Autodesk: A Great Example Of A Good Business And A Bad Investement

Not all bad investments are made in bad businesses and not all good businesses are good investments. There are a multitude of factors that go into the making of a good investment far beyond finding a good business.

First of all, you can find a good business that is simply valued too high by overall excitement about it or its products in the market. We saw some of this during the Internet stock bubble of the late 1990s. There were some fine businesses that are still providing us with excellent products today, but that were just priced at ridiculous valuations in 1999. When the bubble burst, the overvalued great businesses saw their share prices decimated right along with the overvalued poor ones. Market history is replete with examples of stocks that soared to the moon with the excitement generated by the launch of a new and “game changing” technology.

Time after time, history is also replete with the examples of these stock prices crashing back to earth when the excitement surrounding the innovative new product wears off and investors begin to price the business at a realistic valuation. Just as markets are driven to extreme lows by excessive pessimism to create exceptional opportunities for value investors. When valuations of particular businesses or sectors are driven to extreme highs, it can present opportunities for enormous profits for those willing to short-sell stocks. At the very least, we should always be aware that these situations exist and avoid allocating capital to vastly overpriced stocks.

A Game Changing Product And Business

Autodesk, Inc. (ADSK, Financial) operates as a design software and services company worldwide. The company's Architecture, Engineering and Construction segment offers Autodesk Building Design Suites to manage various phases of design and construction; Autodesk Revit products that provide model-based design and documentation systems; Autodesk Infrastructure Design Suites; AutoCAD Civil 3D products that offer a surveying, design, analysis, and documentation solution; and AutoCAD Map 3D software, which offers direct access to data needed for infrastructure planning, design, and management. Its Platform Solutions and Emerging Business segment offers AutoCAD software, a computer-aided design application for professional design, drafting, detailing, and visualization; and AutoCAD LT, a professional drafting and detailing software. The company's Manufacturing segment provides Autodesk Product Design Suites for digital prototyping; Autodesk Inventor that allows manufacturers to go beyond 3D design to digital prototyping; AutoCAD Mechanical software to accelerate the mechanical design process; and Autodesk Moldflow family of injection molding simulation software. Its Media and Entertainment segment provides Autodesk Maya and Autodesk 3Ds Max software products that offer 3D modeling, animation, effects, rendering, and compositing solutions; and Autodesk Flame, Autodesk Smoke and Autodesk Lustre software applications that offer editing, finishing, and visual effects design and color grading solutions. Autodesk, Inc. also sells consumer products for digital art, personal design and creativity, and home design in various digital storefronts and over the Internet.

For anyone not yet familiar with the reality of 3D printing, this is truly an amazing and exciting process. The software and machines that allow it are changing industries around the world and the entire process of research and development for new product prototypes and one-off custom manufactured items.

When the impact that this technology and the machines that bring it to life would have on the manufacturing and new product development cycle and cost structure became apparent, the stock prices of the businesses involved exploded higher. While the potential of these businesses is enormous, reality appears to be setting in and it is becoming evident that this technology becoming a consumer staple is a least quite a ways into the future, if it ever becomes cost effective enough to become a household device.

Balance Sheets Always Tell A Story

When reviewing the balance sheet of Autodesk, I noticed that the company is carrying $1,456 million of goodwill on their books as a non-current asset. In accounting, goodwill is an intangible asset associated with a business combination. Goodwill is recorded when a company acquires (purchases) another company and the purchase price is greater than the combination or net of 1) the fair value of the identifiable tangible and intangible assets acquired, and 2) the liabilities that were assumed.

According to the Accounting Coach website, “Goodwill is reported on the balance sheet as a noncurrent asset. Since 2001, U.S. companies are no longer required to amortize the recorded amount of goodwill. However, the amount of goodwill is subject to a goodwill impairment test at least once per year.” So this particular “asset” exists with no real tangible value to the shareholders.

The entire value of shareholder equity in Autodesk is only $2,219 million. This means that an “asset” that exists only as an accounting entry on the balance sheet makes up 65.6% of the total value held by the shareholders. This leaves only 34.5% of the equity that is backed by tangible assets. There is just something about that ratio that makes me uncomfortable.

