Autodesk emerges victorious in initial legal battle against Starboard, but the war may continue.

Company: Autodesk (ADSK)

Autodesk offers a range of 3D design, engineering, and entertainment technology solutions for various industries, including architecture, engineering, construction, manufacturing, and media and entertainment. Its product offerings include AutoCAD Civil 3D, Building Connected, Autodesk Build, Revit, Computer-Aided Manufacturing Solutions, Fusion 360, ShotGrid, and 3ds Max. Additionally, Autodesk provides comprehensive digital design, engineering, manufacturing, and production solutions for manufacturers in automotive, transportation, industrial machinery, consumer products, and building product industries. The company also offers Wonder Studio, a cloud-based 3D animation and VFX solution.

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

Activist: Starboard Value

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

Average Cost: n/a

Starboard is a highly successful activist investor with a wealth of experience in helping companies improve operational efficiency and increase margins. Over the course of their 150 activist campaigns, the firm has achieved an average return of 24.83%, compared to 12.99% for the Russell 2000 over the same period. In the information technology sector, Starboard has an even more impressive track record, with a return of 36.43% in 53 prior engagements, compared to 18.82% for the Russell 2000 over the same period.

What's happening

On June 17, Starboard announced that it is filing a lawsuit to delay Autodesk's 2024 annual meeting and reopen the director nomination window. This is due to Autodesk's delayed disclosure of an internal investigation into reporting irregularities that Starboard believes may have misled and disenfranchised shareholders. Despite the Delaware Chancery Court ruling against Starboard on June 20, the activist still thinks that Autodesk needs board enhancement and improved growth and profitability through operational performance, capital allocation policies, and investor communications.

Behind the scenes

Autodesk generates about 75% of its revenue from Architecture, Engineering, and Construction (AEC) solutions, where it is the No. 1 or No. 2 player. Its remaining revenue comes from its growing manufacturing applications (20%) and legacy applications in entertainment like movies and TV (5%).

Autodesk is a leader in AEC software with 90%+ gross margins and 35% operating margins. Its gross margins are best in class, reflecting its value add and pricing power. However, Starboard correctly judges the company's operating margins based on the potential embodied in its gross margins and market position. Autodesk spends approximately 28% of its revenue on sales and marketing and 9% on general and administrative expenses, which is higher than its peers. The company's FY2023 operating margins of 36% missed its own target of 38%, despite front-loading revenue through multiyear contracts. Starboard has great experience working with companies like Autodesk from a board level to improve margins and create shareholder value. Adding only two or three directors to the board would have been a great plan to improve margins and create value for shareholders.

On April 1, Autodesk announced that its annual report would be submitted late due to an audit committee investigation into the company's free cash flow and non-GAAP operating margin practices. 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 exceeded their historical use, helping the company meet its FY23 free cash flow goal.

In March, Autodesk informed the U.S. Securities and Exchange Commission of issues with its board, but withheld this information from investors until after the closure of its nomination window. Despite this, Starboard offered to work with Autodesk to improve the board, but the company declined. Starboard then requested that Autodesk reopen the nomination window so that shareholders could make a fully informed decision following the recent disclosures. The company rejected this offer, and Starboard filed a lawsuit in the Delaware Court of Chancery to compel Autodesk to delay its 2024 annual meeting and reopen the nomination window. The court rejected Starboard's claim on June 20.

The investigation into Autodesk's accounting practices has raised concerns beyond just an accounting issue. Firstly, the fact that free cash flow was a factor in executive compensation suggests a lack of alignment between management and shareholders. Secondly, the board's response to the investigation, where Deborah Clifford was appointed as chief strategy officer instead of being fired, raises questions about the board's ability to oversee management and hold them accountable.

It is clear that the developments at Autodesk will necessitate governance changes. The extent of these changes will not be determined by the company's actions but rather the level of involvement. Starboard is still uncertain whether this situation can be resolved with a few board seats or a complete board and management overhaul, but that will become clearer as more information about accountability becomes available. From our perspective, the company's response to penalizing management and engaging with shareholders does not suggest a "minor change" scenario. The governance issue is critical and must be addressed before Starboard can make any significant economic changes that directly benefit shareholders.

To improve shareholder value, Autodesk should focus on increasing operating margins and trading multiples. While increasing margins by 1,000 basis points would have a significant impact, applying a higher multiple to that would have an even greater effect. Currently, Autodesk trades at an EV/CY2025E earnings before interest, taxes, depreciation and amortization multiple of 19.4x, which is below some peers and the peer average of 23.5x. While Autodesk is a market leader and should trade at a higher-than-average multiple, simply reaching the peer average would be meaningful for shareholders. This occurs 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 instead of missing and lowering them.

The loss of Starboard in the Delaware Court has removed the quick scenario from the table. Although there is a proposal on the proxy this year that would allow 25% of shareholders to call a special meeting, even if it is approved, the company can delay implementation, making it ineffective before the next annual meeting. The outcome will depend on the board's willingness to dig in and the persuasiveness of Starboard and other shareholders. If it comes to that, the company's chances of winning will decrease dramatically. However, Starboard is an activist with the patience and conviction to wait until 2025.

Autodesk has been engaged by an activist before, specifically during Sachem Head's campaign from November 2015 to June 2017, which resulted in three board seats and the appointment of a new CEO, Andrew Anagnost. It is worth noting that one of the director designees resulting from Sachem Head's agreement was Rick Hill, who has a history with Starboard. Hill was the chairman of Tessera when Starboard waged a proxy fight there, and he fought the firm tooth and nail. Ultimately, Starboard replaced a majority of the board with Hill staying on and eventually becoming the firm's biggest supporter. Since then, he has served as Starboard's director designee at both Marvell Technology and Symantec. Although he no longer serves on the board of Autodesk, he could potentially be an informal advisor to Starboard or a cautionary tale for the company.

Ken Squire is both 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.