Monday, November 12, 2012

Is Adobe the Next Big Cloud Play?

Behavioral finance enthusiasts are fond of giving examples of how investors act irrationally when faced with a position that involves a short term loss in order to obtain a larger long term gain. They have a point. Nobody really likes the potential for short term losses but if investors can avoid the myopia then Adobe Systems (NASDAQ: ADBE) could present an opportunity to profit while others irrationally avoid it. I like the company's prospects and think there is good potential here.

Adobe’s Profit Drivers

The first principle driver for future growth is its movement into the cloud and the second is everybody else’s movement into the cloud!

In plain English, Adobe is shifting its digital media solutions from a perpetual license model to a cloud based subscription service. Furthermore as more companies shift into the cloud and integrating multi-platform marketing efforts Adobe’s digital marketing suites will become increasingly important as content needs to be created across platforms.

Similarly the huge growth in data generated by engaging in marketing activity on a social networking site like Facebook means that companies need to buy brand building analytics in order to understand the interaction of potential customers. Facebook generates huge amounts of profiling data which can be mined and made sense of by data analytics. While Facebook isn’t necessarily good at using it to make money (or at least commensurate with its market evaluation) it doesn’t mean that marketers can’t do it.

Short Term Pain Long Term Gain

When any company shifts from a perpetual license to a monthly subscription model there will be an inevitable drop off in revenues. Indeed, Adobe predicted that digital media revenues would be down in 2013 but then start to grow strongly in 2014.

Here is how revenues are trending by segment.

Clearly the shift is starting to hurt headline revenues in digital media. In fact Adobe is exceeding its expectations with regards to signing up subscription customers and this means that guidance for the next quarter is going to be adjusted downwards.

Here is what Adobe guided versus market expectations

  •          Q4 Revenues guidance of $1.075-1.1 billion vs. market estimates of $1.21 billion
  •          Q4 Non-GAAP EPS guidance of 53-58c vs. market estimates of 67c

See what I mean about staying calm over the short term?

The key metric that Adobe is nudging analysts towards within Creative Cloud subscriptions (digital media) is something it calls the annualized recurring run rate (ARR). This is the number of current subscribers times the (annualized) monthly revenue per user (ARPU). Here are the numbers plus Q4 guidance. Please note that the first row is my approximation based on company statements.

Subscription growth has been greater than expected and Adobe’s guidance implies that it will accelerate further in Q4. This is good news –because investors should want adobe to shift its sales towards subscription- but perversely it also means that headline revenue numbers will be worse thanks to loss of upfront perpetual license sales.

Long term the key issue is Adobe should be generating more profits from this model and the plan is to increase monthly pricing to closer to $50. Obviously this move will increase churn so I would expect Adobe to try and gradually finesse the increase while keeping an eye on the affect on churn rates.

How Will Adobe Make Money by the Shift?

I confess I was a bit puzzled by some of the things that Adobe said and I think management are being overly cautious and downplaying expectations. For example, when asked about operating margin differences between perpetual sales and subscription they responded by saying there wasn’t going to be any ‘great’ difference. Similarly, cash flow was predicted to be similar with the change in sales.

While this narrative is great for keeping analyst’s modeling expectations in check it is not the sort of experience that a company like Intuit (NASDAQ: INTU) has had when it shifted to the cloud. I’ve discussed Intuit at length in an article linked here. Intuit has managed to increase operating margins, cash flow conversion, reduce churn, and reduce marketing costs as a consequence of shifting to the cloud. It is the benchmark for software companies shifting to the cloud and I don’t see why Adobe can’t do the same. The interactivity and ongoing service provided by Intuit is a similar sort of model to what Adobe will bring.

So far the main advantage that I have heard from Adobe is that it feels it can get 10% more customers by offering services in this way but overall I think management are being too conservative.

Adobe Digital Marketing and Analytics

While most attention was focused on digital media investors should not forget the fast growing digital marketing segment. Adobe’s stated ambition is to be to marketing what (NYSE: CRM) is to sales. This is a poignant aim because Salesforce has entered the marketing analytics arena itself! As Oracle (NASDAQ: ORCL) has found out in the CRM space it is a strong competitor but I think Adobe has a strong position within marketing and the integrated offering of media, publishing, and marketing analytics will resonate stronger than Salesforce’s offering.

As for Oracle and IBM, they both offer a complete solution of data warehousing plus analytics and Oracle is included as a leader in Gartner’s Magic Quadrant of Web Content Management solution providers but this is for its Oracle real time decisions or RTD product which is an overall Business Intelligence application. It is not focused on marketing analytics in the way that Adobe is and with increasing data from social media, marketers will require analytics devoted to that space.

I like what Adobe is doing here and if Intuit is a useful guide then the company can achieve more than it is promising right now. We only have to look at how Intuit took market share from H&R Block and how Salesforce has taken market share from Oracle to see the potential for Adobe. Furthermore, the evidence is that moving to software as a service based models generates lasting improvements in operational metrics. There is a reason why Oracle is responding to Salesforce by moving towards the cloud.

The Bottom Line

In conclusion, the potential to improve its operational metrics and its customer numbers is significant and provides upside potential from what analysts are being guided to model now. Adobe's transformation is not an easy one to contemplate immediately, so thanks to readers who have stuck by reading this post. I think if investors can look beyond the short term revenue disruption the long term potential is there for Adobe to transform itself into a pure cloud play.