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

Adobe Waiting for CS6

Adobe (ADBE) yesterday reported a Q1, 2012 with only a slight increase in revenue over Q1 2011, with a decline in earnings per share (EPS). I use Adobe as a proxy for the computer software industry, but in this case special factors may have contributed to the poor showing, so the industry as a whole may do better in Q1. Adobe's fiscal Q1 2012 ended March 2, 2012, so it is a frontrunner to firms that report on a regular calendar basis (Q1's ending on March 31).

GAAP revenue was $1.045 billion, down 10% sequentially from $1.152 billion but up 2% from $1.027 billion year-earlier. Net income was $185.2 million, up 7% sequentially from $173.7 million but down 21% from $234.6 million year-earlier. Earnings per share (EPS) were $0.37, up 6% sequentially from $0.35 and down 20% from $0.46 year-earlier.

At the analyst conference call management claimed the poor showing was because of customers beginning to anticipate the future release of Creative Suite 6 (CS6). Creative Suite comes in a variety of flavors incorporating a number of Adobe software products such as the well-known Photoshop and Acrobat. Because the web is transitioning to include mobile devices and a new standard, HTML5, the products for web developers (including page layout, photo, animation, and video editing) are also changing rapidly.

Because of cost issues, developers sometimes do not upgrade to each new version. This was particularly true during the recession. If is possible that management is right in believing that the number of changes has become so great that CS6 will be a must-do upgrade even for customers that have CS5.5 or CS5, much less earlier versions.

The problem for web designers is that the design standards of 3 years ago, where they could count on a (well-designed) site appearing the same to viewers no matter which browser or operating system they used. Now every mobile device has a different screen size and many device users prefer apps, using a mobile web browser only as a last resort. What designers have had to do since the iPhone introduction is either write multiple web pages (one for desktop/notebook screens and one for each mobile device) or include programming on a single page that reformats that page for various screen configurations. Plus they

Given the endless complaining I have heard from fellow designers and programmers, I expect CS6 will be a big hit if it actually delivers the ability to design once and deploy, with minimal changes, to an assortment of devices. On the other hand if they think CS6 fails in that regard, they will probably cherry pick and only upgrade the Adobe software that work well for them.

The lower profits on flat revenues is attributable to up front investment in marketing and readying CS6 for deployment.

A number of pundits declared Adobe dead when Apple refused to support Flash animation on iPhones. So far Adobe is coping well with the new environment. It is the nature of IT things to see rapid die-offs and new growth.

Another area Adobe seems to be doing well in is helping its customers with dealing with another complex area, Internet advertising. A well-designed web page that does not generate ad revenue is not a good ROI. In January Adobe closed its acquisition of Efficient Frontier, which should help keep Adobe in the forefront of this area.

Today Adobe closed down $1.35 to $33.16. Its price to earnings ration was 29.5, which is pretty steep even if you buy the back-with-CS6 story. Adobe's lack of faith in its own future is shown by it's failure to pay a dividend. On the other hand it generated $314 million in free cash flow and ended with a cash balance of $2.8 billion.

CS6 is scheduled for release in late Q2, so probably in May. We will get a little bit of revenue feedback when Q2 results are announced in June.

Disclaimer: I don't have a position in Adobe. I do use some Adobe software, and I am long in a variety of technology stocks that might have relationships with Adobe.