##### 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: June 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 August 10, 2001, was 6,086,603.





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TABLE OF CONTENTS



|                               |                                                                                               |                                                                                               |  |  |  |  |  | 
|------------------------------ | --------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  | 
|PART I  FINANCIAL INFORMATION
|                               | ITEM 1. FINANCIAL STATEMENTS                                                                 
|                               |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS JUNE 30, 2001 AND DECEMBER 31, 2000                    
|                               |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF INCOME THREE AND SIX MONTHS ENDED JUNE 30, 2001 AND 2000
|                               |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS SIX MONTHS ENDED JUNE 30, 2001 AND 2000      
|                               |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                         
|                               | ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULST OF OPERATIONS
|                               | ITEM 3. QUANTATATIVE AND QUALITATAVE DISCLOSURES ABOUT MARKET RISK                           
|PART II  OTHER INFORMATION   
|                               | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                  
|                               | ITEM 6. EXHIBITS AND REPORST ON FORM 8-K                                                     
|SIGNATURES                    



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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               
|                              
|                              
|                              
|                              
|                               |                                                                                               | June 30, 2001 and December 31, 2000                  |    |      | 3 | 
|                              
|                              
|                              
|                              
|                              
|                               |                                                                                               | Condensed Consolidated Statements of Income         
|                              
|                              
|                              
|                              
|                               |                                                                                               | Three and Six Months Ended June 30, 2001 and 2000    |    |      | 4 | 
|                              
|                              
|                              
|                              
|                              
|                               |                                                                                               | Condensed Consolidated Statements of Cash Flows     
|                              
|                              
|                              
|                              
|                               |                                                                                               | Six Months Ended June 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   |  
|                              
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|                              
|PART II   OTHER INFORMATION  
|                              
|                              
|                              
|                              
|                              
|                               | Item 4. Submission of Matters to a Vote of Security Holders                                   |                                                      |    | 14   |  
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|                              
|                              
|                              
|                               | Item 6. Exhibits and Reports on Form 8-K                                                      |                                                      |    | 14   |  
|                              
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|                              
|                              
|                              
|SIGNATURES                     |                                                                                               |                                                      | 15 |     

2



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##### Table of Contents






PART I  FINANCIAL INFORMATION




Item 1. Financial Statements




MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

|                                               |                                      |                            |            |          |        |      |              |  |  |   |        |        |        | 
|---------------------------------------------- | ------------------------------------ | -------------------------- | ---------- | -------- | ------ | ---- | ------------ |  |  | - | ------ | ------ | ------ | 
|                                               |                                      |                            |            | June 30, |        |      | December 31, | 
|in thousands                                   |                                      |                            | 2001       |          |        | 2000 |             
|                                               |                                      |                            |            |          |        |      |             
|Assets:                                        |                                      |                            | (Unaudited | )       
|                                              
|                                              
|                                              
|                                              
|Current assets:                               
|                                              
|                                              
|                                              
|                                              
|                                               | Cash and cash equivalents            |                            | $          | 17,190   |        |      |              |  |  |   | $      | 17,961 |       
|                                              
|                                              
|                                              
|                                              
|                                               | Accounts receivable, net             |                            |            | 11,038   |        |      |              |  |  |   |        | 11,442 |       
|                                              
|                                              
|                                              
|                                              
|                                               | Prepaid and deferred expenses        |                            |            | 3,275    |        |      |              |  |  |   |        | 3,255  |       
|                                               |                                      |                            |            |          |        |      |              |  |  |   |       
|                                               |                                      | Total current assets       |            |          | 31,503 |      |              |  |  |   |        |        | 32,658 | 
|                                               |                                      |                            |            |          |        |      |              |  |  |  
|Property and equipment, net                    |                                      |                            | 4,635      |          |        |      |              |  |  |   | 4,462  |       
|                                              
|                                              
|                                              
|                                              
|Goodwill, net                                  |                                      |                            | 6,506      |          |        |      |              |  |  |   | 6,768  |       
|                                              
|                                              
|                                              
|                                              
|Other assets                                   |                                      |                            | 2,205      |          |        |      |              |  |  |   | 1,981  |       
|                                               |                                      |                            |            |          |        |      |              |  |  |  
|Total assets                                   |                                      | $                          | 44,849     |          |        |      |              |  |  | $ | 45,869 |       
|                                               |                                      |                            |            |          |        |      |              |  |  |  
|Liabilities and Shareholders Equity:         
|                                              
|                                              
|                                              
|                                              
|Current liabilities:                          
|                                              
|                                              
|                                              
|                                              
|                                               | Borrowings under lines of credit     |                            | $          |         |        |      |              |  |  |   | $      | 49     |       
|                                              
|                                              
|                                              
|                                              
|                                               | Current portion of capital leases    |                            |            | 406      |        |      |              |  |  |   |        | 406    |       
|                                              
|                                              
|                                              
|                                              
|                                               | Accounts payable                     |                            |            | 2,018    |        |      |              |  |  |   |        | 2,466  |       
|                                              
|                                              
|                                              
|                                              
|                                               | Accrued expenses                     |                            |            | 4,948    |        |      |              |  |  |   |        | 7,152  |       
|                                              
|                                              
|                                              
|                                              
|                                               | Deferred revenue                     |                            |            | 8,553    |        |      |              |  |  |   |        | 6,936  |       
|                                               |                                      |                            |            |          |        |      |              |  |  |  
|                                               |                                      | Total current liabilities  |            |          | 15,925 |      |              |  |  |   |        |        | 17,009 | 
|                                               |                                      |                            |            |          |        |      |              |  |  |  
|Capital lease obligation, less current portion |                                      |                            | 383        |          |        |      |              |  |  |   | 658    |       
|                                              
|                                              
|                                              
|                                              
|Minority interest                              |                                      |                            | 627        |          |        |      |              |  |  |   | 539    |       
|                                              
|                                              
|                                              
|                                              
|Shareholders equity:                         
|                                              
|                                              
|                                              
|                                              
|                                               | Common stock                         |                            |            | 21,874   |        |      |              |  |  |   |        | 21,998 |       
|                                              
|                                              
|                                              
|                                              
|                                               | Preferred stock                      |                            |            |         |        |      |              |  |  |   |        |       |       
|                                              
|                                              
|                                              
|                                              
|                                               | Retained earnings                    |                            |            | 6,718    |        |      |              |  |  |   |        | 5,819  |       
|                                              
|                                              
|                                              
|                                              
|                                               | Accumulated other comprehensive loss |                            |            | (678     | )      |      |              |  |  |   |        | (154   | )     
|                                               |                                      |                            |            |          |        |      |              |  |  |  
|                                               |                                      | Total shareholders equity |            |          | 27,914 |      |              |  |  |   |        |        | 27,663 | 
|                                               |                                      |                            |            |          |        |      |              |  |  |  
|Total liabilities and shareholders equity     |                                      | $                          | 44,849     |          |        |      |              |  |  | $ | 45,869 |       
|                                               |                                      |                            |            |          |        |      |              |  |  |  

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

3



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##### Table of Contents



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




|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |        |   |           |        |        | 
|---------------------------------------------------- | ------------------------------- | ------------------------ | --------- | ------------------ | ------ | - | ---------------- | ----- | ------ | - | --------- | ------ | ------ | - | --------- | ------ | ------ | 
|                                                     |                                 |                          |           | Three Months Ended |        |   | Six Months Ended |      
|                                                     |                                 |                          |           | June 30,           |        |   | June 30,         |      
|                                                     |                                 |                          |           |                    |        |   |                  |      
|in thousands except share and per share data         |                                 | 2001                     |           |                    | 2000   |   |                  | 2001  |        |   | 2000      |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |       
|Revenue:                                            
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Software licenses               |                          | $         | 6,016              |        |   | $                | 5,742 |        |   | $         | 12,207 |        |   | $         | 11,778 |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Software maintenance services   |                          |           | 3,308              |        |   |                  | 2,468 |        |   |           | 6,321  |        |   |           | 4,721  |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Professional services and other |                          |           | 4,916              |        |   |                  | 2,871 |        |   |           | 9,553  |        |   |           | 5,321  |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|                                                     |                                 | Total revenue            |           |                    | 14,240 |   |                  |       | 11,081 |   |           |        | 28,081 |   |           |        | 21,820 | 
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|Cost of revenue:                                    
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Software licenses               |                          |           | 973                |        |   |                  | 1,003 |        |   |           | 1,950  |        |   |           | 2,102  |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Services                        |                          |           | 4,316              |        |   |                  | 2,768 |        |   |           | 8,384  |        |   |           | 5,322  |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|                                                     |                                 | Total cost of revenue    |           |                    | 5,289  |   |                  |       | 3,771  |   |           |        | 10,334 |   |           |        | 7,424  | 
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|Gross profit                                         |                                 |                          | 8,951     |                    |        |   | 7,310            |       |        |   | 17,747    |        |        |   | 14,396    |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|Operating expenses:                                 
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Sales and marketing             |                          |           | 4,915              |        |   |                  | 4,151 |        |   |           | 9,850  |        |   |           | 8,354  |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Research and development        |                          |           | 1,697              |        |   |                  | 1,474 |        |   |           | 3,395  |        |   |           | 2,920  |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | General and administrative      |                          |           | 1,166              |        |   |                  | 1,018 |        |   |           | 2,483  |        |   |           | 2,044  |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Goodwill amortization           |                          |           | 178                |        |   |                  | 113   |        |   |           | 356    |        |   |           | 227    |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|                                                     |                                 | Total operating expenses |           |                    | 7,956  |   |                  |       | 6,756  |   |           |        | 16,084 |   |           |        | 13,545 | 
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|Operating income                                     |                                 |                          | 995       |                    |        |   | 554              |       |        |   | 1,663     |        |        |   | 851       |       
|                                                    
|                                                    
|                                                    
|                                                    
|Other income, net                                    |                                 |                          | 11        |                    |        |   | 130              |       |        |   | 130       |        |        |   | 215       |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|Income before income taxes and minority interest     |                                 |                          | 1,006     |                    |        |   | 684              |       |        |   | 1,793     |        |        |   | 1,066     |       
|                                                    
|                                                    
|                                                    
|                                                    
|Provision for income taxes                           |                                 |                          | 301       |                    |        |   | 204              |       |        |   | 536       |        |        |   | 318       |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|Net income before minority interest                  |                                 |                          | 705       |                    |        |   | 480              |       |        |   | 1,257     |        |        |   | 748       |       
|                                                    
|                                                    
|                                                    
|                                                    
|Minority interest in net income of subsidiary        |                                 |                          | 27        |                    |        |   | 1                |       |        |   | 88        |        |        |   | 28        |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|Net income                                           |                                 | $                        | 678       |                    |        | $ | 479              |       |        | $ | 1,169     |        |        | $ | 720       |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|Basic net income per common share                    |                                 | $                        | 0.11      |                    |        | $ | 0.08             |       |        | $ | 0.19      |        |        | $ | 0.11      |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|Weighted average common shares                       |                                 |                          | 6,059,904 |                    |        |   | 6,260,951        |       |        |   | 6,074,274 |        |        |   | 6,273,763 |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|Diluted net income per common share                  |                                 | $                        | 0.11      |                    |        | $ | 0.08             |       |        | $ | 0.19      |        |        | $ | 0.11      |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       
|Weighted average common and common equivalent shares |                                 |                          | 6,308,571 |                    |        |   | 6,266,564        |       |        |   | 6,268,138 |        |        |   | 6,275,689 |       
|                                                     |                                 |                          |           |                    |        |   |                  |       |        |   |           |        |       

