                                 |                          |           |                    |        |   |                   |      
|in thousands except share and per share data         |                                 | 2001                     |           |                    | 2000   |   |                   | 2001  |        |   | 2000      |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Revenue:                                             |                                 |                          |           |                    |        |   |                   |       |        |   |           |        |        |   |           |       
|                                                     | Software licenses               |                          | $         | 5,993              |        |   | $                 | 5,463 |        |   | $         | 18,200 |        |   | $         | 17,241 |       
|                                                     | Software maintenance services   |                          |           | 3,606              |        |   |                   | 3,147 |        |   |           | 9,927  |        |   |           | 7,868  |       
|                                                     | Professional services and other |                          |           | 4,837              |        |   |                   | 2,971 |        |   |           | 14,390 |        |   |           | 8,292  |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|                                                     |                                 | Total revenue            |           |                    | 14,436 |   |                   |       | 11,581 |   |           |        | 42,517 |   |           |        | 33,401 | 
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Cost of revenue:                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |        |        |   |           |       
|                                                     | Software licenses               |                          |           | 938                |        |   |                   | 940   |        |   |           | 2,888  |        |   |           | 3,042  |       
|                                                     | Services                        |                          |           | 4,195              |        |   |                   | 2,808 |        |   |           | 12,579 |        |   |           | 8,130  |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|                                                     |                                 | Total cost of revenue    |           |                    | 5,133  |   |                   |       | 3,748  |   |           |        | 15,467 |   |           |        | 11,172 | 
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Gross profit                                         |                                 |                          | 9,303     |                    |        |   | 7,833             |       |        |   | 27,050    |        |        |   | 22,229    |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Operating expenses:                                  |                                 |                          |           |                    |        |   |                   |       |        |   |           |        |        |   |           |       
|                                                     | Sales and marketing             |                          |           | 5,099              |        |   |                   | 4,344 |        |   |           | 14,949 |        |   |           | 12,698 |       
|                                                     | Research and development        |                          |           | 1,749              |        |   |                   | 1,528 |        |   |           | 5,144  |        |   |           | 4,448  |       
|                                                     | General and administrative      |                          |           | 1,178              |        |   |                   | 1,038 |        |   |           | 3,661  |        |   |           | 3,082  |       
|                                                     | Goodwill amortization           |                          |           | 178                |        |   |                   | 113   |        |   |           | 534    |        |   |           | 340    |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|                                                     |                                 | Total operating expenses |           |                    | 8,204  |   |                   |       | 7,023  |   |           |        | 24,288 |   |           |        | 20,568 | 
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Operating income                                     |                                 |                          | 1,099     |                    |        |   | 810               |       |        |   | 2,762     |        |        |   | 1,661     |       
|Other income, net                                    |                                 |                          | 139       |                    |        |   | 181               |       |        |   | 269       |        |        |   | 396       |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Income before income taxes and minority interest     |                                 |                          | 1,238     |                    |        |   | 991               |       |        |   | 3,031     |        |        |   | 2,057     |       
|Provision for income taxes                           |                                 |                          | 371       |                    |        |   | 297               |       |        |   | 907       |        |        |   | 615       |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Net income before minority interest                  |                                 |                          | 867       |                    |        |   | 694               |       |        |   | 2,124     |        |        |   | 1,442     |       
|Minority interest in net income of subsidiary        |                                 |                          | 52        |                    |        |   | 26                |       |        |   | 140       |        |        |   | 54        |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Net income                                           |                                 | $                        | 815       |                    |        | $ | 668               |       |        | $ | 1,984     |        |        | $ | 1,388     |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Basic net income per common share                    |                                 | $                        | 0.13      |                    |        | $ | 0.11              |       |        | $ | 0.33      |        |        | $ | 0.22      |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Weighted average common shares                       |                                 |                          | 6,082,270 |                    |        |   | 6,208,463         |       |        |   | 6,076,939 |        |        |   | 6,251,996 |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Diluted net income per common share                  |                                 | $                        | 0.13      |                    |        | $ | 0.11              |       |        | $ | 0.31      |        |        | $ | 0.22      |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       
|Weighted average common and common equivalent shares |                                 |                          | 6,380,734 |                    |        |   | 6,210,668         |       |        |   | 6,307,452 |        |        |   | 6,254,046 |       
|                                                     |                                 |                          |           |                    |        |   |                   |       |        |   |           |       

The accompanying notes are an integral part of these condensed consolidated financial statements.

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MECHANICAL DYNAMICS, INC. AND
SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

