Starboard loses initial legal fight against Autodesk, but the battle may just be beginning

Business: Autodesk engages in three-dimensional (3D) design, engineering and entertainment technology solutions. Its product offerings are focused on the following categories: Architecture, Engineering and Construction, AutoCAD and AutoCAD LT, Manufacturing, and Media and Entertainment. Its products include AutoCAD Civil 3D, Building Connected, Autodesk Build, Revit, Computer-Aided Manufacturing Solutions, Fusion 360, ShotGrid and 3ds Max. Autodesk's product development and manufacturing software provides manufacturers in automotive, transportation, industrial machinery, consumer products and building product industries with comprehensive digital design, engineering, manufacturing and production solutions. It also offers Wonder Studio, which is a cloud-based 3D animation and VFX solution.

Stock Market Value: $52.2B ($242.31 per share)

Autodesk shares' 2024 performance

Percentage Ownership:  approximately 1% (more than $500 million position)

Average Cost: n/a

Activist Commentary: Starboard is a very successful activist investor and has extensive experience helping companies focus on operational efficiency and margin improvement. The firm has taken a total of 150 activist campaigns in their history and has an average return of 24.83% versus 12.99% for the Russell 2000 over the same period. Starboard has had an even better track record in the information technology sector. In 53 prior engagements, it has a return of 36.43% versus 18.82% for the Russell 2000 over the same period.

Autodesk is a global leader in design, engineering and entertainment software solutions. About 75% of revenue is generated from Architecture, Engineering, and Construction (AEC) solutions. These are application areas in which Autodesk is the No. 1 or No. 2 player — where it generates significant recurring revenue and maintains pricing power. Its remaining revenue comes from its growing manufacturing applications (20%) and legacy applications in entertainment like movies and TV (5%).

With 90%+ gross margins and 35% operating margins, Autodesk is a leader in AEC software. The company's gross margins are best in class, a reflection of its value add and pricing power. Further, its operating margins are not much worse than those of its peers at first blush. However, Starboard correctly does not judge the company's operating margins on the mean of its peer set, but by the potential embodied in its gross margins and market position. Autodesk currently spends approximately 28% of its revenue on sales and marketing versus 23% for peers, and 9% on general and administrative expenses compared to 5% to 7% for peers. In other words, operating expenses as a percent of revenue is roughly 1,000 basis points higher than peers. Moreover, the company's FY2023 operating margins of 36% missed its own target of 38%, which was adjusted downward from an original target of 40% despite front-loading revenue through multiyear contracts. This engagement had great potential to be an excellent amicable and constructive activist campaign for Starboard. The firm has had great experience working with companies just like Autodesk from a board level to improve margins and create tremendous shareholder value. That would have been a great plan here and would have likely meant adding only two or three directors to the board.

But the cooperative, constructive scenario was seemingly dashed on April 1, when Autodesk publicly notified shareholders that its annual report would be submitted late following information being delivered to the audit committee, which resulted in the launch of an investigation regarding the company's free cash flow and non-GAAP operating margin practices. Ultimately, the committee found that despite signaling to investors that it would be shifting its enterprise customers toward annual billing, Autodesk had recently pursued multi-year upfront contracts at levels that even exceeded their historical use, helping the company meet its FY23 free cash flow goal.

To make matters worse, the company informed the U.S. Securities and Exchange Commission of these issues by early March, but it withheld the information from investors until after the closure of its nomination window, preventing a potential activist director nomination this year. Despite this, Starboard said it reached out privately to offer to work with Autodesk to improve the board, but the company declined. So, Starboard requested that Autodesk reopen the nomination window so that shareholders could make a fully informed decision following the recent disclosures, given the fact pattern. The company rejected that offer. Starboard filed a lawsuit in the Delaware Court of Chancery to compel Autodesk to delay its 2024 annual meeting set for July 16 and to reopen its nomination window, which closed on March 23. The court rejected Starboard's claim on June 20.

While the findings of the investigation alone are worrisome, there are two things in our mind that could elevate it from an acute accounting issue to a much more serious governance issue. First, while Autodesk reports free cash flow as a key operational metric, it was also a factor in executive compensation. Second, how the board and management responded to this investigation might be an even bigger problem. Here, the board seemed to determine that Deborah Clifford could no longer remain as CFO. What happened next did not exactly inspire a strong feeling of board oversight and accountability: Instead of firing her, Autodesk appointed Clifford to the role of chief strategy officer. While the first issue reflects on management and its lack of alignment with shareholders, the second issue goes directly to the board's ability to oversee management and hold them accountable.

It is incontrovertible that these developments at Autodesk will require governance changes. The level of change that is necessary will not depend on the company's acts, but rather the level of involvement. Starboard does not know yet whether this situation can be rectified with a few board seats or a total board and management overhaul, but that will become clearer as more facts as to accountability come out. From our perspective, the company's response with respect to penalizing management and notifying and working with shareholders does not bode well for the "minor change" scenario. The governance issue is paramount here and must be addressed before Starboard can make any real economic changes directly enhancing shareholder value.

Once that is resolved, a reconstituted board and management team to the extent necessary can focus on improving operating margins and trading multiples. Improving margins by 1,000 basis points by itself could greatly increase shareholder value, but applying a bigger multiple to that will have an exponential effect. Presently, Autodesk trades at an EV/CY2025E earnings before interest, taxes, depreciation and amortization multiple of 19.4x versus some peers above 30x and a peer average of 23.5x. A good argument can be made that a market leader like Autodesk should trade at a higher-than-average multiple, but just getting to the peer average would be very meaningful for shareholders. This happens when shareholders have more confidence in the governance of the company – when the board offers more transparency, oversight and accountability – and when management hits its targets as opposed to missing and lowering them.

Whether that happens will depend on several things. Starboard's loss in the Delaware Court takes the quick scenario off of the table. While there is a proposal on the proxy this year that would allow 25% of shareholders to call a special meeting, even if that is approved, the company can drag its feet on implementation so it would not really be useful prior to the next annual meeting. This might come down to how hard the board wants to dig in and how convincing Starboard and other shareholders can be. Otherwise, it will have to wait until 2025. The good news is that Starboard is an activist with the patience and conviction to wait until 2025. If it comes to that, the company's chances of winning would go down dramatically.

One final note: This is not the first time Autodesk has been engaged by an activist. Sachem Head had an activist campaign here between November 2015 and June 2017, and ultimately settled for three board seats and the appointment of a new CEO, Andrew Anagnost, who is currently at Autodesk's helm. It should be noted that one of the director designees pursuant to Sachem Head's agreement was Rick Hill, who has a very interesting relationship with Starboard. He was the chairman of Tessera when Starboard waged a proxy fight there. At the time, he fought the firm tooth and nail and was its most vocal opponent. Starboard ultimately replaced a majority of the board with Hill staying on and eventually becoming the firm's biggest supporter. Since then, he has served as its director designee at both Marvell Technology and Symantec. He no longer serves on the board of Autodesk, but he could certainly be an informal advisor to Starboard – or a cautionary tale for Autodesk.

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments.