Starboard loses first legal battle with Autodesk; the fight is just beginning

work: Autodesk is involved in three-dimensional (3D) design, engineering, and entertainment technology solutions. The company’s products focus on the areas of architecture, engineering and construction, AutoCAD and AutoCAD LT, manufacturing, and media and entertainment. 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 comprehensive digital design, engineering, manufacturing, and production solutions to manufacturers in the automotive, transportation, industrial machinery, consumer products, and building products industries. The company also offers Wonder Studio, a cloud-based 3D animation and VFX solution.

Stock market value: $52.2 billion ($242.31 per share)

Ownership: Approximately 1% (positions worth over $500 million)

Average cost: None

Activist Commentary: Starboard is a highly successful activist investor with extensive experience helping companies focus on improving operational efficiencies and profitability. The firm has conducted a total of 150 activist campaigns to date, with an average return of 24.83% over that period, beating the Russell 2000 Index’s 12.99%. Starboard has an even better track record in the information technology sector, with an average return of 36.43% over that period across its past 53 initiatives, beating the Russell 2000 Index’s 18.82%.

Starboard sent a letter to Autodesk shareholders on June 17 announcing that it would file a lawsuit to force the company to postpone its 2024 annual meeting scheduled for July 16 and reopen the director nomination period. This follows Autodesk’s delay in disclosing an internal investigation into fraud reports that Starboard claims may have misled and disenfranchised shareholders. Although the Delaware Chancery Court ruled against Starboard on June 20, the activists still believe Autodesk needs to strengthen its board of directors, as well as improve growth and profitability through operational performance, capital allocation policies, and investor communications.

Autodesk is a global leader in design, engineering, and entertainment software solutions. Approximately 75% of revenue comes from architecture, engineering, and construction (AEC) solutions. These are application areas where Autodesk is either the #1 or #2 player, generating significant recurring revenue and maintaining pricing power. The remaining revenue comes from growing manufacturing applications (20%) and legacy applications in entertainment, such as film and television (5%).

Autodesk is a leader in AEC software, with gross margins of over 90% and operating margins of 35%. The company’s gross margins are best in class, reflecting its value-add and pricing power. And at first glance, the company’s operating margins are not that bad compared to its peers. However, Starboard correctly judges the company’s operating margins not by its peers’ average, but by the potential inherent in its gross margins and market position. Autodesk currently spends about 28% of revenue on sales and marketing, compared to 23% for its peers. It also spends 9% on general and administrative expenses, compared to 5%-7% for its peers. In other words, its operating expenses as a percentage of revenue are about 1,000 basis points higher than its peers. Moreover, the company’s operating margin for fiscal year 2023 is 36%, falling short of its own target of 38%, revised downward from its original target of 40%, despite front-loaded revenue from multi-year contracts. This effort could have very well been a friendly and constructive activist campaign for Starboard. The company has extensive experience working with companies like Autodesk at the board level to improve margins and create significant value for shareholders. Again, this is a great plan and would have only required adding 2-3 directors to the board.

However, that collaborative and constructive scenario appeared to be dashed on April 1, when Autodesk publicly notified shareholders that it would delay filing its annual report after information was provided to the Audit Committee, which in turn launched an investigation into the company’s free cash flow and non-GAAP operating margin practices. Ultimately, the Committee found that despite indicating to investors that Autodesk was moving its enterprise customers to annual billing, it had recently pursued multi-year, upfront contracts at levels that exceeded historical usage, helping it meet its FY23 free cash flow targets.

To make matters worse, the company had reported these issues to the U.S. Securities and Exchange Commission by early March, but withheld the information from investors until the nomination period had ended, preventing possible activist director nominations this year. Nevertheless, Starboard said it had informally offered to work with Autodesk to improve its board, but the company declined. Starboard then asked Autodesk to reopen the nomination period, given the facts and circumstances, to allow shareholders to make an informed decision following the recent disclosures. The company rejected the offer. Starboard filed suit in the Delaware Court of Chancery to compel Autodesk to postpone its 2024 annual meeting, scheduled for July 16, and reopen the nomination period, which ended on March 23. The court dismissed Starboard’s request on June 20.

While the findings alone are disturbing, we believe there are two points that could elevate this from a serious accounting issue to a much more serious governance issue. First, Autodesk reports free cash flow as a key operating metric, which also drives executive compensation. Second, the bigger issue may be how the board and management responded to the investigation. Here, the board appears to have decided that Deborah Clifford could not remain in her position as CFO. What followed did not inspire a strong sense of board oversight and accountability. Instead of firing her, Autodesk appointed Clifford as Chief Strategy Officer. While the first issue reflects a lack of alignment between management and shareholders, the second issue is directly related to the board’s ability to oversee and hold management accountable.

These developments at Autodesk will undoubtedly require governance changes. The level of change required will depend on the level of engagement, not the company’s actions. Starboard remains to be seen whether this situation will be remedied with fewer seats on the board or a full overhaul of the board and management, but that will become clear as the facts regarding accountability emerge. From our perspective, the company’s response of imposing penalties on management and informing and cooperating with shareholders does not bode well for a “small change” scenario. Governance issues are paramount here and need to be addressed before Starboard can make real economic changes that directly enhance shareholder value.

Once that is resolved, a restructured board and management team can focus on improving operating margins and trading multiples to the extent necessary. Improving margins by just 1,000 basis points can significantly increase shareholder value, but applying larger multiples has an exponential effect. Currently, Autodesk trades at 19.4x EV/CY2025E earnings before interest, taxes, depreciation, and amortization, compared to 30x for some peers and 23.5x for the peer average. While an argument can be made that a market leader like Autodesk should trade at a higher multiple than average, even reaching the peer average can be very meaningful for shareholders. This will happen if shareholders have more confidence in the company’s governance, if the board has more transparency, oversight, and accountability, and if management is meeting and exceeding targets.

Whether that happens depends on several factors. Starboard’s loss in Delaware court makes the quick scenario unlikely. There is a proposal in this year’s proxy that would allow 25% of shareholders to call a special meeting, but even if it is approved, the company may delay implementation, making it practically useless before the next annual meeting. This may depend on how serious the board is about it and how well it can convince Starboard and other shareholders. If not, we 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 that happens, the company’s chances of winning will be significantly reduced.

One last thing: this isn’t the first time Autodesk has been involved with activists. Sachem Head ran an activist campaign here from November 2015 to June 2017, eventually resulting in three board seats and the appointment of a new CEO, Andrew Anagnost, who is now at the helm of Autodesk. One of the people appointed to the board as per Sachem Head’s agreement was Rick Hill, who has a very interesting relationship with Starboard. He was the chairman of Starboard when they fought the proxy fight on Tessera. At the time, he fought the company hard and was its most vocal opponent. Starboard ended up replacing the majority of the board, and Hill stayed on and ended up being the company’s biggest supporter. Since then, he has been appointed to the board of both Marvell Technology and Symantec. He is no longer on Autodesk’s board, but it’s entirely possible that he will become an informal advisor to Starboard. Or, it could be a lesson for Autodesk.

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