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

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##### Table of Contents



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




|                                                     |                                                  |                                   |                                               |                                           |   |                  |        |      |   |     |       |  
|---------------------------------------------------- | ------------------------------------------------ | --------------------------------- | --------------------------------------------- | ----------------------------------------- | - | ---------------- | ------ | ---- | - | --- | ----- | -
|                                                     |                                                  |                                   |                                               |                                           |   | Six Months Ended |       
|                                                     |                                                  |                                   |                                               |                                           |   | June 30,         |       
|                                                     |                                                  |                                   |                                               |                                           |   |                  |       
|in thousands                                         |                                                  |                                   | 2001                                          |                                           |   | 2000             |       
|                                                     |                                                  |                                   |                                               |                                           |   |                  |       
|                                                     |                                                  |                                   |                                               |                                           |   | (Unaudited)      |       
|Cash flows from operating activities:               
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Net income                                       |                                   | $                                             | 1,169                                     |   |                  | $      | 720  |  
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Adjustments to reconcile net income to net cash 
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  | provided by operating activities:
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   | Depreciation and amortization                 |                                           |   | 1,225            |        |      |   | 840 |      
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   | (Gain) loss on disposal of assets, net        |                                           |   | 43               |        |      |   | (24 | )    
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   | Minority interest in net income of subsidiary |                                           |   | 88               |        |      |   | 28  |      
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   | Changes in assets and liabilities:           
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   |                                               | Accounts receivable                       |   |                  | (187   | )    |   |     | (475  | )
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   |                                               | Prepaid and deferred expenses             |   |                  | (168   | )    |   |     | (72   | )
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   |                                               | Other assets                              |   |                  | (234   | )    |   |     | (71   | )
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   |                                               | Accounts payable                          |   |                  | (169   | )    |   |     | 523   |  
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   |                                               | Accrued expenses                          |   |                  | (1,952 | )    |   |     | (563  | )
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   |                                               | Deferred revenue                          |   |                  | 1,868  |      |   |     | 1,881 |  
|                                                     |                                                  |                                   |                                               |                                           |   |                 
|                                                     |                                                  |                                   |                                               | Net cash provided by operating activities |   |                  | 1,683  |      |   |     | 2,787 |  
|                                                     |                                                  |                                   |                                               |                                           |   |                 
|Cash flows from investing activities:               
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Proceeds from the sale of property and equipment |                                   |                                               | 25                                        |   |                  |        | 118  |  
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Purchases of property and equipment              |                                   |                                               | (1,307                                    | ) |                  |        | (531 | )
|                                                     |                                                  |                                   |                                               |                                           |   |                 
|                                                     |                                                  |                                   |                                               | Net cash used in investing activities     |   |                  | (1,282 | )    |   |     | (413  | )
|                                                     |                                                  |                                   |                                               |                                           |   |                 
|Cash flows from financing activities:               
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Net payments under line of credit agreements     |                                   |                                               | (49                                       | ) |                  |        | (7   | )
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Proceeds from the issuance of common stock       |                                   |                                               | 101                                       |   |                  |        | 106  |  
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Repurchases of Company common stock              |                                   |                                               | (495                                      | ) |                  |        | (529 | )
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Payments on capital lease obligations            |                                   |                                               | (228                                      | ) |                  |        | 0    |  
|                                                     |                                                  |                                   |                                               |                                           |   |                 
|                                                     |                                                  |                                   |                                               | Net cash used in financing activities     |   |                  | (671   | )    |   |     | (430  | )
|                                                     |                                                  |                                   |                                               |                                           |   |                 
|Effect of exchange rate changes on cash              |                                                  |                                   | (501                                          | )                                         |   |                  | (147   | )   
|                                                     |                                                  |                                   |                                               |                                           |   |                 
|Net increase (decrease) in cash and cash equivalents |                                                  |                                   | (771                                          | )                                         |   |                  | 1,797  |     
|                                                    
|                                                    
|                                                    
|                                                    
|Cash and cash equivalents at beginning of period     |                                                  |                                   | 17,961                                        |                                           |   |                  | 17,741 |     
|                                                     |                                                  |                                   |                                               |                                           |   |                 
|Cash and cash equivalents at end of period           |                                                  | $                                 | 17,190                                        |                                           |   | $                | 19,538 |     
|                                                     |                                                  |                                   |                                               |                                           |   |                 
|Supplemental disclosures of cash flow information:  
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Cash paid during the period for:                
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   | Interest                                      |                                           | $ | 19               |        |      | $ | 3   |      
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                   | Income taxes                                  |                                           | $ | 818              |        |      | $ | 440 |      
|                                                     |                                                  |                                   |                                               |                                           |   |                 

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

5



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##### Table of Contents



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 six month periods ended June 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 $709,000 and $333,000 for the three
month periods ended June 30, 2001 and 2000, respectively, and $645,000 and
$502,000 for the six month periods ended June 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 |           |  | Six Months Ended | 
|                                             |                                                  |  | June 30, |  |  | June 30, |                   
|                                             |                                                  |  |          |  |  |          |                   
|                                             |                                                  |  |          |  |  |          | 2001               |           |  | 2000             |  |           | 2001 |  |  | 2000      | 
|                                             |                                                  |  |          |  |  |          |                    |           |  |                  |  |           |      |  |  |           | 
|Weighted average common shares used in basic
|                                            
|                                            
|                                            
|                                            
|                                             | net income per common share                      |  |          |  |  |          |                    | 6,059,904 |  |                  |  | 6,260,951 |      |  |  | 6,074,274 |  |  |  | 6,273,763 | 
|                                            
|                                            
|                                            
|                                            
|                                             | Effect of stock options                          |  |          |  |  |          |                    | 248,667   |  |                  |  | 5,613     |      |  |  | 193,864   |  |  |  | 1,926     | 
|                                             |                                                  |  |          |  |  |          |                    |           |  |                  |  |           |      |  |  |          
|Weighted average common and common          
|                                            
|                                            
|                                            
|                                            
|                                             | equivalent shares used in diluted net income per
|                                            
|                                            
|                                            
|                                            
|                                             | common share                                     |  |          |  |  |          |                    | 6,308,571 |  |                  |  | 6,266,564 |      |  |  | 6,268,138 |  |  |  | 6,275,689 | 
|                                             |                                                  |  |          |  |  |          |                    |           |  |                  |  |           |      |  |  |          

