How Does Autodesk Make Money?

And is it a growth stock?

Motley Fool Staff
Motley Fool Staff
Jul 23, 2019 at 2:59PM
Technology and Telecom

Autodesk (NASDAQ:ADSK) recently abandoned its decades-old licensing model and switched to a software-as-a-service model. While the transition was painful -- revenue has been flat over the last few years and profits have plunged -- the company is finally on the verge of reaping the rewards from the transition.

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Fool.com contributor Brian Feroldi discuss Autodesk's financial results in detail and share why they believe the company is poised to post strong profit growth from here.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on July 2, 2019.

Dylan Lewis: Brian, one of the reasons that I love having you on the show is that you are always bringing stock ideas to the table. I think more than most of our writers, you really like looking for new opportunities, new places for people to put their money. You came to me with an idea that you were excited about. That's why we're talking about Autodesk today.

Brian Feroldi: Autodesk is a company that I don't think a lot of investors have on their radar or know about at all. And yet, this is a business that's worth about $30 billion. It is truly a software giant, but it does fly under the radar.

Lewis: For the unacquainted, what does it do?

Feroldi: Autodesk, their flagship product most listeners have probably heard of, it's called AutoCAD. The CAD stands for computer-aided design. This software has been around for almost four decades now. It's used by professionals of all types -- architects, project managers, engineers, graphic designers, even city planners and construction professionals. They use AutoCAD to design, fabricate, manufacture countless products -- everything from small, individual products to basically city-sized projects. Users can basically draw their models in 2D or 3D, print them out, make design changes rapidly. It's a step change better than the old method of drawing things by hand.

Lewis: Any of our listeners out there that work in any of those fields -- engineering, architecture, etc. -- are probably like, "Yes! Finally, they are talking about AutoCAD! They're talking about Autodesk!" All the professions that you laid out there. They have a bunch of different types of software, but they generally operate in a very specific type of software environment.

Feroldi: Yeah, which is I think a big reason why this company goes under the radar a little bit for most investors. They don't make consumer products. A couple of weeks ago, we talked about Adobe Systems. I think a lot of our listeners have probably at least heard of or use maybe Photoshop or Premiere or something like that. To get into Autodesk's products, and they have a range, you really have to be a professional in that field. This isn't something that most people will play with on their own.

To give listeners a sense, their main products are AutoCAD; they also have a product called Revit, which is for building information modeling; Maya, which is used for high-end 3D animations, it's used to make 3D animated movies, for example; Fusion 360 is used for product design; BIM 360 is used for construction management. And that's really just the tip of the iceberg and the most well-known. This company literally has dozens of software products that are out there.

Lewis: One of the reasons to love them is, they have made the tough and very difficult switch that almost all software companies have to make at some point. It's almost like going through puberty. They were on the licensing model for quite some time, and they have decided to make the switch over to software as a service. A little bit painful, but it's ultimately what you want to see for a business like this.

Feroldi: Yeah, this is a trend that we've seen over and over again and we've talked about numerous times on the show. Adobe Systems, Microsoft, Oracle, all the big software companies that have been selling software for decades under the licensing model have transitioned over to the software-as-a-service model. It is painful in the short term. Your revenue takes a hit, your net income and your cash flow sink. But after the painful transition period is over, you reap rewards for years and years. And that's exactly what we've seen from Autodesk over the last couple of years.

Lewis: Brian, looking at the books for this company, let's talk financials. What do you see?

Feroldi: Autodesk was pulling in about $2.5 billion in fiscal 2016, which was right before they started to go whole hog in on the SaaS transition. The year after that, their revenue actually fell to about $2 billion. It took about three years for it to return to that $2.6 billion that it hit in 2016. The last couple of years have seen basically flat on the top line. However, now that the transition is behind them, and they are really starting to kick in on the SaaS side, their revenue is now growing very quickly. The estimates for fiscal 2020, which is the current year, is about 22% top-line growth. To give listeners some perspective, that number is about 40% U.S. and 60% international. This is predominantly an international business.

Lewis: That is one of the reasons right there why you read the conference calls and you look at company management. If you are simply looking at the results the company has put up over the last couple of years, you are scratching your head and wondering why we're talking about this business. It looks ugly. You need to have the commentary and understand what's going on with the transition to SaaS and the expectations for where management thinks this business will be going.

One of the reasons I'm so excited about this company is gross margins, Brian. This looks like a SaaS company when it comes to gross margins. 89%, and that's been climbing quite a bit over the last couple of years.

Feroldi: Yeah, their gross margins were exceptionally strong, as we've seen in so many software companies, prior to the transition because the licensing model is very lucrative. But their gross margin did decline after the transition was happening, mostly because revenue was plunging. But we have seen a return of gross margin rising in recent years. I do think there's reason for investors to believe that number can continue pushing higher as the scale continues to grow.

