Adobe Systems Incorporated (NASDAQ:ADBE), the San Jose, Calif.-based creator of industry standard media and web design software, is one brave company. Unafraid to turn its business model upside down, Adobe is willing to take heavy losses and book rising expenses to make it happen.
I’m talking about Adobe’s cloud-based initiatives, which I believe will lift its stock price skyward – if it can stabilize its top and bottom growth after the transition. Let’s evaluate the company’s recent quarterly earnings and these growth initiatives to see if investors should take note.
Adobe by the numbers
For the first quarter of fiscal 2013, Adobe Systems Incorporated (NASDAQ:ADBE) earned 13 cents per share, or $65.1 million, a 65% drop from the 37 cents per share, or $185.2 million, it reported in the prior year quarter. Adjusting for one-time charges, earnings dropped year-on-year from 57 cents to 35 cents per share, but still topped the Thomson Reuters consensus estimate of 31 cents.
Revenue declined 3.6% to $1.01 billion, but beat the consensus estimate of $986 million.
Adobe’s weakened earnings were caused by a long-term overhaul of its business model, where it is transforming its packaged software business into a cloud-based one. This led to its quarterly decline in operating margins, which slid from 27.6% to 9.7%. Expenses rose 16% as packaged product sales slid 16%. Adobe noted that these quarterly declines were caused by cloud-based subscriptions rising ahead of expectations.
Rising expenses have been a continuous trend over the past three years. Luckily, long-term debt levels remain nearly unchanged, and its cash hoard has grown substantially to $3.5 billion – but still a modest amount by tech standards.
The Creative Cloud
In the past, Adobe Systems Incorporated (NASDAQ:ADBE) sold its packaged software individually, and users would purchase newer versions as they were released. Customers would pay $700 to $2,500 for software from its Creative Suite – which includes Photoshop, Illustrator, Dreamweaver, Flash Builder and Dreamweaver, among others.
Under Adobe’s new model, known as the Creative Cloud, its focus has shifted towards a cloud-based online subscription model – which offers its Creative Suite software ‘as a service’ on the Internet. Projects on the cloud can be automatically saved online and accessed from any computer, while updates can be installed on the server side, without user intervention. The cloud-based service initially costs less than its packaged counterpart, with subscription fees between $30 to $50 monthly for full access to Adobe’s Creative Suite. As a result, Adobe is expected to take short-term losses to build long-term gains.
During the quarter, Adobe added 12,500 subscribers weekly – a 25% increase from the prior year quarter. The company has successfully attracted users with its free trial period, which allows users to test its tools before converting to full subscriptions. The strategy has been highly effective – during the quarter, Adobe turned 153,000 of those trial users to paid ones, well ahead of the analyst projection of 120,000. In addition, 90% of those showed their long-term commitment by selecting annual contracts. To date, Adobe has converted 479,000 trial users into paid subscribers.
Adobe’s target is to have 1.25 million users in the subscription-based Creative Cloud by the end of fiscal 2013, and up to four million by the end of 2015.
CFO Mark Garrett noted that revenue from the Creative Cloud will grow 15% annually after the transition to subscriptions stabilizes.
The Marketing Cloud
Adobe’s other cloud-based service, the Marketing Cloud, aims to provide digital marketing services to companies. It offers clients a full suite of tools to measure and manage gathered data from social sites, online purchases and page views. As the Internet evolves, these tools, which can quickly chart sitewide statistics, are invaluable in planning and streamlining e-commerce strategies. 70% of Adobe’s digital marketing revenue is generated in the United States.
On this front, Adobe Systems Incorporated (NASDAQ:ADBE) is about to run headfirst into some heavyweight competitors – Google Inc. (NASDAQ:GOOG), Oracle Corporation (NASDAQ:ORCL), and International Business Machines Corp (NYSE:IBM). That’s one David fighting three Goliaths. Google, Oracle and IBM are the largest companies respectively in digital advertising, databases and business services.
However, Adobe is confident that its Marketing Cloud is on track to generate $1 billion in annual revenue, and continue growing its revenue 20% annually, despite the looming threat of these rivals.
Dual-cloud synergies
CEO Shantanu Narayen has repeatedly emphasized the synergies between the Creative and Marketing Clouds. Narayen believes that customers from one segment will be more likely to purchase products and licenses from the other one.
For example, Adobe can use its widespread creative presence in the film and media industries to encourage those companies to purchase its digital marketing software. Large digital marketing customers could also be convinced to use Adobe’s Creative Suite software to upgrade their websites and marketing campaigns.
Combined with its Creative Cloud, online subscriptions are becoming an increasingly important part of Adobe’s revenue, accounting for 31% of total recurring revenue during the quarter, up from 26% a year earlier. Digital marketing revenue rose 25% from the previous year, while total subscription revenue climbed 53%.
Challenges and Bottom Line
Although Adobe’s long-term plans look sound, there are several factors that could derail its growth. First, the company’s comparatively modest cash reserves make its shift to cloud-based subscriptions an “all-in” bet. Second, although Adobe’s initial subscription figures are encouraging, investors will have to wait a few years to see the real churn (return) rates of current subscribers.
Third, I think Adobe Systems Incorporated (NASDAQ:ADBE) is underestimating the ability of Google, Oracle Corporation (NASDAQ:ORCL) and IBM to gum up its growth in digital marketing. Those three companies have much stronger cash positions than Adobe, and have shown in the past that they aren’t afraid to take losses to claim market share.
Company | Adobe | Oracle | IBM | |
Cash and Equivalents | 3.54B | 33.70B | 48.09B | 11.18B |
Long-term Debt | 1.51B | 19.76B | 7.21B | 33.27B |
Source: Yahoo Finance, 3/20/2013
Google is an especially dangerous rival, not only in digital marketing, but also cloud-based creative software. The company’s cloud-based service, Google Drive, already offers a full suite of free office software – Google Docs. In the future, Google could offer cloud-based alternatives to Adobe’s Creative Suite software for free, and although those might not satisfy professional users, they may be enough for average consumers.
In closing, I sincerely admire Adobe’s efforts to brave short-term losses while focusing on long-term goals. It’s the kind of visionary effort that many large tech companies shy away from executing out of a fear of quarterly losses. I believe Adobe’s efforts will pay off, but even so, it is walking a tightrope with a small cash position and it is staring into the eyes of some very well-funded rivals. Therefore, Adobe Systems Incorporated (NASDAQ:ADBE) is an ideal stock for brave, patient investors who share the company’s long-term vision for the future.
The article Adobe and a Tale of Two Clouds originally appeared on Fool.com and is written by Leo Sun.
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