Adobe Revenue: Will Subscription Model Work?

Adobe Systems (ADBE) has been adopting a new, subscription model for its software which results in a delay in recognition of revenue. Is that really the reason for its less-than-stellar revenue growth during 2012, or is the company perhaps using this story to cover other trends?

On March 19 Adobe reported revenue for the quarter ending March 1 at $1.008 billion, down 13% sequentially from $1.153 billion, and down 5% from $1.045 billion in the year-earlier quarter. Declining revenue usually results in low P/E ratios, but as I write, at a price of $43.57 per share, ADBE's trailing PE is 30.68, which is very high for a technology stock in this market.

Perhaps earnings are improving despite the revenue downtrend? No, GAAP earnings per share (EPS) were $0.13, down 70% sequentially from $0.44 and down 65% from $0.37 year-earlier. Nor were the poor earnings from strange GAAP rules; non-GAAP EPS was $0.35, down from $0.57 year-earlier.

Surely there must be some new source of revenue and profits that has impressed sell-side analysts, that must be factored into future earnings. While Adobe's Digital Marketing segment had 20% y/y revenue growth, there are no known new initiatives that account for the optimism.

So it would seem to come down to the subscription model. In the past Adobe sold its array of software products as versions available on disk. Photoshop is its best known product, but as the Internet has become the greatest driving force in our economy a variety of products to help with Web site content production and management were introduced. Software products could be bought separately, but most designers needed multiple products, and they were packaged together in Creative Suite. Despite being sold in high volumes, Creative Suite (CS) has never been cheap. The cost of buying a full license for CS depended on the exact options chosen, but let's just ballpark it at $2000.

Over time CS improved, partly just to keep up with changes in the Internet. New versions of CS were introduced about every 2 years. If you already had a full copy of CS you could buy an upgrade for, ballpark, $1000.

With the vast majority of Web designers dependent on CS, charging them $1000 every two years for upgrades was a nice source of recurring revenue. Only many designers found they could skip upgrades at least some of the time. If they had CS 3, they might skip CS 4 and buy the CS 5 upgrade. Wait too long (typically 2 full versions), and the ability to buy at the upgrade price went away.

Meanwhile, for many customers the set of DVDs used to install CS receded into history, as the software package was downloaded from the Internet instead.

In 2012 Adobe decided to push a subscription model to replace the old system. Customers can pay a monthly fee and get upgrades automatically. Better still, instead of having to wait for 6.0 to replace 4.0, the upgrades come as they are available.

However, note the impact on cash flows. Someone who was going to buy CS 6.0 for hundreds or thousands of dollars instead starts a subscription at (rates vary) $49.99 per month.

At the end of a year the subscription client will have paid $600 to Adobe. In two years they will have paid $1200, more than the cost of an upgrade. If customers stop skipping versions, in effect the subscription systems becomes a major price increase. You see other companies doing the same thing, for instance Microsoft with Office 365. The subscription service also cuts down on pirated software.

So the theory of bullish ADBE investors is that once we go through a full subscription cycle revenue will ramp. There might even be some cost of goods sold decrease from the elimination of physical media (management says that would be quite minor).

The problem with betting on this outcome is that you are also betting on the continued dominance of Adobe in making software for Web design.

A year to two years ago investors were not so confident in Adobe, and we should recall why. Apple, a long-time Adobe ally, had refused to allow Adobe's Flash product to be used on its smartphones and tablets. In addition the industry was (and still is) making a transition to a new standard, HTML5. Since then the emergence of other mobile hardware/software platforms has Balkanized the app world, meaning just creating Web pages is not longer the prime goal of developers for the Internet.

Adobe has responded well to this challenge. The new CS, at least in theory, can create Web pages and applications that work reasonably well on multiple device form factors. Being able to design once in CS and export to multiple formats (or to include code that senses the form factor and presents the page accordingly) is a big help to Web designers.

I would still be cautious about projecting out too much. Adobe is not the only company addressing the new Internet Tower of Babel that Apple created. Just for instance, Akamai provides datacenter software that can distinguish between requests from cellphones and computers and message the outgoing data automatically. Open source software that has many of the capabilities of Adobe products is available for free. While most designers, from freelancers to large enterprise design departments, find Adobe is worth the price because of its functionality, free could become more competitive in the future. In addition several proprietary competitors exist in the Web design segment.

It is hard to imagine an Internet without Adobe, but there is danger as well as opportunity in the subscription model. Adobe management is confident that adoption will go well, and that assumption seems to already be built into today's stock price.

Disclaimer: I don't have a position in Adobe and won't take one for at least one week following the initial publication of this story. I do subcontracting work for Microsoft and am long Akamai.