Lewis: Unfortunately, they are not profitable on a GAAP basis yet. Some of that tied to that transition, like were talking about. I imagine at some point down the road, you have a business that's putting off the margins that they are putting off, it's going to find a way to become profitable after these early investments have been made. So I'm not super concerned about that. There are some other things to be mindful of. They have a net debt position, so more debt on the balance sheet than cash. But there are some good things when you look at free cash flow and you look at their non-GAAP profitability.

Feroldi: Yes, their non-GAAP numbers, as you said, which is a nonstandard accounting record, are positive. The big reason for that delta is mostly because of stock-based compensation, which is something we'll touch on later in the show. They also do have a net debt cash position of about $1.1 billion in net debt on the balance sheet. Some of that is because this company has been actively repurchasing its own stock. They also make acquisitions on occasion to build out their software offering. The numbers here wouldn't scream at you fantastic; however, once you get the idea of the transition in your mind, you actually see that now that they're in the tail end, the numbers are going to get better and better from here, and they are pumping out free cash flow. And all these numbers, I believe, are poised to rise substantially. Backward-looking financials aren't the best. Forward-looking financials look pretty darn good.

Lewis: If you are comparing a SaaS company to maybe a baseball player, one of the numbers that you want to see on the back of the baseball card is the net revenue retention rate number. That's pretty much like on-base percentage for a SaaS company. You want to see that they are getting customers to spend more as each cohort ages a year out. It's like a comps number for restaurants. We don't have a precise one here for this business, which irks me a little bit, but they give a range.

Feroldi: Yeah, they say that their net revenue retention range is consistently between their target, which is 110% to 120%. As you said, we don't get an exact figure. But that is a healthy range to be in the middle of, so it does indicate that they are growing sales within their current paying-customer base at a pretty healthy clip. That range that they offer isn't the best that we've ever seen, but it is very strong for a company of Autodesk's size and scale. So I think investors should be pretty happy there.

Lewis: Yeah, what that says is, not only can they grow by acquiring customers once they have customers in the ecosystem, they will hopefully be collecting more dollars from them down the road as well. It seems like there is quite an opportunity here. While some customers have made that transition to the SaaS model that they are trying to push, a lot of legacy customers have not, and that remains one of the big growth levers for this business.

Feroldi: Yeah, that was the thing that jumped off at me at the page when I was starting to research this company in depth. Again, Autodesk has had its software under a licensing model for decades. When you do that, you as a user, if you paid the hefty licensing fee, say five or even 10 years ago, that software still works on your computer. You can still design with it. When they made the SaaS transition to a subscription model, they've converted about 4.3 million of their customers over to a SaaS model, which sounds like a huge number. But the exciting thing for investors is, there are 18 million active users of their software. That means that 14 million people are out there actively using Autodesk's products, are dependent on it, but have not yet subscribed. That is a massive untapped opportunity for this business.

Lewis: Sometimes you'll hear numbers like that when you talk about a freemium model business. I know when I was looking at the prospectus for Dropbox, they were saying, "Oh, we have this tiny portion of paying members and hundreds of millions of people that use the service, or tens of millions of people that use the service for free." They always love to promote the idea that, "We have this huge growth lever if we can just convert a slightly higher percentage of those free users." But these are people that are actually paying for the software, and will probably need an upgrade at some point. You can only run on legacy software for so long before it starts to become a hindrance to your business.

Feroldi: Yeah, that's the exciting thing here. As you said, these were 18 million people who purchased some Autodesk product at some point in the past and just have yet to make the transition to the SaaS model. Autodesk is wisely investing heavily right now in R&D to make the software-as-a-service product as compelling as possible. One thing that they call out that I'm particularly excited about is, they're investing heavily in augmented reality and virtual reality functionality so that they can build that directly into their products. While those markets haven't caught on on the consumer side, I can easily see them being a big deal in the construction business. Imagine, for example, that you want to build a house and you're working with an architect. Well, using augmented reality or virtual reality, you could literally put on a headset using AutoCAD software and walk through the designed house before anything was being built at all. You as the consumer can go around and see what the lighting looks like, see what the layout looks like. That's when you can really give feedback to the designer. It will also help the designer to close on the sales process. I think the AR/VR angle could potentially be a huge growth driver for this business in the long term.

Lewis: Yeah, that's some Jetsons-level tech in my view. That's the kind of thing that you wildly fantasize about being possible at some point down the road. One of the other things to be excited about with this company is, they see a far larger total addressable market out there than what they are currently capturing in revenue.

Feroldi: Yeah. They call out infrastructure, the global rising middle class, and a huge push toward, believe it or not, green design, to make buildings as energy efficient and with as few resources as possible, as all drivers to push more people into relying on AutoCAD products. For a sense of scale here, management pegs its total addressable market opportunity today at about $48 billion. They see that number jumping to $59 billion by 2023. For perspective, their revenue estimate for this year is $3.3 billion. So, literally 10x TAM potential, as management sees it.