Options to purchase shares of the Companys common stock for the three
months ended June 30, 2001 and 2000 of 45,359 and 653,173, respectively, and for
the six months ended June 30, 2001 and 2000 of 115,907 and 650,552,
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

6



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have maturities less than one year. Any derivative the Company enters
into is designated at inception as a hedge of 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 June 30,
2001 and 2000, the Company had approximately $97,000 and $252,000, 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 July 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141,
Business Combinations (SFAS 141) and No. 142, Goodwill and Other Intangible Assets (SFAS 142).

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. Total goodwill
included in the Companys Consolidated Financial Statements was $6.5 million at
June 30, 2001 and $6.8 million at December 31, 2000. Pre-tax goodwill
amortization expense was $178,000 during the three month period ended June 30,
2001 and $113,000 during the three month period ended June 30, 2000. Pre-tax
goodwill amortization expense was $356,000 during the six month period ended
June 30, 2001 and $227,000 during the six month period ended June 30, 2000. The
Company is currently assessing the effect of the new standards related to the
impairment testing of goodwill.

(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 which are designed to be representative of
third party transactions.

7



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

|             |                             |                          |               |       |                             |        |   |                           |       |        |   |       |        |        |   |       |       |        |  |  |  |  | 
|------------ | --------------------------- | ------------------------ | ------------- | ----- | --------------------------- | ------ | - | ------------------------- | ----- | ------ | - | ----- | ------ | ------ | - | ----- | ----- | ------ |  |  |  |  | 
|             |                             |                          |               |       | Three Months Ended June 30, |        |   | Six Months Ended June 30, |      
|             |                             |                          |               |       |                             |        |   |                           |      
|In thousands |                             |                          | 2001          |       |                             | 2000   |   |                           | 2001  |        |   | 2000  |       
|             |                             |                          |               |       |                             |        |   |                           |       |        |   |       |       
|Revenue:    
|            
|            
|            
|            
|             | North America
United States |                          | $             | 4,171 |                             |        | $ | 2,855                     |       |        | $ | 6,901 |        |        | $ | 5,636 |      
|            
|            
|            
|            
|             |                             | Canada and Mexico        |               |       | 774                         |        |   |                           | 1,203 |        |   |       | 1,615  |        |   |       | 2,539 |       
|            
|            
|            
|            
|             | Europe                     
|            
|            
|            
|            
|             |                             | Germany                  |               |       | 1,397                       |        |   |                           | 1,498 |        |   |       | 2,559  |        |   |       | 2,531 |       
|            
|            
|            
|            
|             |                             | Other European countries |               |       | 2,610                       |        |   |                           | 2,558 |        |   |       | 5,149  |        |   |       | 5,087 |       
|            
|            
|            
|            
|             | Asia/Pacific               
|            
|            
|            
|            
|             |                             | Japan                    |               |       | 4,396                       |        |   |                           | 2,302 |        |   |       | 10,306 |        |   |       | 4,963 |       
|            
|            
|            
|            
|             |                             | Other Asian countries    |               |       | 892                         |        |   |                           | 665   |        |   |       | 1,551  |        |   |       | 1,064 |       
|             |                             |                          |               |       |                             |        |   |                           |       |        |   |      
|             |                             |                          | Total revenue |       | $                           | 14,240 |   |                           | $     | 11,081 |   |       | $      | 28,081 |   |       | $     | 21,820 | 
|             |                             |                          |               |       |                             |        |   |                           |       |        |   |      

No customer accounted for greater than 10% of total revenue during the three
month periods ended June 30, 2001 and 2000. The Companys largest distributor,
ISI-Dentsu, is located in Japan and accounted for approximately 9.9% and 12.4%
of the Companys total revenue for the three month periods ended June 30, 2001
and 2000, respectively. ISI-Dentsu accounted for approximately 12.7% and 16.4%
of the Companys total revenue for the six month periods ended June 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 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 Package and 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;