How is the business being run?

Something else that doesn’t really sit well with me is management compensation that does not appear to be aligned with increasing the earnings and tangible book value of businesses I own. In fiscal year 2014 (ended 01/31/15), Autodesk’s top five executives were paid $2,2970,277 in base salaries and an additional $2,992,248 in “non-equity incentive plan compensation”. This brought the total non-equity compensation for these top five executives to an amount equal to 7.27% of the net earnings for the whole company for fiscal year 2014!

As they say in the television infomercials, but wait, there’s more. In addition to the cash portion of their compensation, these five individuals received stock grants with an additional estimated value of $7,197,399.00 or 8.77% of the net profit for the business. All told, these executives were rewarded with total compensation equal to $13,159,924.00 or 16% of the net profit generated by the business.

The oddest thing I noticed when reviewing the management compensation notes contained in the 2014 Annual Report for the company was that the senior vice president of sales and services received compensation of $575,000 in commissions on sales from last year. Now, I have managed several businesses and I have compensated my sales forces in many ways. I have used commissioned reps, I have used dedicated sales forces paid purely on a commission basis with expenses reimbursed and I have employed salaried sales staffs. I have never had a senior vice president of sales who was paid a commission of $575,000 on top of a $457,162.00 salary.

But that is not the end of it, in addition to drawing over $1 million in salary and commission, Steven Blum took his wife along on a business trip and was reimbursed to the tune of $22,044.00 for her travel expenses and gifts. In all fairness to Mr. Blum, the actual expenses for his wife’s travel and gifts were not that much; the final reimbursement only reached that level because the company also compensated him for the additional tax liability he incurred because his wife’s expenses were treated as additional income for him under IRS rules!

Now, I am not one who likes to play the class envy game and I do not begrudge anyone making large sums of money … if they earn it. As a matter of fact, I don’t normally care what executive compensation is within businesses I own as long as an appropriate value is being returned to me as one of the owners. I think asking the business to pay for travel expenses and gifts for my wife is just a bit over the top. It appears to me that the top executives in this business are being paid more like private hedge fund managers than executives of a publicly traded business.

What has management done for shareholders?

As I stated earlier, I do not resent highly compensated managers in businesses where I invest as long as they deliver a real high level of return on my invested capital. I do understand that most investors look at the change in share price when trying to assess their return on investments; but that overlooks the fact that share prices and the real value of a business are two very different things. A share price that has risen without an increase in the shareholder equity or book value per share of that business is only meaningful if one sells the shares owned at the higher price. The value of a business is only truly increased by rising tangible book value/share, rising free cash flow/share or an actual increase in shareholder equity. I believe that eventually share prices will rise of fall in order to reflect the real underlying value of a business and intermediate deviations from that are just noise when the price rises too high or buying opportunities when the price falls too far.

In the case of Autodesk, the share price has performed much better than the actual business seems to justify. For the 2014 fiscal year that ended January 31, 2015, the business had a decline in book value of $42 million from the end of fiscal 2013. Shareholder equity also declined by a similar amount. The net tangible assets of the business also fell by 43% from $1,188,500,000.00 to $675,500,000.00; while the goodwill carried on the balance sheet soared by 44% from $1,009,900,000 to $1,456,200,000.

The reported earnings/share collapsed from $0.93/share in 2013 to $0.32/share in 2014. As shown in the table below, earnings are expected to rebound to $1.04/share this year but that projection has decreased by 11.2% from the $1.17/share being forecasted just 60 days ago. The estimate revisions for the year ending January 2017 have fared even worse at they have dropped from $1.49/share just 90 days ago to the current projection of $1.08/share. This represents a downward revision of 27.52%.

These projections place the valuation of this stock at 48.62 times next year’s expected earnings with a year over year forward growth rate of 3.85%. Even if we were to use what appear to be very optimistic projections of 21.5% earnings growth rate for the coming five years, this stock is still very richly valued at a PEG (price to earnings growth) multiple of 2.35; more than twice its industry and sector average.

