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Burning Questions Of Our Movement

So, what happens next? What should we, as the founders of this company and owners of the largest piece of it, be doing to maximise the value of what we've built? What should our company be doing to advance within the industry? How can we best apply the principles upon which we built this company to the very different circumstances and environment in which we now operate? Obviously we've done a lot of right things, but what have we done wrong? What significant opportunities are we, at this very moment, overlooking? And why are our sales only $2 million per month and not, say, ten or twenty million? Can we get there? How?

One fatal luxury of success is a failure to question one's assumptions. We must constantly be looking at what we're doing and the general environment and watch for indications we should be changing our strategy. There is, to my mind, a growing spirit of ``we're number 1'', ``we're unbeatable'', and ``all the competition is   garbage''. This can destroy us! We have to maintain good morale and believe in what we do, but we have to remember that we got where we are by running scared. There is no shortage of competitors out there with a lean and hungry look. We should be continually reviewing their products and strategies and taking the best ideas for incorporation into our own.

``The only function of economic forecasting is to make astrology look respectable.''

Ezra Solomon

We've talked a lot informally about just what is involved in being a public company. I'd like to put it on paper, just so everybody has the same information all at the same time. Once you become a public company you operate in a fishbowl. Not only is the value of your company and therefore your performance rated daily in the open market, many business decisions you were free to make in private now become open for the world to see. This can lead to making decisions which may be bad for the long term future of the company in order to prevent a cataclysm in the market for the company's stock.

Those who hold and trade the stock obtain information about it primarily from the quarterly and annual reports the company files, from press releases the company issues when important events occur, through reports by financial analysts who follow the stock and are in regular contact with management, and to a lesser extent from presentations the management makes at various financial conferences. Our stock is held largely in institutional hands. This means that it is mostly in the accounts of pension funds, pooled investment accounts run by banks, and in mutual funds specialising in high-tech. The money managers who run these funds are accountable to the people who put the money in them, and their results are evaluated on a quarterly basis. If a fund is significantly underperforming the market, the money can evaporate as fast as the morning dew on the surface of Mercury. In fact, if a pension fund is underperforming the market, the custodians of it can be personally sued for malfeasance of their fiduciary responsibilities under ERISA. So to put it lightly, these money managers are under a lot of pressure.

  They, in turn, look at the quarterly results issued by the company as the major indicator of the company's progress. It's a gross oversimplification, but worthwhile nonetheless to consider the stock price as made up of two components, the earnings (usually expressed as earnings per share or EPS), and the price/earnings ratio or PE. Thus:

Price = EPS PE

The reason for breaking things down this way, is that similar stocks, such as banks, auto companies, aerospace companies, copper mines, and CAD companies will, in the absence of outstanding information peculiar to an individual company, trade at about the same P/E ratios. Thus one talks about the ``market multiple'' of a given industry. The P/E band moves up and down constantly; in an ebullient market such as 1983, P/E's overall may be twenty times those of a gloom and doom period such as 1974. Autodesk is in a somewhat strange position in that if it is considered a microcomputer software company it will probably settle at a P/E about half that it would command if seen as a CAD company. And of course next year, if software is in and CAD is out, the numbers may reverse. But in the minds of those looking at the stock on a daily basis, the P/E is relatively constant.

Thus, the primary determinant of the price is the earnings per share. This is very simple to calculate: you take our profits after taxes and divide by the number of shares outstanding. Zooming in a bit more, and assuming the number of shares as a constant, our earnings are broken down as follows:

PreTaxEarnings = Sales - Expenses
AfterTaxEarnings = PreTaxEarnings (1 - TaxRate)
GrossMargin = PreTaxEarnings / Sales
AfterTaxMargin = AfterTaxEarnings / Sales

Now let's look at these numbers and what they mean in the minds of investors. The two key numbers everybody's trying to guess are Sales and EPS. Thus, if you overhear me talking to an investor trying to probe us for information, you might hear me say ``we're sticking with 90 cents on 25'', which translates to ``Look, I hope we really blow the top off the industry and end up with the whole pie, but I sure don't want to be dumped on if `all' we do is increase our sales by 250% this year. We're 95% confident that, assuming no changes in the current competitive environment and the economy as a whole, that our sales will be at least $25 million and we'll earn at least 90 cents per share of outstanding stock.''

As each set of quarterly results are issued, they will be eagerly digested for indications as to whether the company is ahead, on, or behind expectations. Investors want to see each quarter increase both Sales and EPS from the last, and compare each quarter's results with those of the comparable quarter in the previous year to see if growth over the year matches the expected growth rate. To date, our business has not been seasonal, so straight quarter-to-quarter growth will be expected.

