AutoDesk has been one of the beneficiaries of the Software-as-a-Service investor phenomenon. Investors have paid up significantly in valuation terms for stocks like ADSK and ADBE, which have shifted from a one-time software sale model to a subscription model to obtain the software. Both stocks have hit new all-time highs over the past year as more and more customers switch to the subscription model.
We have expressed our skepticism on numerous occasions about the enthusiasm surrounding these stocks, as I mentioned in an ADBE Name That Trade post in May:
Color me skeptical. Adobe was selling Adobe software products 3 years ago, and it is still selling Adobe software products today. The potential market for its products, the profile of its customers, and its competition has not changed. Add it all up, and I simply don’t see the investment rationale for paying a significantly higher valuation for what is, to me, a business that is almost identical to what it was a few years ago.
Now, the market is naturally growing for ADSK and ADBE, especially internationally. ADSK gets around 70% of its revenues from outside the U.S., and its main growth markets are emerging markets where engineers use AutoCAD for new construction projects. It’s not as if the underlying business wouldn’t grow if the business model remained the one-time software sale as it was in the past. But investors are optimistic that the potential market opportunity (and increased price discrimination), will increased earnings growth in the long run.
However, consensus analyst estimates expect around $3.10 in EPS in ADSK in 2017, and have modeled out about 10% earnings growth from there, as the subscription model becomes mature. If ADSK meets those expectations (quite uncertain given that we’re talking 3-5 years out), then the company will have grown EPS from $1.93 in 2012 to $3.09 in 2017. That would imply an annual earnings growth rate of around 10% per year. In other words, ADSK seems to be a business that grows around 10% per year, whatever the model.
However, the stock around $55 is already nearly a 18x multiple on the 2017 earnings estimate. That seems like quite a stretch for a business that is expected to grow 10% after that. Moreover, management itself acknowledges the numerous risks to its business model shift in its recent quarterly report:
Market acceptance of such offerings is affected by a variety of factors, including but not limited to: security, reliability, performance, current license terms, customer preference, social/community engagement, customer concerns with entrusting a third party to store and manage their data, public concerns regarding privacy and the enactment of restrictive laws or regulations. Whether our business model transition will prove successful and will accomplish our business and financial objectives is subject to numerous uncertainties, including but not limited to: customer demand, attach and renewal rates, channel acceptance, our ability to further develop and scale infrastructure, our ability to include functionality and usability in such offerings that address customer requirements, tax and accounting implications, pricing and our costs.
The company is obviously trying to reduce legal liability by laying out all of the risks, but the risks are not trivial either. While AutoCAD is a splendid software offering, the business execution of a major customer transition is no small task.
Technically, ADBE looks like a double top given its price action over the past 6 months:
[caption id="attachment_42664" align="aligncenter" width="600"]
ADSK daily chart, 50 day ma in pink, 200 day ma in yellow, Courtesy of Bloomberg[/caption]
Given that ADSK remains below $57.50, the stock is at risk of testing the $50 support level in the coming weeks. No major catalysts exist for the stock until the late August earnings report, which is implied volatility is relatively low:
[caption id="attachment_42665" align="aligncenter" width="600"]
ADSK 30 day implied volatility, Courtesy of Bloomberg[/caption]
Options will start to get more expensive as the earnings date approaches, but at the moment, implied volatility is relatively cheap considering the large moves in ADSK over the past year.
TRADE – ADSK ($55.70) Bought Aug 55 / 50 Put Spread for $1.38
-Bought 1 Aug 55 Put for 1.80
-Sold 1 Aug 50 Put at 0.42
Break-Even on Aug Expiration:
Profits: btwn 50 and 53.62 make up to 3.62, max gain of 3.62 at 50 or lower
Losses: btwn 53.62 and 55 lose up to 1.38, with max loss of 1.38 at 55 or higher
Rationale: We view the likelihood of a 5-10% move higher in ADSK as less likely than a 5-10% move lower over the next month, for 3 main reasons. First, the technical situation suggests significant resistance above. Second, the growth stocks in general have been under pressure this week, which could be the start of a Mar/Apr type selloff. Finally, ADSK has rallied more than 20% over the last 3 months, even with an already elevated fundamental valuation. We plan to hold on to this position unless ADSK breaks $57.50 to the upside or $52.50 to the downside.