##### 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: March 31, 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 May 7, 2001, was 6,059,344.





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TABLE OF CONTENTS



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



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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
March 31, 2001 and December 31, 2000                 |    |      | 3  | 
|                              
|                              
|                              
|                              
|                               |         | Condensed Consolidated Statements of Income
Three Months Ended March 31, 2001 and 2000     |    |      | 4  | 
|                              
|                              
|                              
|                              
|                               |         | Condensed Consolidated Statements of Cash Flows
Three Months Ended March 31, 2001 and 2000 |    |      | 5  | 
|                              
|                              
|                              
|                              
|                               |         | Notes to Condensed Consolidated Financial Statements                                       |    |      | 6  | 
|                              
|                              
|                              
|                              
|                               | Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations      |    |      | 8  | 
|                              
|                              
|                              
|                              
|                               | Item 3. | Quantitative and Qualitative Disclosures about Market Risk                                 |    |      | 13 | 
|                              
|                              
|                              
|                              
|PART II  OTHER INFORMATION   
|                              
|                              
|                              
|                              
|                               | Item 6. | Exhibits and Reports on Form 8-K                                                           |    |      | 14 | 
|                              
|                              
|                              
|                              
|SIGNATURES                     |         |                                                                                            | 15 |     

2



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##### Table of Contents









Item 1. Financial Statements




|                                               |                                        |                            |             |           |        |   |              |        |        | 
|---------------------------------------------- | -------------------------------------- | -------------------------- | ----------- | --------- | ------ | - | ------------ | ------ | ------ | 
|                                               |                                        |                            |             | March 31, |        |   | December 31, |       
|in thousands                                   |                                        | 2001                       |             |           | 2000   |  
|                                               |                                        |                            |             |           |        |  
|Assets:                                        |                                        |                            | (Unaudited) |          
|Current assets:                               
|                                              
|                                              
|                                              
|                                              
|                                               | Cash and cash equivalents              |                            | $           | 15,060    |        |   | $            | 17,961 |       
|                                              
|                                              
|                                              
|                                              
|                                               | Accounts receivable, net               |                            |             | 13,215    |        |   |              | 11,442 |       
|                                              
|                                              
|                                              
|                                              
|                                               | Prepaid and deferred expenses          |                            |             | 2,908     |        |   |              | 3,255  |       
|                                               |                                        |                            |             |           |        |   |             
|                                               |                                        | Total current assets       |             |           | 31,183 |   |              |        | 32,658 | 
|                                               |                                        |                            |             |           |        |   |             
|Property and equipment, net                    |                                        |                            | 4,324       |           |        |   | 4,462        |       
|                                              
|                                              
|                                              
|                                              
|Goodwill, net                                  |                                        |                            | 6,684       |           |        |   | 6,768        |       
|                                              
|                                              
|                                              
|                                              
|Other assets                                   |                                        |                            | 1,760       |           |        |   | 1,981        |       
|                                               |                                        |                            |             |           |        |   |             
|Total assets                                   |                                        | $                          | 43,951      |           |        | $ | 45,869       |       
|                                               |                                        |                            |             |           |        |   |             
|Liabilities and Shareholders Equity:         
|                                              
|                                              
|                                              
|                                              
|Current liabilities:                          
|                                              
|                                              
|                                              
|                                              
|                                               | Borrowings under lines of credit       |                            | $           | 82        |        |   | $            | 49     |       
|                                              
|                                              
|                                              
|                                              
|                                               | Current portion of capital leases      |                            |             | 406       |        |   |              | 406    |       
|                                              
|                                              
|                                              
|                                              
|                                               | Accounts payable                       |                            |             | 1,470     |        |   |              | 2,466  |       
|                                              
|                                              
|                                              
|                                              
|                                               | Accrued expenses                       |                            |             | 5,375     |        |   |              | 7,152  |       
|                                              
|                                              
|                                              
|                                              
|                                               | Deferred revenue                       |                            |             | 8,372     |        |   |              | 6,936  |       
|                                               |                                        |                            |             |           |        |   |             
|                                               |                                        | Total current liabilities  |             |           | 15,705 |   |              |        | 17,009 | 
|                                               |                                        |                            |             |           |        |   |             
|Capital lease obligation, less current portion |                                        |                            | 497         |           |        |   | 658          |       
|                                              
|                                              
|                                              
|                                              
|Minority interest                              |                                        |                            | 600         |           |        |   | 539          |       
|                                              
|                                              
|                                              
|                                              
|Shareholders equity:                         
|                                              
|                                              
|                                              
|                                              
|                                               | Common stock                           |                            |             | 21,818    |        |   |              | 21,998 |       
|                                              
|                                              
|                                              
|                                              
|                                               | Preferred stock                        |                            |             | 0         |        |   |              | 0      |       
|                                              
|                                              
|                                              
|                                              
|                                               | Retained earnings                      |                            |             | 6,040     |        |   |              | 5,819  |       
|                                              
|                                              
|                                              
|                                              
|                                               | Accumulated other comprehensive income |                            |             | (709      | )      |   |              | (154   | )     
|                                               |                                        |                            |             |           |        |   |             
|                                               |                                        | Total shareholders equity |             |           | 27,149 |   |              |        | 27,663 | 
|                                               |                                        |                            |             |           |        |   |             
|Total liabilities and shareholders equity     |                                        | $                          | 43,951      |           |        | $ | 45,869       |       
|                                               |                                        |                            |             |           |        |   |             