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| |  | the timing and acceptance of new products and product enhancements by the Company or its competitors;                                                                                 
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  | 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 June 30, |      |      | Six Months Ended June 30, |       
|                                |                    |      |                             |      |      |                           |       
|dollars in thousands            |                    | 2001 |                             |      | 2000 |                           |        | % Change |   |  | 2001 |   |  | 2000 |        |      | % Change |  
|                                |                    |      |                             |      |      |                           |        |          |   |  |      |   |  |      |        |      |          |  
|Software licenses               |                    | $    | 6,016                       |      |      | $                         | 5,742  |          |   |  | 4.8  | % |  | $    | 12,207 |      |          | $ | 11,778 |      |   |  | 3.6  | %
|                               
|                               
|                               
|                               
|                                | % of total revenue |      |                             | 42.3 | %    |                           |        | 51.8     | % |  |      |   |  |      |        | 43.5 | %        |   |        | 54.0 | %
|                               
|                               
|                               
|                               
|Software maintenance services   |                    | $    | 3,308                       |      |      | $                         | 2,468  |          |   |  | 34.0 | % |  | $    | 6,321  |      |          | $ | 4,721  |      |   |  | 33.9 | %
|                               
|                               
|                               
|                               
|                                | % of total revenue |      |                             | 23.2 | %    |                           |        | 22.3     | % |  |      |   |  |      |        | 22.5 | %        |   |        | 21.6 | %
|                               
|                               
|                               
|                               
|Professional services and other |                    | $    | 4,916                       |      |      | $                         | 2,871  |          |   |  | 71.2 | % |  | $    | 9,553  |      |          | $ | 5,321  |      |   |  | 79.5 | %
|                               
|                               
|                               
|                               
|                                | % of total revenue |      |                             | 34.5 | %    |                           |        | 25.9     | % |  |      |   |  |      |        | 34.0 | %        |   |        | 24.4 | %
|                                |                    |      |                             |      |      |                           |        |          |   |  |      |   |  |      |        |      |          |  
|Total revenue                   |                    | $    | 14,240                      |      |      | $                         | 11,081 |          |   |  | 28.5 | % |  | $    | 28,081 |      |          | $ | 21,820 |      |   |  | 28.7 | %
|                                |                    |      |                             |      |      |                           |        |          |   |  |      |   |  |      |        |      |          |  

The Companys total revenue increased 28.5% and 28.7% during the three and
six month periods ended June 30, 2001, respectively, as compared to the
corresponding periods in 2000. The growth in revenue resulted 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. The increases in these components of revenue were partially
offset by a decrease in the sales of third-party software products licensed
through the Companys European and Canadian subsidiaries.

Revenue from international customers accounted for approximately 65.3% and
63.4% of the Companys total revenue during the three months ended June 30, 2001
and 2000, respectively. International revenue accounted for approximately 69.7%
and 62.5% of total revenue during the six months ended June 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 ADAMS software licenses in Japan and

9



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the rest of Asia. The increase in
international revenue was partially offset by the recent strengthening of the
U.S. dollar, which, relative to the European, Canadian and Japanese currencies,
negatively impacted the Companys second quarter revenue by approximately $1.2
million. Since most of the Companys international operating 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 continues to strengthen in 2001 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 4.8% and 3.6% during the three
and six month periods ended June 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 7.7% of total revenue
during the three month period ended June 30, 2001, as compared to $1.1 million,
or 10.0% of total revenue during the corresponding period in 2000. Revenue from
third party products totaled approximately $2.1 million, or 7.4% of total
revenue during the six month period ended June 30, 2001, as compared to $2.4
million, or 10.9% 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 34.0% and 33.9% during the three and six
month periods ended June 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.

Professional services and other revenue consists primarily of revenue from
consulting, training and funded research and development projects. Professional
services revenue increased 71.2% and 79.5% during the three and six month
periods ended June 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 June 30, |      |   | Six Months Ended June 30, |         
|                          |                                 |                  |       |                             |      |   |                           |         
|dollars in thousands      |                                 | 2001             |       |                             | 2000 |   |                           | % Change |   |  | 2001 |    |  | 2000 |       |      | % Change |  
|                          |                                 |                  |       |                             |      |   |                           |          |   |  |      |    |  |      |       |      |          |  
|Cost of software licenses |                                 | $                | 973   |                             |      | $ | 1,003                     |          |   |  | (3.0 | %) |  | $    | 1,950 |      |          | $ | 2,102 |      |   |  | (7.2 | %)
|                         
|                         
|                         
|                         
|                          | Gross profit margin on software |                  |       | 83.8                        | %    |   |                           | 82.5     | % |  |      |    |  |      |       | 84.0 | %        |   |       | 82.2 | %
|                         
|                         
|                         
|                         
|                          |                                 | licenses revenue
|                         
|                         
|                         
|                         
|Cost of services          |                                 | $                | 4,316 |                             |      | $ | 2,768                     |          |   |  | 55.9 | %  |  | $    | 8,384 |      |          | $ | 5,322 |      |   |  | 57.5 | % 
|                         
|                         
|                         
|                         
|                          | Gross profit margin on services |                  |       | 47.5                        | %    |   |                           | 48.2     | % |  |      |    |  |      |       | 47.2 | %        |   |       | 47.0 | %
|                         
|                         
|                         
|                         
|                          |                                 | revenue         

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 3.0% and
7.2% during the three and six month periods ended June 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 noted above.

