Saturday, January 5, 2013

What the Short Sellers Dont Understand About Adobe

Investing in stocks is supposed to be easy, but it rarely is. Take a look at Adobe Systems (NASDAQ: ADBE). There is no end of confusion with this stock, and most of it is centered on its transition to subscription-based software as a service (SaaS) sales from a perpetual license model. In other words, Adobe is deliberately trying to give up immediate upfront license revenues in favor of longer term revenues.

This creates a disturbing trend whereby revenues, earnings, and cash flows (everything you normally look at to go up) initially dip but then should accelerate as the longer term benefits of subscription based customers kicks in. In fact, Adobe intends to accelerate this process in order to get to the trough point earlier in 2013. See what I mean about investing not being easy?

Adobe’s Transition Ahead of Schedule

I appreciate that this is somewhat of a conceptual argument, but if you are interested in the stock than you must spend the time understanding it. This chart helps to clarify how Adobe makes its money and the transition.

Note the yearly decline in digital media revenues. Of course this is part of the plan. Let me paraphrase one important comment from the conference call: a customer might pay $780 for a license upfront in the perpetual model, but he will pay roughly $480 a year in the subscription model.

In reality it is not quite that simple, because subscription customers will churn. When asked about the retention ratio (how many annual subscribers would renew), Adobe’s management disclosed that they were modeling 80%.

For example purposes, putting this together gives a very crude figure of $480+ ($480*.8) = $864 over two years instead of $780 over one.  It’s not hard to see how that the immediate transition from $780 to $480 will hurt initially, but then happiness returns as revenues migrate into another $384 next year. This is roughly how to think of Adobe in 2013. The company is modeling a trough year in terms of revenues, earnings, and cash flows, but then forecasts a compound annual growth rate of 15% for the creative cloud from 2014-2016.

If this translates into overall revenue growth, then the $4.1 billion forecast last year will turn into $6.24 billion in 2016, and if Adobe can get back to converting around 30% of its revenues into free cash flow (as it did in 2009-11) then it could be generating nearly 12% of its current enterprise value (EV) by then.

If you want to model 30% FCF Conversion as an ‘underlying rate’ for 2013, then the 4.1 billion in forecast revenues translates into (4.1*.3)/15.9=7.7% of its current EV.

Still think the stock is expensive?

Believing the Numbers

The poster boy of the transition to the cloud is Intuit (NASDAQ: INTU), and if its example is anything to go by then Adobe will find its customers enjoying the ease of access to updates and applications that they otherwise would not have gotten. In addition, Intuit is finding it easier to market and cross sell to its customers. This is a key point for Adobe because its mix digital media and marketing has powerful cross selling opportunities and will help differentiate it from the competition.

In its own right Adobe’s digital marketing solutions are seeing rapid growth as marketers seek to generate returns on investment across multi channel platforms, while using data analytics to work with the huge amounts of information being generated by things like social media.

The Competition

Yes, Google (NASDAQ: GOOG) offers some free analytics and a growing premium service, but there is no sign that it is eating into Adobe’s growth. Google Analytics is seen as being supportive of Google’s overall revenue generation in Search and Advertising rather than a focal point. In addition, IBM (NYSE: IBM) is a growing presence in data analytics, but I believe it is right to think of Adobe as being to marketing analytics what is to sales. In other words, a leader in a fast growing niche whose constituents are familiar with the product and sales approach.  IBM’s target markets are more horizontal across many industries.

Market, Psychology and Criminals

One big point in Adobe’s favor is that –unlike Autodesk (NASDAQ: ADSK) - it is faced with very favorable markets while it makes the transition to SaaS. Digital media and marketing are hot areas right now, while Autodesk is facing some significant near term challenges in its execution however longer term it is starting to look attractive.

Behavioral psychology also suggests that Adobe will find it easier to attract new customers. Offering a lower initial pricing point tends to be more efficient at generating the same revenue because, according to the theory, people tend to overweight near term losses.

Another little discussed point (for obvious reasons) is that Adobe is often the victim of intellectual property theft. Offering more accessible entry points will somewhat encourage those who are currently stealing from the company and using some incomplete Adobe solutions to buy the original subscription.

Where Next For Adobe?

For the short sellers it looks like a day of reflection is at hand. For the longs the progress of the company carries on and ahead of plan. It is not the easiest company to analyze but prospects appear very good here, and I think as long as it exceeds its internal targets then the market will reward the company. There is a reason why so many are keen on investing in cloud based models: they work.