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

3



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##### Table of Contents






|                                                     |                                 |                          |           |                    |        |   |           |       |        | 
|---------------------------------------------------- | ------------------------------- | ------------------------ | --------- | ------------------ | ------ | - | --------- | ----- | ------ | 
|                                                     |                                 |                          |           | Three Months Ended |       
|                                                     |                                 |                          |           | March 31,          |       
|                                                     |                                 |                          |           |                    |       
|in thousands except share and per share data         |                                 | 2001                     |           |                    | 2000   |  
|                                                     |                                 |                          |           |                    |        |  
|                                                     |                                 |                          |           | (Unaudited)        |       
|Revenue:                                            
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Software licenses               |                          | $         | 6,191              |        |   | $         | 6,036 |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Software maintenance services   |                          |           | 3,013              |        |   |           | 2,253 |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Professional services and other |                          |           | 4,637              |        |   |           | 2,450 |       
|                                                     |                                 |                          |           |                    |        |   |          
|                                                     |                                 | Total revenue            |           |                    | 13,841 |   |           |       | 10,739 | 
|                                                     |                                 |                          |           |                    |        |   |          
|Cost of revenue:                                    
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Software licenses               |                          |           | 977                |        |   |           | 1,099 |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Services                        |                          |           | 4,068              |        |   |           | 2,554 |       
|                                                     |                                 |                          |           |                    |        |   |          
|                                                     |                                 | Total cost of revenue    |           |                    | 5,045  |   |           |       | 3,653  | 
|                                                     |                                 |                          |           |                    |        |   |          
|Gross profit                                         |                                 |                          | 8,796     |                    |        |   | 7,086     |      
|                                                     |                                 |                          |           |                    |        |   |          
|Operating expenses:                                 
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Sales and marketing             |                          |           | 4,935              |        |   |           | 4,203 |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Research and development        |                          |           | 1,698              |        |   |           | 1,446 |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | General and administrative      |                          |           | 1,317              |        |   |           | 1,026 |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Goodwill amortization           |                          |           | 178                |        |   |           | 114   |       
|                                                     |                                 |                          |           |                    |        |   |          
|                                                     |                                 | Total operating expenses |           |                    | 8,128  |   |           |       | 6,789  | 
|                                                     |                                 |                          |           |                    |        |   |          
|Operating income                                     |                                 |                          | 668       |                    |        |   | 297       |      
|                                                    
|                                                    
|                                                    
|                                                    
|Other income, net                                    |                                 |                          | 119       |                    |        |   | 85        |      
|                                                     |                                 |                          |           |                    |        |   |          
|Income before income taxes and minority interest     |                                 |                          | 787       |                    |        |   | 382       |      
|                                                    
|                                                    
|                                                    
|                                                    
|Provision for income taxes                           |                                 |                          | 235       |                    |        |   | 114       |      
|                                                     |                                 |                          |           |                    |        |   |          
|Net income before minority interest                  |                                 |                          | 552       |                    |        |   | 268       |      
|                                                    
|                                                    
|                                                    
|                                                    
|Minority interest in net income of subsidiary        |                                 |                          | 61        |                    |        |   | 27        |      
|                                                     |                                 |                          |           |                    |        |   |          
|Net income                                           |                                 | $                        | 491       |                    |        | $ | 241       |      
|                                                     |                                 |                          |           |                    |        |   |          
|Basic net income per common share                    |                                 | $                        | 0.08      |                    |        | $ | 0.04      |      
|                                                     |                                 |                          |           |                    |        |   |          
|Weighted average common shares                       |                                 |                          | 6,088,056 |                    |        |   | 6,286,725 |      
|                                                     |                                 |                          |           |                    |        |   |          
|Diluted net income per common share                  |                                 | $                        | 0.08      |                    |        | $ | 0.04      |      
|                                                     |                                 |                          |           |                    |        |   |          
|Weighted average common and common equivalent shares |                                 |                          | 6,220,446 |                    |        |   | 6,287,077 |      
|                                                     |                                 |                          |           |                    |        |   |          

