Autodesk shares climbed 44 per cent in 2019. Its shift to a subscription model has reaped rewards but are its shares too expensive to buy now?

Software-as-a-service (SaaS) is fast-becoming the go-to business model for software companies. The SaaS model gives the service provider a predictable and recurring revenue stream, while clients enjoy hassle-free software updates, cloud storage, and the ability to access the software seamlessly on multiple devices.

One company that has quietly transitioned to the SaaS model is Autodesk, listed on NASDAQ under the ticker ADSK. The 3D design and engineering software company is reaping the returns of this shift as recurring revenue streams have steadily increased. 

The market has also appreciated the company's shift toward the SaaS model. Autodesk's stock climbed 44 per cent in 2019, compared to a 29 per cent gain for the S&P 500.

With all that said, I decided to do a quick review of Autodesk using my blogging partner Ser Jing's six-point investment framework.

1. IS ITS REVENUE SMALL IN RELATION TO A LARGE AND/OR GROWING MARKET, OR IS ITS REVENUE LARGE IN A FAST-GROWING MARKET? 

I think the answer to this is yes. Autodesk raked in US$715 million (S$965.5 million) in revenue in the third quarter ended 31 Oct alone, and US$2.5 billion in its fiscal year 2019, which ended on 31 Jan.

On the surface that seems huge, but Autodesk's revenue is still tiny compared to its total addressable market. Management expects that its market opportunity today is about US$48 billion. It sees that figure rising to US$59 billion by 2023.

To get a better grasp of Autodesk's market opportunity, we need to understand what Autodesk really does. In short, the company provides a suite of different software-as-a-service, including computer-assisted design, construction management, and animation among others. It is the go-to software provider for the architecture and construction world. 

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Its Revit design software is one of the most commonly used among architects, which in turn leads to engineers and construction professionals using Autodesk services to collaborate with each other. Travis Hoium explained in an article for the Motley Fool:

"Once architects are hooked, then the waterfall of other available products begins. Engineering firms are more likely to use Navisworks (another one of Autodesk's software) for model reviews of engineering and construction documents if an architect works in Revit. Building information modeling software like BIM360 also becomes more efficient in optimizing the construction process."

The switch to a subscription model has also started paying off. Recurring revenue streams are growing, while the company's painful transition years in 2016 and 2017 are already behind it. In the first three quarters of fiscal 2020, Autodesk generated a 57 per cent increase in recurring subscription revenue and a 29 per cent jump in total revenue. 

More importantly, there is a group of customers who are still on the licensing model who could potentially transition to the subscription model in the future. As of July this year, Autodesk converted about 4.3 million customers to its SaaS model.

But there are around 18 million active users of its software, which means that 14 million more users could potentially switch to the subscription model in the future. Autodesk's very own user base represents a huge untapped addressable market.

The other big market opportunity is the move towards augmented reality and 3D models. While the technologies have not yet caught on, they could potentially be another avenue of growth. 

2. DOES AUTODESK HAVE A STRONG BALANCE SHEET WITH MINIMAL OR REASONABLE AMOUNT OF DEBT? 

The next criterion in the framework is balance sheet strength. I typically want to invest in companies that have minimal or reasonable amounts of debt so that it can continue to sustain its operations should bad times arise.

Unfortunately, Autodesk fails in this regard. The software giant has been investing heavily in acquisitions and has suffered losses over the last few years. That has hurt its financials.

As of 31 Oct 2019, Autodesk had around US$1 billion in cash and marketable securities. However, it also sat on around US$1.75 billion of debt. On top of that, it was in the unenviable position of having negative shareholder equity. The company had US$5 billion in assets and US$5.2 billion in liabilities. That's certainly a black mark in my books.

3. DOES AUTORDESK'S MANAGEMENT TEAM HAVE INTEGRITY, CAPABILITY, AND AN INNOVATIVE MINDSET? 

I think Autodesk's management team has proven itself to be innovative and capable in a few ways. Current CEO Andrew Anagnost has only had a short history as CEO, but he has already managed to transition the company to a subscription-based model fairly seamlessly.

For the three months ended 31 Oct, around 83 per cent of the company's total revenue was from recurring subscriptions. In fiscal 2019, Autodesk also managed to top its revenue generated in 2016, the year it started to make the transition to subscription.

Autodesk has also invested heavily in R&D. I believe its investments in expanding its product services, specifically into augmented reality, will pay off substantially when the market is eventually ready for it.

I also believe that the compensation structure for Anagnost and other executives is tied to that of Autodesk's long-term shareholders. The performance metrics for the CEO and other senior executives included total annual recurring revenue, free cash flow per share, and total shareholder return over 1,2, and 3 years.

While I prefer to see a larger focus on shareholder return over a longer time frame, I think that the performance indicators seem reasonable.

4. ARE ITS REVENUE STREAMS RECURRING IN NATURE?

Recurring revenue is an underappreciated but beautiful thing for a company to have. Not only does it mean reliable revenue streams year after year, but the company can also spend less time and money on past sales and focus on other aspects of its business.

Autodesk ticks this box easily. Its transition to a subscription-based model means that its revenue is likely going to be recurring year after year.

Its net revenue retention range is also consistent between management's target of 110 per cent to 120 per cent, which means existing customers are increasing their net spend on its products by 10 per cent to 20 per cent each year.

Autodesk provides free software training in a bid to grow its user base and to let students as young as grade school get familiar with its software. But the high lifetime value of each customer makes these customer acquisition efforts extremely worthwhile over the long-term.

On top of that, the fact it has about 4 million subscriptions to its services means there is very little customer concentration risk.

5. DOES AUTODESK HAVE A PROVEN ABILITY TO GROW? 

Autodesk is one of the early movers in software. It was founded nearly 40 years ago by John Walker who co-authored the first versions of AutoCAD. The software company has grown from focusing solely on computer-assisted design to one that has a whole suite of services. 

Its revenue has also soared to around US$3 billion. In more recent years, the company's top line has fluctuated due to the move towards subscriptions. But with the transition more or less complete, it is likely to have a smoother growth ride ahead. Analysts are also anticipating twenty-plus per cent annual revenue growth for 2020.

6. DOES AUTODESK HAVE A HIGH LIKELIHOOD OF GENERATING A STRONG AND GROWING STREAM OF FREE CASH FLOW IN THE FUTURE? 

The true value of a company is not based on its profits but on its cash that it can generate in the future. That is why the sixth criterion of Ser Jing's investment framework is so essential. 

While Autodesk's free cash flow generation has been lumpy for the last few years, the completion of the transition to subscriptions will likely mean better days ahead. This year, Autodesk showed signs that it has begun to reap the fruits of its work.

In the nine months ended 31 Oct 2019, the company generated US$677.7 million in free cash flow. 

The company's gross profit margin stands north of 80 per cent, which means that as the company scales down other expenses, we can expect it to generate a healthy net profit margin, and in turn a higher free cash flow margin.

RISKS

A discussion of a company will not be complete without addressing the potential risks.

As mentioned earlier, the main risk I see in Autodesk is its weak balance sheet. The company has net negative shareholder equity and is sitting on a pile of debt. That said, it has started to generate a decent amount of free cash flow. This should enable it to pay off its interest expenses and to reduce some of its debt load.

The company also paid its executives nearly US$250 million in share-based compensation in the year ended 31 Jan 2019. While stock-based compensation does not factor into the company's cash flow statement, it does have a meaningful impact.

It reduces earnings per share and results in heavy dilution of shareholder interest. For a company that is generating around US$3 billion in revenue, stock-based compensation of US$250 billion does seem excessive. 

Competition is another major risk. Autodesk operates in a highly competitive environment that is subject to change. That said, Autodesk has been investing heavily in research and technology to update its software and provide new services. I also believe its customer base who have familiarised themselves with Autodesk will be unwilling to swap products so easily.

VALUATION 

What is a good price to pay for Autodesk? As with any company, this requires a reasonable amount of judgment and estimation.

Autodesk is anticipated to generate an annualised revenue of around US$3.2 billion in its current fiscal year. The company's customer count can increase as more of its existing customers switch to subscription models. Revenue will also likely grow organically as existing customers pay more in revenue each year. This can happen by increasing the number of services they buy or through price hikes.

In 10 years' time, I estimate that around a quarter of Autodesk's 14 million existing clients who are currently not on subscription plans will eventually switch over. That will bring the total number of customers subscribing to Autodesk's services to eight million (from four million now).

In addition, if the net revenue retention rate continues at 110 per cent per year for 10 years, revenue could eventually reach US$16 billion.

It is difficult to estimate Autodesk's mature-state profit margin, but considering its 80 per cent-plus per cent gross margin, it could easily reach a 10 per cent net profit margin. That translates to US$1.6 billion in net profit.

Attaching a 30 times multiple to the projected net profit, the software giant's market cap could potentially scale to US$48 billion.

Based on my estimate and the current market cap of the stock of around US$40 billion, the future market cap translates to 20 per cent upside. 

However, a 20 per cent upside for a 10-year holding period is too low for my liking.

THE GOOD INVESTORS' CONCLUSION 

There are certainly many things to like about Autodesk. Its transition into a subscription-based model gives it a more predictable recurring revenue stream. The addressable market opportunity for the company is also immense compared to its current revenue.

But having said all that, from a valuation standpoint, the company seems expensive. At its current market cap of US$40 billion, Autodesk sports a 12.5 price-to-sales (PS) ratio. It also only provides a 20 per cent upside to my 10-year valuation projection.

Admittedly, my projection is very rough and conservative, but Autodesk's high valuation leaves very little room for execution risk. In addition, if its relatively high stock-compensation scheme continues to rise, it might leave shareholders grasping at straws because of dilution, even if the company generates more free cash flow in the future.

As such, even though Autodesk seems like a solid growth company, it still remains only on my watchlist.

This article was first published in The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.