Monday, March 25, 2013

Adobe Keeps on Delivering

Adobe Systems $ADBE continues to seamlessly climb the wall of worry surrounding the stock. It may seem bizarre for me to argue this case if you look at how well the stock has done over the last year, but I happen to think there is still plenty of upside in the company. Its transition to cloud based sales is working and has further to run. In addition its performance confirms the attraction of the software as a service (SaaS) model, and I think investors should approach this investment theme with confidence.

How to Judge Adobe

Naturally when any company makes a transition in its business model the inherent risk and change in operational metrics will attract naysayers. Of course if you are a yea-sayer than you will get a built-in buying opportunity. Such is the case with Adobe. I’m going to try to cover the salient points here as I’ve discussed the development of the company in articles linked here and here.

Essentially what investors need to understand is that shifting from a perpetual model to cloud based subscription will have a negative short term effect on the top line but should generate larger lifetime values (LTV) for the company. In addition it should encourage more people to sign up with Adobe and lead to lower customer acquisition costs.

The key factor in generating higher LTV is to keep the retention ratio high. Indeed, Adobe was asked about this issue on the recent conference call. No number was given, but I believe its management had previously cited a figure of around 80%.

To put this crudely one perpetual customer generates $780 in one year. Now turning to the subscription model, he will generate $480 in year one of a subscription, and assuming an 80% retention rate this turns into .8*480=$384 in year two. In other words the subscription model generates $864 over two years, but the perpetual generates only $780. The problem is that in the first year the revenue generated is a lot less, hence all the fears over declining revenues.

Indeed, Adobe is facing a trough year in terms of revenues. No matter, the key is the ongoing shift to subscribers and long term retention.

What to Expect From Adobe in 2013

In order to track how the key metrics are developing here is a chart of creative cloud subscribers and something that Adobe calls its creative Annualized Recurring Revenue (ARR):

The ARR is simply the number of current and team subscribers multiplied by average revenue per subscription (annualized) and then including Enterprise Term License Agreements (ETLA).

This may sound complicated but it’s not really. The subscriber numbers just represent how well Adobe is shifting people to the cloud model, and the ARR is a way of reflecting future revenues generated by the model. For 2013 Adobe is aiming to finish on 1.25 million subscribers and an ARR of $685 million. To put this into context total digital media revenues for 2012 were $3.1 billion.

Adobe managed to increase the ARR to $233 million (ahead if its $215 million expectations), and the indications are that cloud adoption is working very well. If there is a small cause for concern it is that the average selling price was flat on the new subscribers.

Adobe’s aim is to try to get average revenue per user (ARPU) up to around $50 per month from the figure of around $41 that I estimate it is on now. Similarly there is some uncertainty as to whether Adobe will get back to the kinds of margins that it generated in the past, although this is not necessarily a problem if it can increase total end users by 10%.

The Cloud Franchise?

The poster boy of the ‘franchise’ is Intuit $INTU, and the evidence is that the model works. Intuit was an early mover into the cloud, and it has managed to increase revenues, margins and cash flow conversion. I’ve discussed the company in more detail here. Its core payroll business is growing in high single digits, while its small business group solutions are growing in the mid teens; the opportunity to cross-sell its solutions is enhanced by being in the cloud.

Autodesk (NASDAQ: ADSK) is also moving to the cloud, although its model has some differences. It is bundling its solutions into suites rather than selling them in standalone flagship solutions. In addition, it is not moving towards the subscription based model just yet, so this is more about a pure shift to the cloud than perpetual to subscription. Autodesk is very interesting (I covered it here), and on evaluation grounds the stock looks cheap, but you will have to factor in extra cyclical risk and emerging market risk. The shift to the cloud may be a secular growth story. Autodesk, however, is not the sort of stock to hold if global manufacturing turns down.

Where Next for Adobe?

The company is achieving its aims and managing the transition to the cloud very well. Despite the caution on the management’s side in terms of guidance, I think it is entirely possible that it can get back to the kind of operational metrics that it had before the switch.

In other words, Adobe converted 30% of its revenue into free cash flow from 2009-11, and if it does so again in future then the stock still looks cheap to me. With revenues of $4.1 billion and $4.5 billion forecast for the next two years, this could mean around $1.2 billion and $1.35 billion in underlying free cash flow over the next two years. That is not bad for a business on an enterprise value of around $18.6 billion as I write. I will hold with a $48 target pending that it keeps hitting its targets and the economy holds up.