You may not have heard of Autodesk (NASDAQ:ADSK), but you've probably heard of its flagship AutoCAD. Autodesk sells a suite of software products that are invaluable for professionals across the board, from graphic designers to architects and more. In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Brian Feroldi explain what makes this company such a good long-term investment. Learn what you need to know about the last few years' results, how switching to the SaaS model changes Autodesk's future opportunities, the biggest risks and yellow flags to watch out for, some of the most exciting growth drivers and unpulled levers, and more.
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This video was recorded on July 2, 2019.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, July 19, and we're talking Autodesk, ADSK. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com's Brian Feroldi. Brian, what's up?
Brian Feroldi: Hey, Dylan! How's it going?
Lewis: It's worth noting here that we are taping this episode on July 2nd. It will be live on July 19th. I have to pre-tape this one because I'm going to be out of the office for a little bit, Brian.
Feroldi: It sounds like you have an interesting vacation. Where are you off to?
Lewis: I'm going to be heading to the Philippines with my girlfriend, Jess. She's from Manila, so we're going back to go to a friend's wedding and meet her family, and hang out there. It should be pretty fun!
Feroldi: That sounds like a high pressure vacation you're going on there, Dylan.
Lewis: [laughs] I've met her mom before. I haven't met her dad yet. I haven't met her entire extended family. I'm working myself up a little bit, pumping myself up, trying to learn what I can. I watched the Anthony Bourdain: Parts Unknown episode about Manila the other night. I'm feeling good. I'm feeling ready!
Feroldi: I like it! Way to go! Just dive head into that. See how that works out. [laughs]
Lewis: [laughs] 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.
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, the reap awards 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 a 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 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 this 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.
Lewis: Yeah. A lot of big growth opportunities for this business. All right, Brian, you have a ringer that you like to throw stocks through. We have talked about some of the things that I think a lot of people would tend to hit on when they are looking at a business. Look at the books, look at some of the opportunity out there. We're going to dig into some of the things that you always make sure to check the boxes on. One of the first things, particularly in the software-as-a-services space, is customers -- specifically, do we have customer concentration?
Feroldi: Yep. You have to think about customers from a number of angles. The entire SaaS model falls apart if you have trouble attracting, and importantly, retaining, customers. That's why we like to put any business through a checklist. On the customer side, is acquiring them expensive? Well, in Autodesk's case, I do think the answer is yes. There are significant barriers to entry to learning how to use the software, and the company spends heavily on sales and marketing to get the word out. Those investments, I think, are worthwhile because as we saw from the net dollar expansion rate, once they do become customers, they do become very sticky. So, that expense is OK in my books.
Are they dependent on the software? Well, I think the answer there is yes. Once you take the time to go through and learn it, you can continue to use it. Is Autodesk's revenue recurring? In this case, yes. Now that they've made the transition to a SaaS model, their revenue is almost all recurring in nature. Does this company have pricing power? Well, we've seen the gross margin rising in recent years, so I think the answer is yes.
Overall, I think that these are typical things that you see of any successful software-as-a-service business.
Lewis: Yeah, I think you're absolutely right there. One of the things, it's not a very measurable thing -- I mean, I guess you could look at market share, but the thing that I love to see with the software-as-a-service segment is, is whatever this company offering industry standard? If so, even if the acquisition costs are a little high for customers, it's going to be really hard for someone else to come in there and disrupt the model. Not only do you have all of the regular stickiness that comes with a software product, but you have a market-leading position, which is huge, and you have customers that truly need the product in the case of these designers, these architects, these engineers. So, that makes me willing to give the benefit of the doubt to a company that may have some higher acquisition costs than the average business.
Feroldi: Yeah, and these are products that take months or even years to master and learn how to use. Once you've spent the time to do that, the switching costs become enormous. That's something that's very attractive for investors.
Lewis: All right, next on the checklist, we have management and company culture. What do you see there?
