Friday, August 24, 2012

Adobe Systems Equity Research

Adobe Systems (NASDAQ: ADBE) became the latest technology company to lower guidance as a result of European difficulties and the market immediately marked the stock down. As ever, rational investors will reflect on the results in the context of the long term picture rather than reacting in a knee jerk fashion. So is there a case to be made for Adobe?
I happen to think there is.


Adobe's Results

Whilst Q2 results beat estimates, the company guided lower than market had estimated for Q3 and it also lowered guidance for full year revenue growth to 6-7% from 6-8%. There were two main reasons for this.

Firstly, Europe was seen as having some softness and management were being 'prudent' in guiding lower. Frankly, I would expect nothing else from a company reporting at this time. There is no doubt that the uncertainty over the Greek elections has given sufficient cause for European corporations to delay spending decisions where they could. However, with the election result seen as being favorable (at least in the short-mid term) there is good reason to believe that this pent-up spending could be released.

Secondly, Adobe expects lower sales in its digital media division (72.8% of sales) due to the launch of a cloud based subscription based model for its flagship creative suite product. I choose my words carefully because, Adobe will still offer the perpetual box solution on the shelf. However, expanding sales via the subscription model will result in lower upfront revenues. Indeed, Adobe stated that it was 'overachieving' with regard to signing companies up to the new model.

Some analysts pointed out that it would take up to four years for Adobe to generate the same level of revenue as compared to a perpetual license sale. This may well be true, but Adobe believe they can sign up at least 10% more clients this way. In addition, let's recall that a SaaS based model tends to imply lower churn rates, lower marketing spend, higher cash flows and ultimately a higher life time value for a client.

The subscription issue is actually what Adobe are trying to do with the company so it would be rather churlish to criticize the company for achieving its aims!


Adobe's End Market Drivers


What makes Adobe attractive is that, unlike competitor Autodesk (NASDAQ: ADSK), its sales growth will largely be dictated by company specific issues as well as secular demand drivers. Autodesk has large element of cyclical demand from the construction and manufacturing sectors, whereas Adobe is a lot more about the secular shift to online and digital based marketing and media.

Adobe's ultimate aim is to be to marketing what Salesforce is to sales. As companies expand their digital presence, they will need to analyze and manage large amounts of data that are produced via this activity. The key advantage being that companies can demonstrate and monitor the return on investment (ROI) for their marketing spend in ever increasing detail.

 As these details become clearer and easier to manage, so marketing departments can become more analytical in how they target marketing spend. Adobe's solutions give corporations the ability to do this. In addition to monitoring ROI in marketing, it also allows companies to engage in predictive analysis of the market reaction to their campaigns. This is especially useful because digital marketing is increasingly distributed over various devices such as mobile, tablet and PC. When companies engage in marketing activity on a social networking site like Facebook (NASDAQ: FB) they will need to engage in brand building analytics in order to understand the interaction of potential customers.

One of the big advantages of Facebook is that it creates a huge amount of profiling data that can be used by Adobe's data analytics and marketing solutions. However, the area is not without competition. For example, Google (NASDAQ: GOOG) offers free and paid-for analytics and IBM (NYSE: IBM) offers its core metrics solution. In addition there are a host of other smaller competitors that offer smaller parts of what Adobe offers as part of a big suite.

Google's free solutions are unlikely to be used as a key part of a large campaign and, customers may feel that the independence Google's paid-for solutions might be compromised by a conflicts of interest. IBM is competitive but Adobe is the clear leader.


So What Next For Adobe?

Clearly the transition to a subscription based model in its flagship product will cause some variability in results in the near term. However, longer term, it is a good move and will make earnings more predictable and with probably higher margins too.

 I like the secular trend towards digital media and marketing and the stock is not expensive. In terms of free cash flow, Adobe has averaged $1.09bn in the last three years. In other words, it's around 7.2% of its enterprise value. That looks attractive for a business with high single digit earnings growth forecast for the next few years and I think there is upside potential to these numbers given the rapid expansion in on-line and digital spending.