|                                                     |                                                           |                                                                                   |                                               |                                           |        |                   |        |       |      |       |       |  
|---------------------------------------------------- | --------------------------------------------------------- | --------------------------------------------------------------------------------- | --------------------------------------------- | ----------------------------------------- | ------ | ----------------- | ------ | ----- | ---- | ----- | ----- | -
|                                                     |                                                           |                                                                                   |                                               |                                           |        | Nine Months Ended |       
|                                                     |                                                           |                                                                                   |                                               |                                           |        | September 30,     |       
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                   |       
|in thousands                                         |                                                           | 2001                                                                              |                                               |                                           | 2000   |                  
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                  
|Cash flows from operating activities:                |                                                           |                                                                                   |                                               |                                           |        |                   |        |      
|                                                     | Net income                                                |                                                                                   | $                                             | 1,984                                     |        |                   | $      | 1,388 |     
|                                                     |                                                           | Adjustments to reconcile net income to net cash
provided by operating activities: |                                               |                                           |        |                   |        |       |      |      
|                                                     |                                                           |                                                                                   | Depreciation and amortization                 |                                           |        | 1,878             |        |       |      | 1,264 |      
|                                                     |                                                           |                                                                                   | (Gain) loss on disposal of assets, net        |                                           |        | 53                |        |       |      | (22   | )    
|                                                     |                                                           |                                                                                   | Minority interest in net income of subsidiary |                                           |        | 140               |        |       |      | 54    |      
|                                                     |                                                           |                                                                                   | Changes in assets and liabilities:            |                                           |        |                   |        |       |      |       |      
|                                                     |                                                           |                                                                                   |                                               | Accounts receivable                       |        |                   | (516   | )     |      |       | (93   | )
|                                                     |                                                           |                                                                                   |                                               | Prepaid and deferred expenses             |        |                   | 55     |       |      |       | 51    |  
|                                                     |                                                           |                                                                                   |                                               | Other assets                              |        |                   | (262   | )     |      |       | (97   | )
|                                                     |                                                           |                                                                                   |                                               | Accounts payable                          |        |                   | (157   | )     |      |       | 551   |  
|                                                     |                                                           |                                                                                   |                                               | Accrued expenses                          |        |                   | (1,833 | )     |      |       | 3     |  
|                                                     |                                                           |                                                                                   |                                               | Deferred revenue                          |        |                   | 1,265  |       |      |       | 1,287 |  
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                  
|                                                     |                                                           |                                                                                   |                                               | Net cash provided by operating activities |        |                   | 2,607  |       |      |       | 4,386 |  
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                  
|Cash flows from investing activities:                |                                                           |                                                                                   |                                               |                                           |        |                   |        |      
|                                                     | Proceeds from the sale of property and equipment          |                                                                                   |                                               | 29                                        |        |                   |        | 124   |     
|                                                     | Purchases of property and equipment                       |                                                                                   |                                               | (1,942                                    | )      |                   |        | (729  | )   
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                  
|                                                     |                                                           | Net cash used in investing activities                                             |                                               |                                           | (1,913 | )                 |        |       | (605 | )    
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                  
|Cash flows from financing activities:                |                                                           |                                                                                   |                                               |                                           |        |                   |        |      
|                                                     | Net borrowings (payments) under line of credit agreements |                                                                                   |                                               | (49                                       | )      |                   |        | 36    |     
|                                                     | Proceeds from the issuance of common stock                |                                                                                   |                                               | 317                                       |        |                   |        | 155   |     
|                                                     | Repurchases of Company common stock                       |                                                                                   |                                               | (495                                      | )      |                   |        | (770  | )   
|                                                     | Payments on capital lease obligations                     |                                                                                   |                                               | (361                                      | )      |                   |        | 0     |     
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                  
|                                                     |                                                           | Net cash used in financing activities                                             |                                               |                                           | (588   | )                 |        |       | (579 | )    
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                  
|Effect of exchange rate changes on cash              |                                                           |                                                                                   | (217                                          | )                                         |        |                   | (323   | )    
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                  
|Net increase (decrease) in cash and cash equivalents |                                                           |                                                                                   | (111                                          | )                                         |        |                   | 2,879  |      
|Cash and cash equivalents at beginning of period     |                                                           |                                                                                   | 17,961                                        |                                           |        |                   | 17,741 |      
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                  
|Cash and cash equivalents at end of period           |                                                           | $                                                                                 | 17,850                                        |                                           |        | $                 | 20,620 |      
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                  
|Supplemental disclosures of cash flow information:   |                                                           |                                                                                   |                                               |                                           |        |                   |        |      
|                                                     | Cash paid during the period for:                          |                                                                                   |                                               |                                           |        |                   |        |       |     
|                                                     |                                                           | Interest                                                                          |                                               | $                                         | 34     |                   |        | $     | 5    |      
|                                                     |                                                           | Income taxes                                                                      |                                               | $                                         | 1,639  |                   |        | $     | 913  |      
|                                                     |                                                           |                                                                                   |                                               |                                           |        |                  

The accompanying notes are an integral part of these condensed consolidated financial statements.

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MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1)   Basis of Presentation

The accompanying unaudited condensed consolidated financial statements
include the accounts of Mechanical Dynamics, Inc. (MDI or the Company) and
its subsidiaries, and have been prepared in accordance with generally accepted
accounting principles for interim financial information and with Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. The Company believes all adjustments, consisting of
normal recurring adjustments considered necessary for a fair presentation, have
been included. For further information, refer to the consolidated financial
statements and footnotes thereto included in the Companys Form 10-K for the
year ended December 31, 2000.

Operating results for the three and nine month periods ended September 30,
2001 and 2000 are not necessarily indicative of the results that may be
expected for the full year.

(2)  Comprehensive Income

Comprehensive income is the total of net income and all other non-owner
changes in equity. Comprehensive income was $1,101,000 and $493,000 for the
three month periods ended September 30, 2001 and 2000, respectively, and
$1,746,000 and $995,000 for the nine month periods ended September 30, 2001 and
2000, respectively. The difference between net income, as reported in the
accompanying condensed consolidated statements of income, and comprehensive
income is the foreign currency translation adjustment for the respective
periods.

