New holding - Autodesk

Written by Gareth Campbell - Senior Equity Analyst, HL Select

Autodesk is a leading provider of computer aided design software. Their products have wide and varied uses, from the refurbishment of Big Ben to special effects in the film Avatar. In all, they serve more than 200 million customers across industries such as construction, manufacturing and media.

The company operates globally but lists its shares in the US, and we’ve taken a position in both the HL Select Global and UK Growth Shares Funds.

Why did we invest?

Autodesk is moving from a perpetual license business model, where customers pay when they want the latest software, to a subscription business model, where they make repeated payments and receive updates as and when they’re ready.

This change has significant benefits for growing the number of users and revenue per user, key metrics that drive long term revenue growth. The other key benefit from a subscription business model is it reduces the economic cyclicality of the business as customers can’t delay software purchases, even in a recession.

Autodesk has eighteen million active users but only four million of them are currently on a subscription contract. Less than two million are still on old perpetual licenses who are likely to upgrade as the need for updated software and functionality increases. The remaining twelve million are using pirated copies of the software!

Autodesk’s management have a long-term plan to coax customers into subscription plans, and while the cadence of new user additions will vary, we’re excited by the growth opportunity for new users. And once new subscribers are on-board, revenue per user should increase because Autodesk won’t need to offer the same level of discounts to turn old users into new subscribers.

Software businesses have very low marginal costs for supplying additional copies of software, this means they typically have strong operating leverage. For example despite expected revenue growth of approximately 17% for the next few years, Autodesk’s management have said they expect operating expenses to only increase around 10% resulting in a rapid improvement in operating margins.

Unique characteristics

Autodesk also has some unique characteristics which increase its barriers to entry. In the construction segment Autodesk are the dominant software provider, to the extent their software and product category are often referred to interchangeably. Like vacuum cleaners became hoovers, building information modelling has become known as Revit, Autodesk’s software solution.

Autodesk provide free software to higher education covering an estimated 200 million students. Collectively these factors create a strong network effect as students choose software that the industry uses and the industry adopts tools that most graduates know well.

Given this, Autodesk is a good example of the virtuous cycle we look for in businesses at HL Select. Autodesk spend more on R&D than peers, which creates value for customers, enabling them to increase prices, which increases profitability and grows the funds available for further product development.

This virtuous cycle fits well with Autodesk’s strategy of developing software that offers 80% of the functionality but at 20% of the price. Collectively this means Autodesk offers a strong and growing value proposition to customers.

Opportunity from uncertainty

The business model transition has created some financial complexity, which we think has opened up an opportunity. As contracts switched from perpetual license to annual subscriptions there was a headwind in revenue per user, which led revenue to fall over a 3 year period and because the company has a high cost base, operating margins turned negative.

But from an operations perspective the business continued to grow and because the new business model leaves it in a stronger position for the future, we believe Autodesk has reached the inflection point where free cash flow growth can start to accelerate. That makes it an exciting time to initiate a new position in Autodesk.

Making space for Autodesk

To build the position in the HL Select Global Growth Shares fund, we cut two of our smaller holdings in the fund. Christian Hansen is suffering from weaker demand for its cultures and enzymes, especially in Chinese markets. With the stock relatively highly rated we viewed the position as unlikely to recover whilst the top line is under pressure.

We’ve also exited from Align Technologies. Their dominance of the clear plastic tooth alignment marketplace looks to be coming under increasing challenge from newer rivals, using simpler technologies to undercut them.

Our mandate on the HL Select UK Growth Shares fund gives us the flexibility to invest globally, although we’ll always invest at least 80% of the fund in UK-listed names. Widening our search globally gives us more exceptional businesses to choose from, and greater access to certain industries and sectors that aren’t well represented in the UK market (technology being a good example). We already own two overseas stocks, LVMH and Adobe, in the UK Growth fund and sold down our FTSE 100 ETF tracker to add Autodesk.