Gross profit margin on software licenses revenue was 83.8% and 82.5% during
the three month periods ended June 30, 2001 and 2000, respectively. Gross profit
margin on software licenses revenue was 84.0% and 82.2% during the six month
periods ended June 30, 2001 and 2000, respectively. The increase in gross profit
margin was due to a decrease in revenue from third-party software products as a
percent of total software licenses revenue. The

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gross profit margin realized
from sales of third-party software products has historically been lower than the
gross profit margin realized from sales of the Companys 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 55.9% and 57.5% during the three and six month
periods ended June 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 the first
half of 2001. Gross profit margin on services revenue was 47.5% and 48.2% during
the three month periods ended June 30, 2001 and 2000, respectively. Gross profit
margin on services revenue was 47.2% and 47.0% during the six month periods
ended June 30, 2001 and 2000, respectively.

Operating Expenses

|                           |                    |      |                             |      |      |                           |       |          |   |  |      |   |  |      |       |      |          |   |       |      |   |  |      |   | 
|-------------------------- | ------------------ | ---- | --------------------------- | ---- | ---- | ------------------------- | ----- | -------- | - |  | ---- | - |  | ---- | ----- | ---- | -------- | - | ----- | ---- | - |  | ---- | - | 
|                           |                    |      | Three Months Ended June 30, |      |      | Six Months Ended June 30, |      
|                           |                    |      |                             |      |      |                           |      
|dollars in thousands       |                    | 2001 |                             |      | 2000 |                           |       | % Change |   |  | 2001 |   |  | 2000 |       |      | % Change |  
|                           |                    |      |                             |      |      |                           |       |          |   |  |      |   |  |      |       |      |          |  
|Sales and marketing        |                    | $    | 4,915                       |      |      | $                         | 4,151 |          |   |  | 18.4 | % |  | $    | 9,850 |      |          | $ | 8,354 |      |   |  | 17.9 | %
|                          
|                          
|                          
|                          
|                           | % of total revenue |      |                             | 34.5 | %    |                           |       | 37.5     | % |  |      |   |  |      |       | 35.1 | %        |   |       | 38.3 | %
|                          
|                          
|                          
|                          
|Research and development   |                    | $    | 1,697                       |      |      | $                         | 1,474 |          |   |  | 15.1 | % |  | $    | 3,395 |      |          | $ | 2,920 |      |   |  | 16.3 | %
|                          
|                          
|                          
|                          
|                           | % of total revenue |      |                             | 11.9 | %    |                           |       | 13.3     | % |  |      |   |  |      |       | 12.1 | %        |   |       | 13.4 | %
|                          
|                          
|                          
|                          
|General and administrative |                    | $    | 1,166                       |      |      | $                         | 1,018 |          |   |  | 14.5 | % |  | $    | 2,483 |      |          | $ | 2,044 |      |   |  | 21.5 | %
|                          
|                          
|                          
|                          
|                           | % of total revenue |      |                             | 8.2  | %    |                           |       | 9.2      | % |  |      |   |  |      |       | 8.8  | %        |   |       | 9.4  | %
|                          
|                          
|                          
|                          
|Goodwill amortization      |                    | $    | 178                         |      |      | $                         | 113   |          |   |  | 57.5 | % |  | $    | 356   |      |          | $ | 227   |      |   |  | 56.8 | %
|                          
|                          
|                          
|                          
|                           | % of total revenue |      |                             | 1.3  | %    |                           |       | 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 six month periods ended June 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
six month periods ended June 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 six month periods ended
June 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 56.8% during the three and six month periods ended June

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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 July 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 Consolidated Financial Statements.
Management is currently assessing the impact of adoption of this standard.