(3)  Earnings per Share

The following table reconciles the weighted average number of shares in
the basic net income per common share calculation to the number of shares in
the diluted net income per common share calculation:

|                                                                                                 |                         |  |                    |         |  |                   |           |       |      |  |           |         |  |  |           |       | 
|------------------------------------------------------------------------------------------------ | ----------------------- |  | ------------------ | ------- |  | ----------------- | --------- | ----- | ---- |  | --------- | ------- |  |  | --------- | ----- | 
|                                                                                                 |                         |  | Three Months Ended |         |  | Nine Months Ended |          
|                                                                                                 |                         |  | September 30,      |         |  | September 30,     |          
|                                                                                                 |                         |  |                    |         |  |                   |          
|                                                                                                 |                         |  | 2001               |         |  | 2000              |           |       | 2001 |  |           | 2000    | 
|                                                                                                 |                         |  |                    |         |  |                   |           |       |      |  |           |         | 
|Weighted average common
shares used in basic net
income per common share                         |                         |  | 6,082,270          |         |  |                   | 6,208,463 |       |      |  | 6,076,939 |         |  |  | 6,251,996 |      
|                                                                                                 | Effect of stock options |  |                    | 298,464 |  |                   |           | 2,205 |      |  |           | 230,513 |  |  |           | 2,050 | 
|                                                                                                 |                         |  |                    |         |  |                   |           |       |      |  |           |        
|Weighted average common
and common equivalent
shares used in diluted
net income per common
share |                         |  | 6,380,734          |         |  |                   | 6,210,668 |       |      |  | 6,307,452 |         |  |  | 6,254,046 |      
|                                                                                                 |                         |  |                    |         |  |                   |           |       |      |  |           |        

Options to purchase shares of the Companys common stock for the three
months ended September 30, 2001 and 2000 of 52,222 and 657,408, respectively,
and for the nine months ended September 30, 2001 and 2000 of 116,296 and
652,964, respectively, were outstanding but were not included in the
computations of diluted earnings per share because the price of the options was
greater than the average market price of the common stock for the period
reported.

(4)  Derivatives

The Company adopted Statement of Financial Accounting Standards No. 133,
Accounting for Derivative Instruments and Hedging Activities in the first
quarter of 2001. Derivatives are financial instruments whose value is derived
from one or more underlying financial instruments, such as foreign currency.
The Company enters into derivative transactions, specifically foreign exchange
forward contracts, to manage the Companys exposure to fluctuations in foreign
exchange rates. The contracts are primarily in European currencies and
Japanese yen and have maturities less than one year. Any derivative the
Company enters into is designated at inception as a hedge of

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risks associated
with specific assets, liabilities, or future commitments, and is monitored to
determine if it remains an effective hedge. The effectiveness of the
derivative as a hedge is based on changes in its market value being highly
correlated with changes in market value of the underlying hedged items. The
Company does not enter into or hold derivatives for trading or speculative
purposes.

The Company uses forward exchange contracts to hedge specific foreign
currency denominated receivables. These contracts, which are one year or less
in length, require the Company to exchange foreign currencies for U.S. dollars
at maturity at rates agreed to at inception of the contracts. The Company
enters into transactions denominated in foreign currencies and includes the
exchange gain or loss arising from such transactions in other income, net. As
of September 30, 2001 and 2000, the Company had approximately $179,000 and
$617,000, respectively, of foreign exchange forward contracts outstanding. Net
unrealized and realized gains and losses associated with exchange rate
fluctuations on forward contracts and the underlying foreign currency exposure
being hedged were immaterial for all periods presented. Cash flows from
forward contracts are classified with the related receivables.

(5)  New Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board issued Statements
of Financial Accounting Standards No. 141, Business Combinations (SFAS
141), No. 142, Goodwill and Other Intangible Assets (SFAS 142), and No.
143, Accounting for Asset Retirement Obligations (SFAS 143). In August
2001, the Financial Accounting Standards Board issued Statements of Financial
Accounting Standards No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets (SFAS 144).

SFAS 141 supersedes Accounting Principles Board Opinion No. 16, Business
Combinations. The most significant changes made by SFAS 141 are: (1)
requiring that the purchase method of accounting be used for all business
combinations initiated after June 30, 2001, (2) establishing specific criteria
for the recognition of intangible assets separately from goodwill, and (3)
requiring unallocated negative goodwill to be written off immediately as an
extraordinary gain (rather than being deferred and amortized).

SFAS 142 supersedes Accounting Principles Board Opinion No. 17,
Intangible Assets, and primarily addresses the accounting for goodwill and
intangible assets subsequent to their acquisition. The most significant
changes made by SFAS 142 are: (1) goodwill and indefinite lived intangible
assets will no longer be amortized, (2) goodwill will be tested for impairment
at least annually at the reporting unit level, (3) intangible assets deemed to
have an indefinite life will be tested for impairment at least annually, and
(4) the amortization period of intangible assets with finite lives will no
longer be limited to forty years. SFAS 142 also specifies that certain
intangible assets that were previously identified as separate from goodwill
(ie. assembled workforce) are not considered separately identifiable for
purposes of this standard and should be included as part of goodwill and
subject to the non-amortization provisions for SFAS 142. The provisions for
SFAS 142 will be effective for the Companys fiscal year beginning January 1,
2002. At adoption, an evaluation of goodwill and intangible assets will be
required, and any impairment of goodwill or intangible assets at that time will
be recognized as a cumulative effect of adoption. Management expects that the
adoption of SFAS 142 will not result in a material adjustment to the Companys
consolidated results.

SFAS 143 clarifies the rules on retirements of tangible long-lived assets
and methodologies to be used to record and accrue retirement and closure costs.
SFAS 144 addresses the financial accounting and reporting for the impairment or
disposal of long-lived assets. Management expects that the adoption of SFAS 143
and SFAS 144 will not have a material impact on the Companys consolidated
financial position or results of operations.

(6) Geographic Operations and Segment Information

The Company operates in one segment  the development, marketing and
support of software products and services for the mechanical segment of the
computer-aided engineering industry. The Company licenses products to
customers on a worldwide basis. Revenue is attributed to the country in which
the sale originates. Sales and marketing operations outside the United States
are conducted principally through the Companys foreign subsidiaries and
international distributors. Intercompany sales and transfers between
geographic areas are accounted for at prices that are designed to be
representative of third party transactions.