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

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|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                    |        |   |     |      |      |  
|---------------------------------------------------- | ------------------------------------------------ | ------------------------------------------- | --------------------------------------------- | ----------------------------- | --------------------------------------------------- | --- | ------------------ | ------ | - | --- | ---- | ---- | -
|                                                     |                                                  |                                             |                                               |                               |                                                     |     | Three Months Ended |       
|                                                     |                                                  |                                             |                                               |                               |                                                     |     | March 31,          |       
|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                    |       
|in thousands                                         |                                                  | 2001                                        |                                               |                               | 2000                                                |    
|                                                     |                                                  |                                             |                                               |                               |                                                     |    
|                                                     |                                                  |                                             |                                               |                               |                                                     |     | (Unaudited)        |       
|Cash flows from operating activities:               
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Net income                                       |                                             | $                                             | 491                           |                                                     |     | $                  | 241    |  
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Adjustments to reconcile net income to net cash 
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  | provided by (used in) operating activities:
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             | Depreciation and amortization                 |                               |                                                     | 595 |                    |        |   | 413 |     
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             | (Gain) loss on disposal of assets, net        |                               |                                                     | 16  |                    |        |   | (14 | )   
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             | Minority interest in net income of subsidiary |                               |                                                     | 61  |                    |        |   | 27  |     
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             | Changes in assets and liabilities:           
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             |                                               | Accounts receivable           |                                                     |     | (2,346             | )      |   |     | (815 | )   
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             |                                               | Prepaid and deferred expenses |                                                     |     | 222                |        |   |     | 516  |     
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             |                                               | Other assets                  |                                                     |     | 211                |        |   |     | (83  | )   
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             |                                               | Accounts payable              |                                                     |     | (771               | )      |   |     | 156  |     
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             |                                               | Accrued expenses              |                                                     |     | (1,579             | )      |   |     | (476 | )   
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             |                                               | Deferred revenue              |                                                     |     | 1,666              |        |   |     | 312  |     
|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                    |        |  
|                                                     |                                                  |                                             |                                               |                               | Net cash provided by (used in) operating activities |     |                    | (1,434 | ) |     |      | 277  |  
|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                    |        |  
|Cash flows from investing activities:               
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Proceeds from the sale of property and equipment |                                             |                                               | 10                            |                                                     |     |                    | 84     |  
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Purchases of property and equipment              |                                             |                                               | (489                          | )                                                   |     |                    | (315   | )
|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                    |        |  
|                                                     |                                                  |                                             |                                               |                               | Net cash used in investing activities               |     |                    | (479   | ) |     |      | (231 | )
|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                    |        |  
|Cash flows from financing activities:               
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Net borrowings under line of credit agreements   |                                             |                                               | 33                            |                                                     |     |                    | 46     |  
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Proceeds from the issuance of common stock       |                                             |                                               | 45                            |                                                     |     |                    | 51     |  
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Repurchases of Company common stock              |                                             |                                               | (495                          | )                                                   |     |                    | 0      |  
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Payments on capital lease obligations            |                                             |                                               | (114                          | )                                                   |     |                    | 0      |  
|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                    |        |  
|                                                     |                                                  |                                             |                                               |                               | Net cash provided by (used in) financing activities |     |                    | (531   | ) |     |      | 97   |  
|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                    |        |  
|Effect of exchange rate changes on cash              |                                                  |                                             | (457                                          | )                             |                                                     |     | (71                | )     
|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                   
|Net increase (decrease) in cash and cash equivalents |                                                  |                                             | (2,901                                        | )                             |                                                     |     | 72                 |       
|                                                    
|                                                    
|                                                    
|                                                    
|Cash and cash equivalents at beginning of period     |                                                  |                                             | 17,961                                        |                               |                                                     |     | 17,741             |       
|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                   
|Cash and cash equivalents at end of period           |                                                  | $                                           | 15,060                                        |                               |                                                     | $   | 17,813             |       
|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                   
|Supplemental disclosures of cash flow information:  
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Cash paid during the period for:                
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             | Interest                                      |                               | $                                                   | 10  |                    |        | $ | 1   |     
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                                  |                                             | Income taxes                                  |                               | $                                                   | 504 |                    |        | $ | 240 |     
|                                                     |                                                  |                                             |                                               |                               |                                                     |     |                   

