Autodesk's Position Continues To Become More Precarious

ADSK

Summary

  • ADSK's conversion to a subscription model has been largely accepted by larger users but vehemently opposed by smaller customers.
  • ADSK has reduced its R&D spending in order to manage costs.
  • ADSK's financial position continues to worsen, such that its current ratio now borders 1.
  • These factors combine to help push smaller customers to competitors and leave the company vulnerable to any headwinds, whether from execution risk or an economic downturn.

Autodesk (NASDAQ:ADSK) recently released its Q1 earnings and hosted the associated earnings call with analysts. The new information includes several developments which impact my short thesis (and its update) which I discuss below.

The Positives

  • Conversion of Legacy Perpetual License Holders

The biggest positive (for the company, not for my short position) was that promotions during the quarter managed to convert a number of legacy users into the subscription model. These new subscribers had been running perpetually licensed software with a median age of 7 years old.

One of the biggest advantages that the subscription model has is its low upfront cost, which presumably persuaded a number of legacy users to turn in their old licenses in order to have access to the newest software paid on an ongoing subscription basis. The program's success was particularly noteworthy given that it was the second time that the company had held a similar promotion. Here's the excerpt from the earnings call describing this (with my slight edit to the voice to text translation):

However, we continue to make meaningful progress in converting non-paying users into subscribers. In Q1, we added 26,000 product subscriptions to another successful promo target in our legacy users. The Q1 promo offer 30% discount on a three-year subscription i[f] they turn in their old perpetual licenses. It's the same type of promo that added 28,000 subs in Q1 last year with 70% discount. We're still finding that more than half of those particularly in the promo are turning in licenses seven years back or older. This is further reinforcing our view, that there are meaningful number of active users whose licenses are more than five years old and are interested in moving to latest software.

These wins are decidedly positive, but I do wonder what the churn rate (after the 3-year discount is over) will be for these new customers.

  • Adoption of New Product Offerings

The second positive was the company's excitement about the acceptance of its newer products, particularly its BIM collaboration and construction management tool "BIM 360" and its integrated product design and development software "Fusion 360". Since ADSK's earnings report isn't granular enough to break out these software sales directly (it breaks out revenues by product family only), the best I can do is to quote the earnings call transcript again to give a flavor of its optimism:

Fusion 360 is also expanding our market opportunity. We had a great Q1 win with a UK-based engineering firm that is choosing to replace Team Center with Fusion Lifecycle. This customer also purchased product design collection, which includes Fusion 360 which successfully completed against DSO and PPP solutions. The more people used fusion, the more they are reinforcing our believe that Fusion is a game changer that's driving the future of making things at the expense of our competition.

This second point is much less quantitative than the first, and as I've mentioned in previous articles, ADSK's management is always "pleased" by its results, so though this too is a real net positive, it's much more difficult to know by how much or how to weight it in an overall appraisal of the company and its prospects.

Neutral

  • ARR Closer to Target Growth But Still Falls Short

ADSK has a road map for its fiscal year 2020 ARR, and the latest update is a classic "glass half full/half empty" situation where the most recent quarter has gotten it closer to being on track but still not there.

Unfortunately for ADSK, the next quarter isn't likely to make up the gap as the company guided for a decrease in subscription additions:

As we look at our outlook for the second quarter, we expect a seasonal decrease in subscriptions additions in Q2 consistent with what we've seen in the last two years. In the Q1, sub ads have added benefit from a seasonally strong EBAs solid prior quarter and the legacy promo.

As a result, I personally still lean to the "glass half empty" side of the argument because I think that to get an overall CAGR of 24% over the projected time, you have to start out ahead of the curve (when the base numbers are small and there's low hanging fruit to be plucked), but I can understand those who might argue that it takes time to get a program rolling, and not until everyone is "on board" do you really begin to pick up steam. Hence, my "neutral" classification.

The Negatives

  • Customer Stratification

The biggest negative is one that the company acknowledges but doesn't seem particularly concerned about. I deem it "customer stratification".

Large customers have generally been accepting of the transition to the subscription model, presumably because the possibility of turning on and off seats is appealing to them, as is the cloud model. They will never be faced with the binary decision of paying for a subscription this month or not paying for it, so for them there's no real issue regarding what will they do if they can no longer afford to pay for the software at all. (That is, as long as they're willing to pay for a single seat, they'll have functional access to all the work product they've previously created.)

Not so for smaller customers. Not only are they balking at the huge increases in the lifetime cost of the software, they're also feeling held hostage by the new paradigm as their entire historical library of work product will be as good as useless if their subscription (rental) lapses.

In a previous article, I'd highlighted such customer reaction, and the company admitted as much on its call. Here are a few excerpts that capture the company's stance on this issue (with my emphasis):

It's a multi-year program, we've rolled out 3 years' worth of changes in the customer base, so that they could actually get a lot of visibility to what they could expect over the next few years. The first year is modest price increases, the program starts June 1 and you're going to see a 5% price increase.

So whether you are a maintenance customers that really wants to see in maintenance or wants to move to subscription now, you're really going to renew and move forward and take - you're going to take an action, a positive actions. Because you got a year ahead to think about it. And what we're going to be doing in that year is we're going to be collecting the customer reaction and we're also going to be demonstrating to the customers more explicitly why there is more value in the subscription world. The value is going to show up just the nature of the offering, we just talk about access controlling insights. We're also going to be adding a lot more value related to bringing the cloud much closer to the subscription offering.

[…]

So as we've rolled it out we've gotten reaction from some of our larger customers whether we're just looking at it and they're going, we were going to move to subscriptions anyway or we're going to move to an EPA. So we're going to probably move forward with a lowest price possible. Our smaller customers are where we've gotten the most noise. And essentially, they're concerned about losing access to their perpetual software.

[…]

They recognize that the program we've put in place puts reasonable price increases for them and they get they love the royalty program. What they are worried about is giving up their perpetual license. So what we are just we're just next year and the by the way it is over this next year. Because they're obviously going to renew at a 5% increase is essentially show the customers that they need small accounts, that moving to a subscription is a more valuable path for them and something that helps them accomplish what they need to do more effectively.

The bulk of the reaction is a bit dismissive of the small user's quandary (notice the use of the word "noise" to characterize the backlash), and it's also condescending in that ADSK knows better than its customers what's good for them - despite the much higher lifetime costs it is forcing customers to absorb. (After all, the main driver of the conversion is higher lifetime per customer revenue to ADSK).

Moreover, the company doesn't at all address the concern regarding the loss of perpetual licenses and the customer's potential inability to use its own work product in the event it elects to allow its subscription to lapse.

Rather, and throughout, ADSK dissembles by solely focusing on the customer's three-year "benefit" while the large discounts apply. Yet - when pressed - it does admit that after the three-year discount period, the anvil hits and customers will pay the going (though nominally still "discounted") rate for the subscription. Here's the quote from the earnings call with my emphasis:

Ken, we've been very explicit at the program where the customer pops up to the terminal discount price of the program. So the main subscription program lasts three years, and at the end of that third year, there is a particular discount. That's the price that everybody trues up to when they exit the program.

This customer stratification and high lifetime costs is one of the factors that will drive users to competitors over the longer term, but before I get to this, let me discuss a second negative:

  • ADSK's Financials Continue to Deteriorate

The company keeps telling everyone to ignore the financials, as they will look bad during the transition, but even understanding that comparisons to previous periods may not be particularly relevant (though we're well into the transition by now), there are still interesting observations to be made.

First, the company boasted about its ability to maintain spend:

Moving to spend management, we're proud that we've been able to drive strong growth in all of our important transition metrics while reducing our Q1 non-GAAP spend by 3%. We know that some of you have been skeptical of our ability to grow our business while keeping spend flat this year and next year, but we continue to achieve our goals by making sure that we're investing in critical elements of our transition while reducing spend in other areas, driving efficiencies throughout the company and the best thing smaller non-core products.

Let's see where that year-over-year reduced spending came from. The two graphs below (one in absolute numbers and one in percentage change) show that the company's biggest expense is sales and marketing, and that that didn't decrease. Neither did G&A expenses. Instead, the "savings" came from the R&D side (it decreased by almost 3% over the year while the other two increased 5% and 14%, respectively). Short term, this might not matter, but longer term, this is part of what is opening the doors to competition. I'll discuss that in more detail below.

ADSK Research and Development Expense (Quarterly) data by YCharts

ADSK Research and Development Expense (Quarterly) data by YCharts

The continuing net losses, coupled with steady share buybacks, have brought the company's current ratio down close to 1. Now certainly current liabilities include deferred revenue, and this is worked off by producing the product. But given that ADSK loses money each quarter, the costs of realizing the deferred revenues are likely on the same order as, or even larger than, the deferred revenues themselves.

This suggests that there's no remaining liquidity to continue buying back shares in any meaningful quantities, and if trends continue, the company may have to turn to the bond or equity markets for future financing.

ADSK Current Ratio (Quarterly) data by YCharts

Should there be any hiccups down the road, either in execution of the (undisclosed) strategic plan or - probably more importantly - on the macro front, the company no longer has the financial resilience that it previously had to withstand these negative events. I'm now of the opinion that the catalyst for the short position will be from the normal economic cycle, where as soon as ADSK's customers undergo any type of slowdown or retrenchment, the effect will be enormously magnified on ADSK's stock price due to it currently being priced to perfection and the company having no remaining financial leeway. At that point, the stock price will drop dramatically - I only wish I could be more certain of the timing(!)