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The following table summarizes selected financial information of the
Companys operations by geographic location:

|             |               |                          |               |   |                    |        |  |                   |       |        |      |   |        |        |  |   |       |        | 
|------------ | ------------- | ------------------------ | ------------- | - | ------------------ | ------ |  | ----------------- | ----- | ------ | ---- | - | ------ | ------ |  | - | ----- | ------ | 
|             |               |                          |               |   | Three Months Ended |        |  | Nine Months Ended |      
|             |               |                          |               |   |                    |        |  |                   |      
|             |               |                          |               |   | September 30,      |        |  | September 30,     |      
|             |               |                          |               |   |                    |        |  |                   |      
|In thousands |               | 2001                     |               |   | 2000               |        |  | 2001              |       |        | 2000 |  
|             |               |                          |               |   |                    |        |  |                   |       |        |      |  
|Revenue:     |               |                          |               |   |                    |        |  |                   |       |        |      |   |        |        |  |  
|             | North America |                          |               |   |                    |        |  |                   |       |        |      |   |        |        |  |   |      
|             |               | United States            |               | $ | 3,213              |        |  | $                 | 3,150 |        |      | $ | 10,114 |        |  | $ | 8,786 |       
|             |               | Canada and Mexico        |               |   | 1,128              |        |  |                   | 926   |        |      |   | 2,743  |        |  |   | 3,465 |       
|             | Europe        |                          |               |   |                    |        |  |                   |       |        |      |   |        |        |  |   |      
|             |               | Germany                  |               |   | 1,435              |        |  |                   | 1,106 |        |      |   | 3,994  |        |  |   | 3,637 |       
|             |               | Other European countries |               |   | 2,590              |        |  |                   | 2,555 |        |      |   | 7,739  |        |  |   | 7,642 |       
|             | Asia/Pacific  |                          |               |   |                    |        |  |                   |       |        |      |   |        |        |  |   |      
|             |               | Japan                    |               |   | 5,127              |        |  |                   | 3,028 |        |      |   | 15,433 |        |  |   | 7,991 |       
|             |               | Other Asian countries    |               |   | 943                |        |  |                   | 816   |        |      |   | 2,494  |        |  |   | 1,880 |       
|             |               |                          |               |   |                    |        |  |                   |       |        |      |  
|             |               |                          | Total revenue |   | $                  | 14,436 |  |                   | $     | 11,581 |      |   | $      | 42,517 |  |   | $     | 33,401 | 
|             |               |                          |               |   |                    |        |  |                   |       |        |      |   |        |       

No customer accounted for greater than 10% of total revenue during the
three and nine month periods ended September 30, 2001 and 2000. The Companys
largest distributor, ISI-Dentsu, is located in Japan and accounted for
approximately 12.0% and 18.9% of the Companys total revenue for the three
month periods ended September 30, 2001 and 2000, respectively. ISI-Dentsu
accounted for approximately 12.4% and 17.3% of the Companys total revenue for
the nine month periods ended September 30, 2001 and 2000, respectively. Total
assets by geographic location have not changed significantly from December 31,
2000.




|        |  |                                                                                      
|------- |  | -------------------------------------------------------------------------------------
|Item 2. |  | Managements Discussion and Analysis of Financial Condition and
Results of Operations

The following discussion provides an analysis of the Companys financial
condition and results of operations, and should be read in conjunction with the
Companys condensed consolidated financial statements and the notes included in
Item 1 of this Form 10-Q.

Overview

The Company develops, markets and supports virtual prototyping solutions.
The Companys virtual prototyping software allows an engineer or designer to
design a complete product by simulating, both visually and mathematically, a
product in motion. The Companys principal software product, ADAMS Full
Simulation Package, is used by customers to simulate mechanical systems. The
Companys revenue has in the past been, and is expected to be in the future,
derived primarily from its ADAMS Full Simulation Packageand related software
products and services.

Forward-Looking Information is Subject to Risk and Uncertainty

Except for the historical information contained in this report, the
matters herein contain forward-looking statements (as defined in the Private
Securities Litigation Reform Act of 1995) that involve risk and uncertainty.
These forward-looking statements include, but are not limited to, revenue
levels, including the level of international revenue, certain costs and
operating expense levels, the level of other income, the Companys liquidity
and capital needs and various business environment and trend information.
Actual future results and trends may differ materially depending on a variety
of factors, including:



| |  | the volume and timing of orders received during the quarter;                                         
|- |  | -----------------------------------------------------------------------------------------------------
| 
| |  | the mix of and changes in distribution channels through which the Companys products are sold;       
| 
| |  | the timing and acceptance of new products and product enhancements by the Company or its competitors;

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| |  | changes in pricing;                                                                                                                                                                   
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | the level of the Companys sales of third-party products;                                                                                                                             
| 
| |  | purchasing patterns of distributors and customers;                                                                                                                                    
| 
| |  | competitive conditions in the industry;                                                                                                                                               
| 
| |  | business cycles affecting the markets in which the Companys products are sold;                                                                                                       
| 
| |  | extraordinary events, such as litigation;                                                                                                                                             
| 
| |  | risks inherent in seeking and consummating acquisitions, including the diversion of management attention to the
assimilation of the operations and personnel of the acquired business;
| 
| |  | fluctuations in foreign exchange rates;                                                                                                                                               
| 
| |  | the impact of undetected errors or defects on the Companys current products, vendors and internal systems; and                                                                       
| 
| |  | economic conditions generally or in various geographic areas.                                                                                                                         

All of the foregoing factors are difficult to forecast. The future
operating results of the Company may fluctuate as a result of these and other
risk factors detailed from time to time in the Companys Securities and
Exchange Commission reports.

Due to all of the foregoing factors, the Company believes that
period-to-period comparisons of its results of operations are not necessarily
meaningful and should not be relied upon as an indication of future
performance. It is likely that, in some future quarters, the Companys
operating results will be below the expectations of stock market analysts and
investors. In such an event, the price of the Companys common stock would
likely be materially adversely affected.