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

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(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 month periods ended March 31, 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 (loss) was ($64,000) and $169,000 for
the three month periods ended March 31, 2001 and 2000, respectively. The
difference between net income, as reported in the accompanying condensed
consolidated statements of income, and comprehensive income (loss) 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 March 31, |          
|                                                                   |                                     |       |  |                              |          
|                                                                   |                                     |       |  | 2001                         |           |  | 2000 |          
|                                                                   |                                     |       |  |                              |           |  |      |          
|Weighted average common shares used in basic net income per common
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   |                                     | share |  |                              | 6,088,056 |  |      |           | 6,286,725 | 
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   | Effect of stock options             |       |  | 132,390                      |           |  |      | 352       |          
|                                                                   |                                     |       |  |                              |           |  |      |          
|Weighted average common and common equivalent shares used in      
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   | diluted net income per common share |       |  | 6,220,446                    |           |  |      | 6,287,077 |          
|                                                                   |                                     |       |  |                              |           |  |      |          

For the three months ended March 31, 2001 and 2000, options to purchase
shares of the Companys common stock of 221,790 and 700,364, respectively, were
outstanding but were not included in the computations of diluted earnings per
share because the price of the options was greater than the average market price
of the common stock for the period reported.

(4)  Derivatives

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

6



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##### Table of Contents



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 March
31, 2001 and 2000, the Company had approximately $800,000 and $940,000,
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 September 2000, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140).
SFAS 140 provides accounting and reporting standards for transfers and servicing
of financial assets and extinguishments of liabilities. SFAS 140 replaces SFAS
125 but it carries over most of SFAS 125s provisions. The statement is
effective for transfers and servicing of financial assets and extinguishments of
liabilities occurring after March 31, 2001. Management expects that adoption of
SFAS 140 will have little, if any, impact on the Companys consolidated
financial position or results of operations.

(6) Geographic Operations and Segment Information

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

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

|             |               |                          |               |   |                              |        |  |   |       |        | 
|------------ | ------------- | ------------------------ | ------------- | - | ---------------------------- | ------ |  | - | ----- | ------ | 
|             |               |                          |               |   | Three Months Ended March 31, |       
|             |               |                          |               |   |                              |       
|In thousands |               | 2001                     |               |   | 2000                         |       
|             |               |                          |               |   |                              |       
|Revenue:    
|            
|            
|            
|            
|             | North America
|            
|            
|            
|            
|             |               | United States            |               | $ | 2,730                        |        |  | $ | 2,781 |       
|            
|            
|            
|            
|             |               | Canada and Mexico        |               |   | 841                          |        |  |   | 1,336 |       
|            
|            
|            
|            
|             | Europe       
|            
|            
|            
|            
|             |               | Germany                  |               |   | 1,162                        |        |  |   | 1,033 |       
|            
|            
|            
|            
|             |               | Other European countries |               |   | 2,539                        |        |  |   | 2,529 |       
|            
|            
|            
|            
|             | Asia/Pacific 
|            
|            
|            
|            
|             |               | Japan                    |               |   | 5,910                        |        |  |   | 2,661 |       
|            
|            
|            
|            
|             |               | Other Asian countries    |               |   | 659                          |        |  |   | 399   |       
|             |               |                          |               |   |                              |        |  |  
|             |               |                          | Total revenue |   | $                            | 13,841 |  |   | $     | 10,739 | 
|             |               |                          |               |   |                              |        |  |  

One customer accounted for 12% of total revenue during the three month
period ended March 31, 2001. No customer accounted for greater than 10% of total
revenue during the three month period ended March 31, 2000. The

7



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##### Table of Contents



Companys
largest distributor, ISI-Dentsu, is located in Japan and accounted for
approximately 15.5% and 20.6% of the Companys total revenue for the three month
periods ended March 31, 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;                                                                                        
|
| |  |  | 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.