Other Income, Net

|                     |                    |      |                             |     |      |                           |          |     |      |  |       |    |          |   |     |     |   |   |     |     |   |  |       |    | 
|-------------------- | ------------------ | ---- | --------------------------- | --- | ---- | ------------------------- | -------- | --- | ---- |  | ----- | -- | -------- | - | --- | --- | - | - | --- | --- | - |  | ----- | -- | 
|                     |                    |      | Three Months Ended June 30, |     |      | Six Months Ended June 30, |         
|                     |                    |      |                             |     |      |                           |         
|dollars in thousands |                    | 2001 |                             |     | 2000 |                           | % Change |     | 2001 |  | 2000  |    | % Change |  
|                     |                    |      |                             |     |      |                           |          |     |      |  |       |    |          |  
|Other income, net    |                    | $    | 11                          |     |      | $                         | 130      |     |      |  | (91.5 | %) |          | $ | 130 |     |   | $ | 215 |     |   |  | (39.5 | %)
|                    
|                    
|                    
|                    
|                     | % of total revenue |      |                             | 0.1 | %    |                           |          | 1.2 | %    |  |       |    |          |   |     | 0.5 | % |   |     | 1.0 | %
|                     |                    |      |                             |     |      |                           |          |     |      |  |       |    |          |   |     |     |   |  

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 month period ended
June 30, 2001, as compared to the corresponding period in 2000, primarily
resulted from a decrease in interest earned given the Companys lower cash and
cash equivalents balance and losses incurred on the disposal of property and
equipment. The decrease in other income, net during the six month period ended
June 30, 2001, as compared to the corresponding period in 2000, primarily
resulted from a decrease in interest earned given the Companys lower cash and
cash equivalents balance and losses incurred on the disposal of property and
equipment, 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 29.8% for the first
six 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 $88,000 and $28,000 for
the six month periods ended June 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 23.0% to 353 at
June 30, 2001, compared with 287 at June 30, 2000. Reflected in this increase
are 41 new employees who joined the Company as a result of the Companys
acquisition of ESTECH in December 2000. On a sequential basis, the Companys
workforce grew by 8 employees during the quarter, from 345 employees at March
31, 2001.

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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 $771,000 during the first six months of
2001 to $17.2 million at June 30, 2001, compared with $18.0 million at December
31, 2000. Through June 30, 2001, cash and cash equivalents decreased primarily
as a result of $2.1 million in cash used to pay down year-end accounts payable
and accrued expenses, $1.3 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 half of 2001.

At June 30, 2001, the Companys principal commitments consisted of
obligations under capital and operating leases for facilities and equipment. The
Company had $789,000 in capital lease obligations outstanding as of June 30,
2001, of which $383,000 was long-term. The Company had no other borrowings under
long-term debt arrangements at June 30, 2001.

The Company has an agreement with its principal bank for a $4.0 million line
of credit facility. No borrowings were outstanding under this agreement as of
June 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 June 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 second 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 4. Submission of Matters to a Vote of Security Holders

The Annual Meeting of Shareholders of the Company was held on May 10, 2001.
At the Annual Meeting, the shareholders of the Company (1) elected David E. Cole
as Director of the Company to hold office until the Annual Meeting of
Shareholders to be held in 2004; and (2) ratified and approved the Board of
Directors selection of Arthur Andersen LLP as the independent auditors of the
Company for the current fiscal year ending December 31, 2001. The votes were as
follows:

|                                     |               |  |     |  |  |            |           |           |           |  |  |  |  |  |     |   |  |  |  |  |  |  |       |       |  |  |  |  | 
|------------------------------------ | ------------- |  | --- |  |  | ---------- | --------- | --------- | --------- |  |  |  |  |  | --- | - |  |  |  |  |  |  | ----- | ----- |  |  |  |  | 
|                                     |               |  | For |  |  | Withheld   |           |           | Abstained | 
|                                     |               |  |     |  |  | or Against |           |           |           | 
|                                     |               |  |     |  |  |            |           |           |           | 
|(1) Election of Director:           
|                                    
|                                    
|                                    
|                                    
|                                     | David E. Cole |  |     |  |  |            |           | 4,296,845 |           |  |  |  |  |  |     | 0 |  |  |  |  |  |  |       | 8,349 | 
|                                    
|                                    
|                                    
|                                    
|(2) Approval of Arthur Andersen LLP: |               |  |     |  |  |            | 4,302,994 |           |           |  |  |  |  |  | 200 |   |  |  |  |  |  |  | 2,000 |      
|                                     |               |  |     |  |  |            |           |           |           |  |  |  |  |  |     |   |  |  |  |  | 




Item 6. Exhibits and Reports on Form 8-K



|(a) |  | Exhibits                                                                                     
|--- |  | ---------------------------------------------------------------------------------------------
|   
|    |  | None. 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 June 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: August 13, 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)         

15