Results of Operations

Revenue

|                                |                    |               |       |                                  |        |   |                                 |          |        |  |      |   |      |      |        |      |          |   |        |      |        |  |      |   |      |  
|------------------------------- | ------------------ | ------------- | ----- | -------------------------------- | ------ | - | ------------------------------- | -------- | ------ |  | ---- | - | ---- | ---- | ------ | ---- | -------- | - | ------ | ---- | ------ |  | ---- | - | ---- | -
|                                |                    |               |       | Three Months Ended September 30, |        |   | Nine Months Ended September 30, |         
|                                |                    |               |       |                                  |        |   |                                 |         
|dollars in thousands            |                    | 2001          |       |                                  | 2000   |   |                                 | % Change |        |  | 2001 |   |      | 2000 |        |      | % Change |  
|                                |                    |               |       |                                  |        |   |                                 |          |        |  |      |   |      |      |        |      |          |  
|Software licenses               |                    | $             | 5,993 |                                  |        | $ | 5,463                           |          |        |  | 9.7  | % |      | $    | 18,200 |      |          | $ | 17,241 |      |        |  | 5.6  | %
|                                | % of total revenue |               |       | 41.5                             | %      |   |                                 | 47.2     | %      |  |      |   |      |      |        | 42.8 | %        |   |        | 51.6 | %      |  |      |   |     
|Software maintenance services   |                    | $             | 3,606 |                                  |        | $ | 3,147                           |          |        |  | 14.6 | % |      | $    | 9,927  |      |          | $ | 7,868  |      |        |  | 26.2 | %
|                                | % of total revenue |               |       | 25.0                             | %      |   |                                 | 27.2     | %      |  |      |   |      |      |        | 23.4 | %        |   |        | 23.6 | %      |  |      |   |     
|Professional services and other |                    | $             | 4,837 |                                  |        | $ | 2,971                           |          |        |  | 62.8 | % |      | $    | 14,390 |      |          | $ | 8,292  |      |        |  | 73.5 | %
|                                | % of total revenue |               |       | 33.5                             | %      |   |                                 | 25.6     | %      |  |      |   |      |      |        | 33.8 | %        |   |        | 24.8 | %      |  |      |   |     
|                                |                    |               |       |                                  |        |   |                                 |          |        |  |      |   |      |      |        |      |          |  
|                                |                    | Total revenue |       | $                                | 14,436 |   |                                 | $        | 11,581 |  |      |   | 24.7 | %    |        | $    | 42,517   |   |        | $    | 33,401 |  |      |   | 27.3 | %
|                                |                    |               |       |                                  |        |   |                                 |          |        |  |      |   |      |      |        |      |          |  

The Companys total revenue increased 24.7% and 27.3% during the three and
nine month periods ended September 30, 2001, respectively, as compared to the
corresponding periods in 2000. The growth in revenue resulted primarily from
an increase in professional services and software maintenance services provided
to the Companys customers, as well as an increase in the sales of the
Companys software products.

Revenue from international customers accounted for approximately 69.9% and
64.8% of the Companys total revenue during the three months ended September
30, 2001 and 2000, respectively. International revenue accounted for
approximately 69.8% and 63.3% of total revenue during the nine months ended
September 30, 2001 and 2000, respectively. The increase in international
revenue as a percent of total revenue in 2001 was due primarily to increased
professional services revenue generated in Japan as a result of the Companys
acquisition of ESTECH Corporation (ESTECH) in December 2000, and, to a lesser
extent, increased sales of ADAMSsoftware licenses in Japan and the rest of
Asia. The increase in international revenue in 2001 was partially offset by
the strengthening of the U.S. dollar, which, relative to the European, Canadian
and Japanese currencies, negatively impacted the Companys third quarter
revenue by approximately $860,000. Since most of the Companys international
operating

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expenses were incurred in foreign currencies, the net impact of
exchange rate fluctuations on income from operations was considerably less than
the impact on revenue. If the U.S. dollar strengthens further in 2001 and 2002
relative to the European, Canadian and Japanese currencies, the Companys
international revenue will be negatively impacted, which could have a material
adverse effect on the Companys consolidated results of operations.

Software licenses revenue consists primarily of license fees for the
Companys software products and, to a lesser extent, license fees for third
party software products licensed through the Companys European and Canadian
subsidiaries. Software licenses revenue increased 9.7% and 5.6% during the
three and nine month periods ended September 30, 2001, respectively, as
compared to the corresponding periods in 2000. This growth in revenue resulted
primarily from an increase in sales of the Companys software products.
Revenue from third party software products totaled approximately $1.1 million,
or 7.6% of total revenue during the three month period ended September 30,
2001, as compared to $1.1 million, or 9.2% of total revenue during the
corresponding period in 2000. Revenue from third party products totaled
approximately $3.2 million, or 7.4% of total revenue during the nine month
period ended September 30, 2001, as compared to $3.5 million, or 10.3% of total
revenue during the corresponding period in 2000.

Software maintenance services revenue consists of revenue generated from
maintenance and support agreements on the Companys software products.
Software maintenance services revenue increased 14.6% and 26.2% during the
three and nine month periods ended September 30, 2001, respectively, as
compared to the corresponding periods in 2000. The increase reflects the
continuing growth of the Companys customer base, as well as the strong
maintenance renewal rate the Company has historically experienced with respect
to software maintenance agreements. In addition, during the third quarter of
2001, the Companys maintenance services revenue benefited from a price
increase implemented on July 1, 2001, whereby fees for the Companys
maintenance services increased from 18% to 20% of paid-up license fees.