Before we move on to the edgy relationship between the company and the financial analysts who cover it, I'd like to define ``visibility'', a key term in that relationship. Visibility measures to what extent outsiders can predict the business trends of a company overall. Consider a defence contractor. In that business, you receive contracts to do work, and the size of the contract and the payment terms are specified in advance. Any changes in the contract are public documents and are disclosed immediately in any case. Thus income is calculable by anybody who reads the paper. Expenses tend to also be pretty well predictable from historical measures, so all you need to come up with pretty reliable sales and earnings forecasts is a subscription to Aviation Leak and a pocket calculator. This is a business with high visibility.

Now let's consider a hypothetical company whose sales are almost entirely booked over the telephone. Most orders are shipped within 48 hours of receipt, so there is no backlog and no sales contracts to forecast. If the phone stops ringing, the money stops flowing. This company's sales flow through many different kinds of outlets and into numerous markets, which may behave differently as economic conditions change. The product costs almost nothing to manufacture, and is sold for a high price which is justified by difficult to measure productivity measures. The high price is largely the result of a lack of competition in the market; a determined competitor could sell such a product for $100 and make money doing it. The expenses of this business are mostly sales and marketing expenses, which are determined by the need to respond to competition and open new markets. Such a business would have really lousy visibility. I leave to you the exercise of naming such a company.

So who do those whose jobs are on the line turn to in order to decide if they should buy or sell our stock? The security analysts. These analysts usually work for the various investment bankers, and ``follow'' a group of stocks, usually in one industry. The analysts initially following our stock are Peter Schleider of L.F. Rothschild and John Rohal of Alex. Brown. We hope additional analysts follow our stock in the future. The analysts write regular research reports on the stock, and talk to management in order to prepare their own estimates of the company's future. These reports are then used by the institutional sales forces of the bankers to sell stock in the aftermarket. An analyst will probe to get as much information as possible, and then issue his own forecast. In some cases this forecast may be much more optimistic than that issued by the company. If the company fails to meet the forecast, the analyst will then write a report which says that the company ``had disappointing earnings'', even if they represented a new high and exceeded the company's own expectations. Now this may be a little hyperbolic, but it has happened, and it does happen. Maintaining close contact with the analysts and seeing that they reach the conclusions you want is an ongoing task for a public company.

In the offering process we ``signed up'' to a set of performance criteria. Our investors will be watching these and, having been sold very many high tech stocks that went south soon after the offering, will be using them as triggers to dump the stock. We cannot let this happen. Therefore, here are the numbers by which we live and die. All of these numbers are consolidated, i.e., the sum of domestic operations and all foreign subsidiaries. We must do $25 million in sales this year (FY ending January 31, 1986). We must generate 90 cents per share after tax profit. Our gross margins must be in the band from 35% to 40% and therefore our after tax margins should be about 20%. We must build the company and our distribution channels and product line to support $45 million in sales the following year and $1.45 per share after tax profit.

These are the company's must-meet goals. We hope to do a lot better, but we must not do worse. If we fail, the management will be battered by the shareholders, and our stock will be gored. But the management cannot make these goals happen. The company as a whole must do this. I tried to involve as many as people as possible in formulating these goals. Now we have our job to do. Let's get on with it.

What will be the environment in which Autodesk will be operating in the future? First of all, we cannot spend the proceeds of the offering on virtually any of the needs we perceive the company to face. Since in the software business we don't use any expensive capital equipment, virtually everything we would spend the money on shows up as an expense on the income statement. If we hire people, that's salary. If we do an advertising blitz, that's promotion. From the standpoint of accounting, spending the money we raised in the offering is precisely the same as spending money we get from selling an AutoCAD. Now please refer back to the equations given above which calculate the critical numbers. If we spend the money from the offering to hire people, or to advertise, or to do any of the obvious things, those dollars are added to Expenses. That gets subtracted from Sales and reduces earnings and margins. Assuming a marginal tax rate of 50%, the reduction of the pretax numbers is twice that of that of the after tax numbers. And remember that our performance is being watched quarterly. Even if we can spend the money knowing that it will generate a major return in six months, that's not good enough. The added expenditures will affect the one or two intervening quarters, and Autodesk will be perceived as having ``disappointing earnings'' or, even worse, ``eroding margins'' and look out below. (If you think for a minute you'll see why eroding margins are a superb leading indicator of competitive pressure.)

Now this may seem to be a lot to digest, but it really is crucial to the way in which the company will continue to operate. When I say, ``We have all this money but we can't spend it'', I am not setting up a smokescreen to deny people in the company what they want. I'm just describing the reality which I hope the above has somewhat clarified.

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Next: What Business Is Up: Information Letter 12 Previous: Mid-Game

Editor: John Walker