Competition

ADSK's customer stratification and its curtailing of R&D spending have begun to open doors for competitors to woo ADSK's smaller customers. In particular, a private European firm, Bricsys (developer of the BRICsCAD software), is making a big push to do this, having recently held a user conference with a new emphasis on sales and marketing. Both cadalyst and blogger Steve Johnson covered the event, from which I cull the following comments and observations (all emphasis mine).

First, the company's recent emergence as a competitor, partially fueled by its new support of Intergraph's CADWorx, and its commitment to stay focused on R&D, targeting an incredible 80% of it employees being developers:

" We are starting what I would call a second life now," said De Keyser, who expects the workforce of fewer than 150 people to reach 300 or 400 in the next 3 to 4 years. He is determined to keep his company lean, however, with sales shouldered by an 80-country network of resellers and a heavy emphasis on development staff. Although Bricsys may need to slightly reduce its investment in R&D - which currently accounts for 40-45% of spending - during this time of growth, the company's priorities won't change. " I think we will stay about 80% developers," De Keyser predicted. " What we are good in is basic research and development - that's the focus."

Last month, the Intergraph CADWorx plant design suite joined the list of supported applications - the culmination of a joint porting effort that began in 2015. (Intergraph's GT STRUDL structural analysis and design modeling software also is available on BricsCAD.) "Intergraph for us is a very substantial step," said De Keyser, who takes it as validation of the extensive work the company has put into rewriting its application programming interfaces (APIs) to foster outside development. "We expect the Intergraph deal will have an impact on our growth as well."

Luc De Bastselier, Bricsys CTO, explained that porting CADWorx to BricsCAD involved moving 3.5 million lines of code and testing more than 400 commands. For users to have a good experience working on the BricsCAD platform, the developers had to maintain the same workflows and performance level that CADWorx had delivered when running on AutoCAD. "That's important because the typical plant models can be quite huge," De Bastselier noted.

Second, it's run profitably which I personally believe proves that its model is sustainable even during inevitable economic downturns:

Steve: So you're making money every year and that's increasing every year?

Erik: Yeah, yeah, absolutely. The percentage is always around 24-25% but as we're increasing revenue it becomes exponential.

Mark: We started in 2002 and I think we have always been profitable.

Moreover, a focus on profitability leads to efficiency which overall leads to better and cheaper products:

Erik: I think it has to do with being lean and being focused. I mean, we're talking about Autodesk, and we're talking about AutoCAD and Revit and Inventor, but did you have a look at all the products they have? The managers that have to work on those products… I don't study the detail of their annual figures, but I think it's obvious that if you have that ton of products, not all of those products are profitable. Of course, not all of them are losing money, but you can't call it lean.

What we are doing is… we are forced to be profitable. We force ourselves to be profitable. And then we have to be lean. We have four developers that constantly automate our systems, and that four will be extended again. That pays off big-time. It's an investment; continuous, continuous, continuous. To invent new things where we can improve to be lean as well.

Finally, and most importantly, the company is committed to continuing to offer perpetual licenses and it claims to be getting positive reactions not just from ADSK's smaller customers but also from some larger ones:

Cyrena: Backing up just a step to sales, were you able to track any impact on your sales numbers with the chronology of Autodesk's announcements of ending perpetual? Did you see an effect that you could map to that?

Erik/Mark (together): Yes.

Erik: We see that especially with large companies. I hear it from Mark always!

Mark: That's what I wanted to explain this morning too, although we have an indirect sales channel, we have our resellers at work out there, especially with the large deals, we are involved always. So there's always one of our guys, a business development manager together with the local sales person in touch with those larger corporations.

In the last few weeks, we have received tons of emails from large corporations; of course it's hard to disclose them, but… [names a corporation]. It doesn't mean they will switch right away, but we have meetings where they say that, "Our contract with Autodesk ends in July, August, whatever, that's the time we will not extend it. We will not renew it, we will not go to subscription, and we are looking for alternatives." These are really big, big, corporations. So yes, yes, we see an impact.

[…]

Another thing that will not change is the company's commitment to offering perpetual licenses, De Keyser affirmed. "Read my lips: We are committed to choice."

Conclusion

Despite generating some positives in the most recent quarter, ADSK is, in my opinion, unlikely to meet long-term growth targets it has previously outlined. More importantly, ADSK's financial results continue to weaken its ability to withstand any execution or macro headwinds, and its conscious stratification of customers and its de-emphasis on R&D are opening the doors for competitors to win its smaller customers. It may take a year or more for the market to appreciate these dynamics, but I believe that it will happen, and whenever that time comes, ADSK's stock will undergo a dramatic drop. As a result, I remain short the stock and have actually added to my position at today's prices.

Disclosure: I am/we are short ADSK.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I actively trade around core positions.