Professional services and other revenue consists primarily of revenue from
consulting, training and funded research and development projects.
Professional services revenue increased 62.8% and 73.5% during the three and
nine month periods ended September 30, 2001, respectively, as compared to the
corresponding periods in 2000. The increase in revenue was primarily due to
consulting revenue generated in Japan as a result of the Companys acquisition
of ESTECH in December 2000.

Cost of Revenue

|                          |                                                  |                                         |       |                                  |      |   |                                 |          |      |   |      |    |  |      |        |      |          |   |       |      |      |   |      |    |  | 
|------------------------- | ------------------------------------------------ | --------------------------------------- | ----- | -------------------------------- | ---- | - | ------------------------------- | -------- | ---- | - | ---- | -- |  | ---- | ------ | ---- | -------- | - | ----- | ---- | ---- | - | ---- | -- |  | 
|                          |                                                  |                                         |       | Three Months Ended September 30, |      |   | Nine Months Ended September 30, |         
|                          |                                                  |                                         |       |                                  |      |   |                                 |         
|dollars in thousands      |                                                  | 2001                                    |       |                                  | 2000 |   |                                 | % Change |      |   | 2001 |    |  | 2000 |        |      | % Change |  
|                          |                                                  |                                         |       |                                  |      |   |                                 |          |      |   |      |    |  |      |        |      |          |  
|Cost of software licenses |                                                  | $                                       | 938   |                                  |      | $ | 940                             |          |      |   | (0.2 | %) |  | $    | 2,888  |      |          | $ | 3,042 |      |      |   | (5.1 | %)
|                          | Gross profit margin on software
licenses revenue |                                         |       | 84.3                             | %    |   |                                 | 82.8     | %    |   |      |    |  |      |        | 84.1 | %        |   |       | 82.4 | %    |   |      |    | 
|Cost of services          |                                                  | $                                       | 4,195 |                                  |      | $ | 2,808                           |          |      |   | 49.4 | %  |  | $    | 12,579 |      |          | $ | 8,130 |      |      |   | 54.7 | % 
|                          |                                                  | Gross profit margin on services
revenue |       |                                  | 50.3 | % |                                 |          | 54.1 | % |      |    |  |      |        |      | 48.3     | % |       |      | 49.7 | % |      |    |  | 
|                          |                                                  |                                         |       |                                  |      |   |                                 |          |      |   |      |    |  |      |        |      |          |  

Cost of software licenses includes software royalty fees, media costs,
payroll and other costs attributable to software documentation and
distribution, and an allocation of depreciation, utilities and other overhead
expenses incurred by the Company. Cost of software licenses revenue decreased
0.2% and 5.1% during the three and nine month periods ended September 30, 2001,
respectively, as compared to the corresponding periods in 2000. The decrease
in cost of software licenses was due to lower royalties paid to third parties
whose products were licensed through the Companys Canadian and European
subsidiaries, which is consistent with the decline in revenue from third-party
software products in the first nine months of 2001.

Gross profit margin on software licenses revenue was 84.3% and 82.8%
during the three month periods ended September 30, 2001 and 2000, respectively.
Gross profit margin on software licenses revenue was 84.1% and 82.4% during
the nine month periods ended September 30, 2001 and 2000, respectively. The
increase in gross profit

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margin was due to an increase in revenue from the
Companys software products as a percent of total software licenses revenue.
The gross profit margin realized from sales of the Companys software products
has historically been higher than the gross profit margin realized from sales
of third-party software products.

Cost of services includes payroll and overhead expenses attributable to
hotline support, consulting, training and funded research and development.
Cost of services revenue increased 49.4% and 54.7% during the three and nine
month periods ended September 30, 2001, respectively, as compared to the
corresponding periods in 2000. The increase in cost of services was primarily
due to the costs associated with professional services revenue generated by
ESTECH in 2001. Gross profit margin on services revenue was 50.3% and 54.1%
during the three month periods ended September 30, 2001 and 2000, respectively.
Gross profit margin on services revenue was 48.3% and 49.7% during the nine
month periods ended September 30, 2001 and 2000, respectively. The decrease in
gross profit margin was due to an increase in professional services revenue as
a percent of total service revenue. The gross profit margin realized from
sales of the Companys professional services has historically been lower than
the gross profit margin realized from sales of software maintenance services.

Operating Expenses

|                           |                    |      |                                  |      |      |                                 |       |          |   |  |      |   |  |      |        |      |          |   |        |      |   |  |      |   | 
|-------------------------- | ------------------ | ---- | -------------------------------- | ---- | ---- | ------------------------------- | ----- | -------- | - |  | ---- | - |  | ---- | ------ | ---- | -------- | - | ------ | ---- | - |  | ---- | - | 
|                           |                    |      | Three Months Ended September 30, |      |      | Nine Months Ended September 30, |      
|                           |                    |      |                                  |      |      |                                 |      
|dollars in thousands       |                    | 2001 |                                  |      | 2000 |                                 |       | % Change |   |  | 2001 |   |  | 2000 |        |      | % Change |  
|                           |                    |      |                                  |      |      |                                 |       |          |   |  |      |   |  |      |        |      |          |  
|Sales and marketing        |                    | $    | 5,099                            |      |      | $                               | 4,344 |          |   |  | 17.4 | % |  | $    | 14,949 |      |          | $ | 12,698 |      |   |  | 17.7 | %
|                           | % of total revenue |      |                                  | 35.3 | %    |                                 |       | 37.5     | % |  |      |   |  |      |        | 35.2 | %        |   |        | 38.0 | % |  |      |   | 
|Research and development   |                    | $    | 1,749                            |      |      | $                               | 1,528 |          |   |  | 14.5 | % |  | $    | 5,144  |      |          | $ | 4,448  |      |   |  | 15.6 | %
|                           | % of total revenue |      |                                  | 12.1 | %    |                                 |       | 13.2     | % |  |      |   |  |      |        | 12.1 | %        |   |        | 13.3 | % |  |      |   | 
|General and administrative |                    | $    | 1,178                            |      |      | $                               | 1,038 |          |   |  | 13.5 | % |  | $    | 3,661  |      |          | $ | 3,082  |      |   |  | 18.8 | %
|                           | % of total revenue |      |                                  | 8.2  | %    |                                 |       | 9.0      | % |  |      |   |  |      |        | 8.6  | %        |   |        | 9.2  | % |  |      |   | 
|Goodwill amortization      |                    | $    | 178                              |      |      | $                               | 113   |          |   |  | 57.5 | % |  | $    | 534    |      |          | $ | 340    |      |   |  | 57.1 | %
|                           | % of total revenue |      |                                  | 1.2  | %    |                                 |       | 1.0      | % |  |      |   |  |      |        | 1.3  | %        |   |        | 1.0  | % |  |      |   | 