Feroldi: Well, let's start at the top. The CEO is Andrew Anagnost. He has only been on the job for a few years. One thing that we like to see as Foolish investors is huge inside ownership. Unfortunately, that's not the case here. He owns about 31,000 shares of stock, which is worth about $5 million at current prices. That's not nothing, but this is a $30 billion business, so that is not even close to a rounding error. But, the good thing for investors is that the CEO is required to own 6X his base salary in stock. That way, his incentives are sort of aligned with investors. But, the business is almost 40 years old. This has been publicly traded for a long time, it's been a very successful company. It would be wrong of us to assume that the inside ownership rates would be very high here. But that is something that we always like to see.
Let's look at the culture. We always check out companies on glassdoor.com. This company gets four stars out of five on Glassdoor. The CEO rating is 84%. Employees seem to like working here, and they seem to give it good reviews.
So, not the best management and company culture that we've ever seen, but I think it's perfectly acceptable.
Lewis: When you look out big picture at the business, any big red flags for you?
Feroldi: No. You mentioned one before about customer concentration. The company does have more than four million paying customers at this point, which, as we talked about, is a small number compared to what we think it could be in the long term. The industry itself does not face any long-term headwinds. In fact, there are significant tailwinds behind this business.
The one thing I will point out is, this business does rely on an outside force for its success, more so than we've talked about with other SaaS businesses. These guys sell their software to architects, construction managers, so there is a need for worldwide spending on infrastructure and building projects to be strong. You could see, if that industry did take a cyclical downturn, that it would be very hard for Autodesk to grow. Now, offsetting that is their amazing opportunity to convert current customers. They may be able to at least tread water, if not post modest growth even during an industry downturn. But that is something for investors to keep in mind.
And then finally, we always look at stock-based compensation, which was not insignificant. This company spent $250 million last year in stock-based compensation. That's a pretty high number for a company that's doing just over $3 billion in revenue. But offsetting that is, this company has been a buyer of its own stock pretty heavily, so that its share count has actually declined over the last couple of years, even with a pretty hefty stock-based compensation.
So, nothing that would be a red flag for me, but maybe a slight yellow coloration flag on some of these.
Lewis: What gets me excited looking at a business like this and looking at the growth rates that management is throwing out there is, you think about the growth that a company might be putting out there, the subscription rates, the renewal rates, all these types of stuff. They're saying like 22% growth, that's what they're eyeing. 26% growth compounded for three years puts the company at a double, just about. So, if you're in a business where most of your revenue's recurring, you have customers spending more money, and you're growing in the low 20% [range], even though they're already a fairly large business for a niche SaaS company, I still think there's a lot of room for this company to grow, especially if they can maintain growth rates in the high teens or low 20s.
Feroldi: Yeah, I completely agree. $30 billion, which we've talked about a couple of times as their market cap, sounds huge. But Adobe cracks $100 billion, and Microsoft is a trillion. When you think about those numbers for comparison, even though Autodesk does provide a more niche product than, say, Microsoft would produce, I believe that there is still substantial upside, even though this company is very sizable already.
You mentioned the growth rates, which are very strong. Wall Street is pricing this business for growth. Its stock has been a terrific performer over the last couple of years. The valuation here is stretched. We see about 13.5X sales right now, and about 36X next year's non-GAAP earnings. Those are high numbers. But I believe that the business has so much going for it, and there's so much visibility into this company's growth, that those numbers are not crazy. I think this stock is actually a buy today.
Lewis: Are you putting this one on your watch list right now, Brian?
Feroldi: Oh, yes, this one is actually at the top of my watch list right now.
Lewis: Anyone who listened to the July 4th week episodes that we did with all the hosts from Industry Focus might remember that Jason Moser and I were both very excited to talk about Autodesk as a stock on our watch list, so much so that we ran into each other during the taping and didn't realize that we both independently had that as our One to Watch. So I, too, have it on my watch list. Once I have the gap in not having talked about the company and having solid internet access so I can access my brokerage account, I will be probably initiating a small position in Autodesk.
Feroldi: That would make two of us, Dylan.
Lewis: [laughs] It's good company to be in. Thanks for joining us today, Brian!
Feroldi: Thanks for having me!
Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or you want to reach out and say hey, you can shoot us an email over at firstname.lastname@example.org, or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes, or you can check out the videos from this podcast over on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass! For Brian Feroldi, I'm Dylan Lewis. Thanks for listening and Fool on!