We also need to consider what the growth rate must be for the four years following next year in order to end up at a 21.5% average after only growing 3.8% next year? Let us not also forget that the forward estimates for this year and next have been falling rapidly for the last 90 days. How likely is it that these lofty projections for future earnings growth will materialize?

In January 2008, Autodesk reported its best year ever when they earned $1.47/share on revenue/share of $8.97. By the end of January 2015, that had changed to $0.35/share earnings with $10.81/share in revenue. It appears the business is working harder and earning less while the management makes more. At the risk of repeating myself, let me say again; I don’t mind managers making lots of money as long as they are sending some back home to the owners as well. That really looks to be far from what is taking place at Autodesk.

What is this business really worth?

There are a lot of different metrics that can be used to determine the fair market value of a business. When attempting to determine current value versus fair value, the more common metrics we apply, the better chance we have of reaching an accurate number.

Price to earnings multiples (P/E) are one of the more common methods used. The table above from Yahoo!Finance shows that Autodesk is currently trading at 50.49 times current year’s projected earnings of $1.04/share. This is not a stock that is cheap. Even compared to next year’s projected earnings of $1.08/share, the stock still carries a P/E ratio of 48.62 times earnings.

The chart below shows the historic relationship between the stock price, the PEG ratio and the median P/E. As you can see, over the past 20 years the price and median P/E ratio have followed each other fairly closely with the median P/E at 32.94 times trailing earnings. So this has not been a historically inexpensive stock.

However, beginning in 2014, earnings began to fall, the stock price continued to rise and the 20-year relationship between the median P/E ratio of the stock and the actual price was put asunder. Based on the trailing twelve month’s earnings and the historic median P/E of 32.943 times that number, we would expect this stock to now be trading at about $12.50/share rather than the $52.51 where it now sits. If it were at that price, it probably would have never come to my attention. But it is not and it did.

If we say that the historic valuation of the stock at 32.943 times earnings is correct and we project out 12 months from now and apply the valuation based on next year’s projected earnings of $1.08, then we are left with a fair value 12 months from now of $35.58/share. A fall to that price would equal a decline of 32.2% over the next 12 months. Do you think if the stock fell that far, that fast, investors would immediately start buying again or quit selling simply because the stock was cheaper than it is now? Not likely.

Just as stocks tend to move far higher than their value when they are loved, they tend to fall much lower than fair value when they come back to earth and become hated. Therefore, it is likely that, when the stock does correct, it will fall well below fair value on the way down.

Fidelity Investments estimates the price to trailing 12-month’s free cash flow (FCF) ratio of Autodesk to currently be 54.19. Good to excellent businesses are generally considered to be worth 15 to 18 times free cash flow and a bargain for value investors when they dip below 10 to 12 times FCF. Once again, this business is very richly valued at the current level.

What will drive the share price lower?

The stock reached its 52-week high on February 27 of this year and has been working its way steadily lower since. This type of gradual decline is what we want to see when considering a short sale of a stock. As the price grids lower, a few more investors at a time decide to cut their losses or protect what is left of their profits and sell. These actions cause the price to fall a bit more and the cycle repeats.

Quite often, this cycle will repeat until one day the bottom falls out on massive trading volume. Once that takes place, you can then enter an order to buy back the shares you sold short. If the price continues to fall, you can keep lowering your buy price at which you will close the trade to protect your profits and if the shares start to rise, your order to buy will take you out of the trade.

Final thoughts and actionable conclusions

In Autodesk, we have a stock that is clearly valued at ridiculous levels compared to any reasonable measure of value. Furthermore, the stock has entered a readily identifiable downtrend and appears to have no real reason to cease moving lower in the near future.

It appears that selling this stock short above $50/share offers exceptional opportunity for profit with little downside risk. If you sell the stock short above $50/share and place a stop loss buy order at $5.00 above the price at which you sold it to close the trade, you will have a downside risk of 10% or less on your allocated capital and an upside potential is the stock falls to a more reasonable value of $25/share.

This position produces a potential reward to risk ratio of 5:1 and you can keep your buy to close order moving down with the share price at a $5.00 gap or 10% higher than the lowest share price, whichever you prefer.