Sales and marketing expenses include costs associated with the Companys
sales channels, such as personnel, commissions, sales office costs, travel,
promotional events, sales order processing, including license administration
and order fulfillment, and advertising and public relations programs. Sales
and marketing expenses also include an allocation of overhead expenses incurred
by the Company. The absolute dollar increase in sales and marketing expenses
during the three and nine month periods ended September 30, 2001, as compared
to the corresponding periods in 2000, resulted from an increase in commissions
paid on the higher level of revenue, as well as the Companys continued
expansion of its worldwide sales and marketing organization.

Research and development expenses include all payroll costs attributable
to research and development activities. Research and development expenses also
include an allocation of overhead expenses incurred by the Company. Costs
associated with funded research and development projects are included in cost
of services. The increase in research and development expenses during the three
and nine month periods ended September 30, 2001, as compared to the
corresponding periods in 2000, primarily resulted from an increase in costs to
support the Companys expanded development efforts. The Company intends to
continue to invest significant resources in research and development in the
future.

General and administrative expenses include the cost of salaries, employee
benefits and other payroll costs associated with the Companys finance,
accounting, human resources, information systems and executive management
functions. General and administrative expenses also include an allocation of
overhead expenses incurred by the Company. The absolute dollar increase in
general and administrative expenses during the three and

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nine month periods
ended September 30, 2001, as compared to the corresponding periods in 2000, was
primarily due to additional expenses incurred to support the Companys
worldwide growth.

Goodwill amortization includes the amortization of purchase price in
excess of net assets on the Companys past acquisitions. Goodwill amortization
increased 57.5% and 57.1% during the three and nine month periods ended
September 30, 2001, respectively, as compared to the corresponding periods in
2000. The increased goodwill amortization resulted from goodwill recorded in
conjunction with the Companys acquisition of ESTECH in December 2000. The
Company amortizes goodwill over the periods estimated to be benefited from the
acquisitions, after considering such factors as demand, competition, service
lives of employees, and expected actions of competitors.

In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets
(SFAS 142), which primarily addresses the accounting for goodwill and
intangible assets subsequent to their acquisition. The provisions for SFAS 142
will be effective for the Companys fiscal year beginning January 1, 2002.
This statement is summarized in Note 5 of Notes to Condensed Consolidated
Financial Statements. Management expects that the adoption of SFAS 142 will
not result in a material adjustment to the Companys consolidated results.

Other Income, Net

|                     |                    |      |                                  |     |      |                                 |     |          |   |  |       |    |  |      |     |     |          |   |     |     |   |  |       |    | 
|-------------------- | ------------------ | ---- | -------------------------------- | --- | ---- | ------------------------------- | --- | -------- | - |  | ----- | -- |  | ---- | --- | --- | -------- | - | --- | --- | - |  | ----- | -- | 
|                     |                    |      | Three Months Ended September 30, |     |      | Nine Months Ended September 30, |    
|                     |                    |      |                                  |     |      |                                 |    
|dollars in thousands |                    | 2001 |                                  |     | 2000 |                                 |     | % Change |   |  | 2001  |    |  | 2000 |     |     | % Change |  
|                     |                    |      |                                  |     |      |                                 |     |          |   |  |       |    |  |      |     |     |          |  
|Other income, net    |                    | $    | 139                              |     |      | $                               | 181 |          |   |  | (23.2 | %) |  | $    | 269 |     |          | $ | 396 |     |   |  | (32.1 | %)
|                     | % of total revenue |      |                                  | 1.0 | %    |                                 |     | 1.6      | % |  |       |    |  |      |     | 0.6 | %        |   |     | 1.2 | % |  |       |    | 
|                     |                    |      |                                  |     |      |                                 |     |          |   |  |       |    |  |      |     |     |          |  

Other income, net consists of net interest income (expense), foreign
currency transaction gain (loss) and gain (loss) on the disposal of property
and equipment. The decrease in other income, net during the three and nine
month periods ended September 30, 2001, as compared to the corresponding
periods in 2000, primarily resulted from a decrease in interest earned given
lower interest rates and the Companys lower cash and cash equivalents balance,
partially offset by a decrease in foreign currency transaction losses incurred
by the Company in 2001. From time to time, the Company may enter into forward
exchange contracts to hedge exposures related to significant foreign currency
transactions. The Company does not use any other types of derivatives to hedge
such exposures nor does it speculate in foreign currency.

Provision for Income Taxes

The Companys effective income tax rate was 29.9% and 29.9% for the first
nine months of 2001 and 2000, respectively. The difference between the
Companys effective rate and the 34.0% statutory federal rate during each
period resulted primarily from tax-exempt interest income earned by the Company
as well as tax benefits gained from the Companys foreign sales corporation.