8



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##### Table of Contents



Results of Operations

Revenue

|                                |                    |      |                              |      |      |   |        |          |   |  |      |   | 
|------------------------------- | ------------------ | ---- | ---------------------------- | ---- | ---- | - | ------ | -------- | - |  | ---- | - | 
|                                |                    |      | Three Months Ended March 31, |     
|                                |                    |      |                              |     
|dollars in thousands            |                    | 2001 |                              |      | 2000 |   |        | % Change |  
|                                |                    |      |                              |      |      |   |        |          |  
|Software licenses               |                    | $    | 6,191                        |      |      | $ | 6,036  |          |   |  | 2.6  | %
|                               
|                               
|                               
|                               
|                                | % of total revenue |      |                              | 44.7 | %    |   |        | 56.2     | %
|                               
|                               
|                               
|                               
|Software maintenance services   |                    | $    | 3,013                        |      |      | $ | 2,253  |          |   |  | 33.7 | %
|                               
|                               
|                               
|                               
|                                | % of total revenue |      |                              | 21.8 | %    |   |        | 21.0     | %
|                               
|                               
|                               
|                               
|Professional services and other |                    | $    | 4,637                        |      |      | $ | 2,450  |          |   |  | 89.3 | %
|                               
|                               
|                               
|                               
|                                | % of total revenue |      |                              | 33.5 | %    |   |        | 22.8     | %
|                                |                    |      |                              |      |      |   |        |          |  
|Total revenue                   |                    | $    | 13,841                       |      |      | $ | 10,739 |          |   |  | 28.9 | %
|                                |                    |      |                              |      |      |   |        |          |  

The Companys total revenue increased 28.9% during the three month period
ended March 31, 2001, as compared to the corresponding period 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 74.2% and
61.7% of the Companys total revenue during the three months ended March 31,
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 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 first quarter revenue by approximately $1.1
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 2.6% during the three
month period ended March 31, 2001, as compared to the corresponding period in
2000. This growth in revenue resulted primarily from an increase in sales of the
Companys ADAMS and Dynamic Designer products, which was partially offset by
decreased sales of third-party software products sold worldwide. Revenue from
third party software products totaled approximately $970,000, or 7.0% of total
revenue during the three months ended March 31, 2001, as compared to $1.3
million, or 11.9% 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 33.7% during the three month period ended
March 31, 2001, as compared to the corresponding period 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.

9



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##### Table of Contents



Professional services and other revenue consists primarily of revenue from
consulting, training and funded research and development projects. Professional
services revenue increased 89.3% during the three month period ended March 31,
2001, as compared to the corresponding period 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 March 31, |  
|                                                 |  |   |                              |  
|dollars in thousands                             |  |   | 2001                         |   |  | 2000 |       |   | % Change | 
|                                                 |  |   |                              |   |  |      |       |   |          | 
|Cost of software licenses                        |  | $ | 977                          |   |  | $    | 1,099 |   |          |  | 11.1 | %
|                                                
|                                                
|                                                
|                                                
|Gross profit margin on software licenses revenue |  |   | 84.2                         | % |  |      | 81.8  | %
|                                                
|                                                
|                                                
|                                                
|Cost of services                                 |  | $ | 4,068                        |   |  | $    | 2,554 |   |          |  | 59.3 | %
|                                                
|                                                
|                                                
|                                                
|Gross profit margin on services revenue          |  |   | 46.8                         | % |  |      | 45.7  | %

Cost of software licenses includes software royalty fees, media costs,
payroll and other costs attributable to software documentation and distribution,
and an allocation of depreciation, utilities and other overhead expenses
incurred by the Company. Cost of software licenses decreased 11.1% from the
first quarter of 2000 to approximately $977,000 in the first quarter of 2001.
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 84.2% and 81.8% during
the three month periods ended March 31, 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 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 increased 59.3% during the three month period ended March 31, 2001,
as compared to the corresponding period 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 quarter of 2001. Gross profit margin on
services revenue was 46.8% and 45.7% during the three month periods ended March
31, 2001 and 2000, respectively.

