In this week’s report, we are revisiting Autodesk. We will assess Autodesk’s performance over the past year, cover recent developments such as the audit committee investigation and transition to the new transaction model, compare its performance to industry peers, and conclude with a valuation update.
Brief Overview
Autodesk Overview: Autodesk is a leading player in design software, serving the AEC, Manufacturing, and Media & Entertainment industries. Over the past decade, the company has demonstrated improvements in profitability and revenue growth stability as it transitioned to a subscription-based model. From FY15 to the trailing twelve months (“TTM”) Q1 FY25, the company achieved a revenue Compound Annual Growth Rate (“CAGR”) of 9.1% and an operating income CAGR of 28.4%, reaching TTM revenue of $5.6 billion and operating income of $1.3 billion (with a margin of 22.2%).
Key Investment thesis: Autodesk offers industry-standard solutions that are deeply integrated into clients’ processes, creating significant switching costs and ultimately leading to strong pricing power. The company operates in industries with multiple tailwinds, including increasing BIM adoption, digitization of the construction industry, rising infrastructure spending, and the convergence of design and make processes in AEC and Manufacturing. Additionally, the company claims to have 15 million non-compliant users, some of whom it can monetize over time. These tailwinds provide a pathway for the company to achieve its long-term target of growing revenue in the range of 10%-15%. Moreover, if management executes effectively, Autodesk’s operating profit margin has room for improvement as its margin profile is in the lower end of other design software companies.
Contents:
Recent Developments
Performance Update
Industry
Valuation
Conclusion
1. Recent Developments
a. Audit committee investigation
On April 1, 2024, Autodesk announced that the Audit Committee and the Board of Directors had commenced an internal investigation regarding the company's free cash flow and non-GAAP operating margin practices. Consequently, the company was not be able to submit its 10-K filing for FY24 within the prescribed period.
What actually happened?
It appears that the company miscommunicated to investors the progress of its transition from multi-year contracts to annual billings. During its Investor Day in 2021, Autodesk communicated its plan to transition from multi-year contracts to annual billings. Historically, multi-year contracts were agreed upon for three-year terms, where customers paid upfront, locked in prices, and obtained higher discounts due to the upfront payment. This approach resulted in higher free cash flow (“FCF”) for Autodesk in the first year but also created volatility in free cash flow and presented a headwind on operating profit margin given the higher discounts. Therefore, the new model was expected to create more predictability in free cash flow and help the company achieve better price realization.
So what went wrong? Despite communicating to investors that the transition would start in FY22, Autodesk reversed course and engaged in multi-year contracts in FY23 to meet its free cash flow targets, which appeared to be closely tied to management compensation incentives.
“Most EBAs are already on annual billing terms. And also, we had already assumed that EBAs would all be on annual billing terms starting next year in our fiscal '23. We're making the change now because with the strong start to fiscal '22, we decided to get moving earlier to execute on the shift.” Debbie Clifford, former CFO, Q2’22
In a normal transition, you would expect billings and free cash flow to decrease as the company invoices one year of a contract rather than three. However, annual billings and free cash flow surged in FY23.
Source: Autodesk Earnings Releases
The audit investigation findings indicated that the company engaged in programs to incentivize customers to accept multi-year upfront billing, renew early, and/or pay before the end of the fiscal year. This resulted in higher free cash flow for the company and possibly higher bonuses for the executive team, as their compensation was closely aligned with free cash flow targets.
“During fiscal year 2022, the company announced that it had begun to shift enterprise customers to contracts billed annually, and that it had assumed fiscal 2023 enterprise contracts would be billed annually. The company subsequently determined, however, to pursue multiyear upfront contracts with enterprise customers to help meet its fiscal year 2023 free cash flow goal. Upfront billings of enterprise customers in fiscal year 2023 substantially exceeded historical levels, helping the company to meet its lowered annual free cash flow target.” Extract from audit committee findings
Following the investigation, CEO Andrew Anagnost highlighted that the findings did not result in a restatement of any audited or unaudited financial statements.
“The first thing, and I can't state how important this is, we don't have to restate any of our financial results. The results that happened historically in the company are the results that the business delivered, and that's really important.” Andrew Anagnost, CEO
However, the issue is not whether the financial statements complied with accounting standards. The problem is that management miscommunicated their plan and seemed to act in their own best interest rather than in the best interest of shareholders.
The only remedial action taken by management was removing former CFO Debbie Clifford from her position and appointing her as Chief Strategy Officer, reporting to the CEO. We do not believe that the issue lies solely with the CFO, and even if it did, appointing her to a new position is not a solution. Incentivizing clients to engage in multi-year contracts likely involved multiple sales teams receiving instructions from top management who possibly approved those deals.
We believe that the core issue is governance, specifically the executive compensation structure, which stimulated this short-term-oriented behavior. We share the concerns of Starboard Value, the investment management firm and large shareholder in Autodesk, which has expressed its concerns over Autodesk’s governance and management execution. Here is a link to the letters, along with some extracts if you are interested to read more.
Source: Starboard Value letter
b. Management compensation
After reviewing Autodesk’s latest proxy statement, it becomes clear how the compensation package could have incentivized management’s actions.
The package comprises both short-term and long-term incentives. Short-term incentives, or annual bonuses, are based on total revenue and non-GAAP operating income. One major criticism of Autodesk is the