Minority Interest in Net Income of Subsidiary

The Company owns a 66% interest in its Japanese subsidiary, Mechanical
Dynamics Japan K.K. (MDI-Japan), through a joint venture agreement with
ISI-Dentsu of Tokyo, Japan, the largest distributor of the Companys software
in Japan. Minority interest in net income of subsidiary of $140,000 and
$54,000 for the nine month periods ended September 30, 2001 and 2000,
respectively, represents ISI-Dentsus 34% interest in the net income of
MDI-Japan.

Employees

The number of the Companys worldwide employees increased 25.5% to 354 at
September 30, 2001, compared with 282 at September 30, 2000. Reflected in this
increase are 42 new employees who joined the Company as a

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result of the
Companys acquisition of ESTECH in December 2000. On a sequential basis, the
Companys workforce grew by 1 employee during the quarter, from 353 employees
at June 30, 2001.

Euro Conversion

In January 1999, 11 of the 15 member countries of the European Union
established fixed conversion rates between their existing sovereign currencies
and the Euro, making the Euro their common legal currency on that date. There
is a transition period from January 1, 1999 to January 1, 2002, during which
the old currencies will remain legal tender in the participating countries as
denominations of the Euro.

The Companys subsidiaries in France and Italy are currently reporting in
Euros. The Companys German subsidiary does not expect any interruptions or
adverse effects as a result of its future conversion to Euros. The Company is
also evaluating any other business implications of conversion to the Euro,
including technical adaptation of information technology and other systems to
accommodate Euro-denominated transactions, long-term competitive implications
of the conversion, and the effect on market risk with respect to financial
instruments. At this time, the Company does not expect that the Euros
introduction will have a material adverse effect on its consolidated results of
operations during or after the transition period.

Liquidity and Capital Resources

Cash and cash equivalents decreased $111,000 during the first nine months
of 2001 to $17.9 million at September 30, 2001, compared with $18.0 million at
December 31, 2000. Through September 30, 2001, cash and cash equivalents
decreased primarily as a result of $2.0 million in cash used to pay down
year-end accounts payable and accrued expenses, $1.9 million in cash used for
purchases of equipment (net of proceeds from disposals), and $495,000 in cash
used to repurchase 62,400 shares of the Companys common stock. These
decreases were primarily offset by cash generated from the earnings of the
Company during the first three quarters of 2001.

At September 30, 2001, the Companys principal commitments consisted of
obligations under capital and operating leases for facilities and equipment.
The Company had $957,000 in capital lease obligations outstanding as of
September 30, 2001, of which $525,000 was long-term. The Company had no other
borrowings under long-term debt arrangements at September 30, 2001.

The Company has an agreement with its principal bank for a $6.0 million
line of credit facility. No borrowings were outstanding under this agreement
as of September 30, 2001. The Companys subsidiaries in Germany, Italy, Sweden
and France also have line of credit and overdraft facilities that provide for
aggregate borrowing availability of approximately $400,000. No borrowings were
outstanding under these facilities as of September 30, 2001.

Long-term cash requirements, other than for normal operating expenses, are
anticipated for the development of new software products and enhancements of
existing products, financing growth, repurchases of the Companys common stock
and the possible acquisition of software products, technologies and businesses
complementary to the Companys business. The Company believes that cash flows
from operations, together with existing cash balances, and available borrowings
will be adequate to meet the Companys cash requirements for working capital,
capital expenditures, and stock repurchases for the next twelve months and the
foreseeable future. The Company has not paid dividends during the period from
1996 through the third quarter of 2001 and intends to continue its policy of
retaining earnings to finance future growth.




Item 3. Quantitative and Qualitative Disclosures about Market Risk

Other than as disclosed in this report on Form 10-Q, there have been no
significant changes in our market risk exposure as described in Managements
Discussion and Analysis of Financial Condition and Results of Operations
included as Item 7a. on Form 10-K for the year ended December 31, 2000 and
incorporated herein by reference.

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PART II  OTHER INFORMATION




Item 6. Exhibits and Reports on Form 8-K



| | (a) |  | Exhibits
| | --- |  | --------

|       |  |                                                                                                
|------ |  | -----------------------------------------------------------------------------------------------
|Number |  | Exhibit                                                                                        
|       |  |                                                                                                
|(4.2)  |  | Line of Credit Document between the Company and KeyBank National Association
dated July 6, 2001

For our documents incorporated by reference, references are to File No. 0-20679.



| | (b) |  | Reports on Form 8-K                                                                               
| | --- |  | --------------------------------------------------------------------------------------------------
|
| |     |  | No reports on Form 8-K were filed by the Company during the three months
ended September 30, 2001.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.

|                        |  |                                                  
|----------------------- |  | -------------------------------------------------
|Dated: November 9, 2001 |  | MECHANICAL DYNAMICS, INC.                        
|                        |  | (Registrant)                                     
|                       
|By:                     |  | /s/ Michael E. Korybalski                        
|                        |  |                                                  
|                        |  | Michael E. Korybalski                            
|                        |  | Chairman of the Board and Chief Executive Officer
|                        |  | (Principal Executive Officer)                    
|                       
|By:                     |  | /s/ David Peralta                                
|                        |  |                                                  
|                        |  | David Peralta                                    
|                        |  | Vice President and Chief Financial Officer       
|                        |  | (Principal Financial and Accounting Officer)     

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INDEX TO EXHIBITS

| |  |        |  |                                                                                                
| |  | ------ |  | -----------------------------------------------------------------------------------------------
| |  | Number |  | Exhibit Title                                                                                  
| |  |        |  |                                                                                                
| |  | (4.2)  |  | Line of Credit Document between the
Company and KeyBank National
Association dated July 6, 2001

For our documents incorporated by reference, references are to File No. 0-20679.

16