Operating Expenses

|                           |  |   |                              |   |  |      |       |   |          |  |      |   | 
|-------------------------- |  | - | ---------------------------- | - |  | ---- | ----- | - | -------- |  | ---- | - | 
|                           |  |   | Three Months Ended March 31, |  
|                           |  |   |                              |  
|dollars in thousands       |  |   | 2001                         |   |  | 2000 |       |   | % Change | 
|                           |  |   |                              |   |  |      |       |   |          | 
|Sales and marketing        |  | $ | 4,935                        |   |  | $    | 4,203 |   |          |  | 17.4 | %
|                          
|                          
|                          
|                          
|% of total revenue         |  |   | 35.7                         | % |  |      | 39.1  | %
|                          
|                          
|                          
|                          
|Research and development   |  | $ | 1,698                        |   |  | $    | 1,446 |   |          |  | 17.4 | %
|                          
|                          
|                          
|                          
|% of total revenue         |  |   | 12.3                         | % |  |      | 13.5  | %
|                          
|                          
|                          
|                          
|General and administrative |  | $ | 1,317                        |   |  | $    | 1,026 |   |          |  | 28.4 | %
|                          
|                          
|                          
|                          
|% of total revenue         |  |   | 9.5                          | % |  |      | 9.6   | %
|                          
|                          
|                          
|                          
|Goodwill Amortization      |  | $ | 178                          |   |  | $    | 114   |   |          |  | 56.1 | %
|                          
|                          
|                          
|                          
|% of total revenue         |  |   | 1.3                          | % |  |      | 1.1   | %

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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 month period ended March 31, 2001, as compared to the corresponding
period 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
month period ended March 31, 2001, as compared to corresponding period in 2000,
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 month period ended March
31, 2001, as compared to corresponding period 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 56.1% during the three month period ended March 31, 2001, as compared
to the corresponding period 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.

Other Income, Net

|                     |                    |      |                              |     |      |   |    |          |   |  |      |   | 
|-------------------- | ------------------ | ---- | ---------------------------- | --- | ---- | - | -- | -------- | - |  | ---- | - | 
|                     |                    |      | Three Months Ended March 31, |    
|                     |                    |      |                              |    
|dollars in thousands |                    | 2001 |                              |     | 2000 |   |    | % Change |  
|                     |                    |      |                              |     |      |   |    |          |  
|Other income, net    |                    | $    | 119                          |     |      | $ | 85 |          |   |  | 40.0 | %
|                    
|                    
|                    
|                    
|                     | % of total revenue |      |                              | 0.9 | %    |   |    | 0.8      | %

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 increase in other income, net primarily resulted from decreased
foreign currency transaction losses incurred by the Company during the first
quarter of 2001, compared to the corresponding period in 2000. 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 three
months ended March 31, 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.

11



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##### Table of Contents



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 $61,000 and $27,000 for
the three month periods ended March 31, 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 21.1% to 345 at
March 31, 2001, compared with 285 at March 31, 2000. Reflected in this increase
are 43 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 13 employees during the quarter, from 332 employees at the end
of 2000.

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 $2.9 million during the first three
months of 2001 to $15.1 million at March 31, 2001, compared with $18.0 million
at December 31, 2000. Through March 31, 2001, cash and cash equivalents
decreased primarily as a result of $2.4 million in cash used to pay down
year-end accounts payable and accrued expenses, $479,000 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 quarter.

At March 31, 2001, the Companys principal commitments consisted of
obligations under capital and operating leases for facilities and equipment. The
Company had $903,000 in capital lease obligations outstanding as of March 31,
2001, of which $497,000 was long-term. The Company had no other borrowings under
long-term debt arrangements at March 31, 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
March 31, 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. Approximately $82,000 in
borrowings was outstanding under these facilities as of March 31, 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

12



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##### Table of Contents



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 first 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.

13



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##### Table of Contents






PART II  OTHER INFORMATION




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

An amended report on Form 8-K/A was filed on March 5, 2001. The financial
statements and pro forma financial information pertaining to the acquisition
were reported under Item 7 of Form 8-K/A.

14



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##### Table of Contents






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: May 11, 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