See also:

www.adobe.com

My main ADBE analysis page.

My Adobe March 19, 2013 conference notes

A Tale of Two Tech Stocks: Adobe and Oracle

I listened to two analyst conferences last week. Each was interesting in its own way. Adobe (ADBE) had its conference on March 17, 2009, for its 1st quarter of fiscal 2009, ending February 27, 2009. Oracle (ORCL) had its conference on the 18th, for its third quarter of fiscal 2009, ending February 28.

You can read my extensive notes on the conferences, including the questions asked by analysts, at:

Adobe analyst conference summary for Q1 2009
Oracle analyst conference summary for Q3 2009

Neither company was acting much like a growth stock in the latest quarter, but both did pretty well considering how the global economy has tanked. Oracle revenues were up 2% from the year-earlier quarter. But that flatness hides the fact that Oracle was doing better in mid 2008, so it appears to have come off the top of a wave.

Oracle management talked a lot about exchange rates, how they did really well in the quarter if you ignore the effects of exchange rates. They explained that they manage the company based on constant U.S. dollars. Which sounds something like fiction when the tale is told to an American investor. Maybe my memory is weak, but I don't recall them putting such emphasis on exchange rates when the dollar was low, and so caused them to have strong quarters from Euros and Yen being converted into dollars. The reality is if the Euro is low, they could compensate by jacking up prices in Europe. Probably it is better to keep the customers happy, that is what I would try to do, but I would not pretend I had a great quarter when my receipts from outside the U. S. were down so much, no matter what the cause.

Mind you, Oracle is a great company. When they saying they are taking market share from SAP, IBM, and Microsoft, they are not kidding. They have found a way to build on their success of their database products. No competitor has been able to match their strategy of buying companies that have technologies that can be sold as add ons to current Oracle customers. They claim there is much interest in new products like Fusion middleware and the Exadata system.

Adobe is another great company, but they have been hit harder by the economy than Oracle. Revenues were down 12% from a year ago despite the introduction of CS4, which in normal times would probably be selling far better.

Adobe has always charged a premium price for premium products. Enterprise demand remained strong, they said. But the little guys apparently decided that in these uncertain times Creative Suite 3 was good enough for now. The cost of buying Adobe products, or even of upgrading them, is significant for professionals. The software costs more than the computers that run it.

But you know what will happen. The amateurs may find a way to make do, but all the pros will want CS4. They know that if they don't pay to upgrade to CS4, eventually they will fall behind their competitors and lose their right to upgrade to CS5. To the extent that this economic shake out causes people to leave the computer graphics business, Adobe will be hurt. But the most likely scenario is that the need for graphics professionals will grow, and sooner or later they will budget the money for upgrades. So I expect that as soon as the economy shows some life, Adobe will recapture any money it did not make last quarter. The world can no longer live without Photoshop, Acrobat, and Flash.

Adobe (ADBE) CS4 Failure to Launch?

Adobe (ADBE) at its analyst conference yesterday reported that fiscal Q4 2008 revenues were barely above those of the year-earlier quarter. Profits increased due to cost cutting.

While other segments increased sales year-over-year, flagship Creative Suite 4, or CS4, revenues were down 11% from year-earlier. Management also commented that compared to the launch of CS3, sales were running 20% slower. Management claimed that this was entirely due to the poor external economy. During the question and answer period several analysts asked if CS4 sales might be lagging because it is not a compelling upgrade to CS3. Management insisted that it is the best productivity enhancer since the invention of computer graphics, that everyone loves CS4, they just are slow to upgrade because of the cost.

Management is probably right on this. There really aren't any good alternatives for professional graphics people. People hate the high price of Adobe products, and they hate being squeezed by the upgrade cycle, but they hate being at a professional disadvantage to those who have upgraded even more. If there is any problem for CS4, it is that in a recession a large number of graphics and Web designers will lose their jobs or their clients. With the newspaper industry threatening to disappear in its entirety, and CS4 making the remaining graphics humans so much more productive, it could be that the CS4 client base will shrink permanently.

Future growth may come from the numerous other Adobe web initiatives. This is a company that knows how to innovate and squeeze money out of its customers (I point that out only because so many highly innovative technology companies lately have not been able to figure out how to make their customers pay for innovation). Case to point is video delivery over the Internet. A few years ago this was done mainly through Apple and Microsoft products. Now it is mainly done with Adobe Flash.

I agree with management that when this recession is over, Adobe will do better, but then I could say that of every company in the world right now.

For a full report on the financials, see my Adobe analyst conference summary for fiscal Q4 2008.

I don't own stock in Adobe. I do use Adobe products. I sometimes work for Adobe competitors and in the past have worked on books about Adobe products.

More data:

www.adobe.com