Adobe (ADBE) is set to become the poster child for old-line software companies — such as Microsoft (MSFT) and Oracle (ORCL) — that are transitioning from traditional software licensing to cloud-subscription models.
When Adobe reports third-quarter earnings on Sept. 17, it will mark the first report since the company officially completed a swift three-year transition to the cloud.
So what should investors expect from a reinvigorated Adobe Systems?
ADBE Stock: Squeezed Earnings
One of the key attractions of a cloud-based revenue model is that it allows a company to lower the entry price of its products, and is thus able to rapidly build a large customer base.
Adobe used to charge a hefty price tag for its premium-boxed software products, but now users can own those same products (and then some) for a song. Prior to 2011, when the company embarked on its ambitious move to the cloud, Adobe used to charge a cool $700 for its flagship Photoshop software.
Under the new model, legions of Adobe fans can now not only enjoy the same iconic Photoshop products, but also have Lightroom thrown in for good measure, all for a piddling sum of $10 per month. Adobe users can now access the company’s Creative Cloud on a subscription plan that charges just $50 per month (students and current users pay even less).
While lower entry costs make for more subscribers, it comes at a price — Adobe realizes much less income over any given fiscal period when selling subscription software products than it would otherwise book when selling perpetual software licenses. This has clearly been reflecting on Adobe’s balance sheet.
In 2011, Adobe reported net income of $833 million on sales of $4.2 billion. Enter the cloud. In 2014, Adobe could only manage to squeeze net income of $268 million on revenue of $4.1 billion. Although Adobe’s top line managed to almost recover from the effects of much lower product prices under the cloud model, the company’s earnings remained lackluster on a quarter over quarter basis.
Time to Reap the Rewards
Adobe’s story sounds quite similar to that of numerous other old-line software companies that now swear by a cloud model — and its long-term story has a much more likable ending.
Adobe exited Q2 2015 with a record 4.6 million Creative Cloud subscriptions, with more than 70% of the company’s revenue now coming from subscriptions. As a result, net income doubled during the first half of the current fiscal year to $233 million, as the company starts reaping the rewards of a successful transition where most of the company’s revenue is of the cloud variety.
Net income was up 67% during the last quarter, and could continue on its hot streak if the company meets its target to finish the year with 5.9 million Creative Cloud subscriptions. And ADBE has a pretty good track record when it comes to earnings results, managing to beat earnings estimates for the last six quarters.
This is the quintessential Software as a Service revenue model, where a company realizes much more revenue and earnings over the lifetime of the average customer than it would otherwise selling perpetual licenses.
Solid Long-Term Potential
Adobe has serendipity to partly thank for its current success, after the company’s watershed moment forced it to take a long hard look at its business model following the catastrophic global economic meltdown of 2008.
The company was not only forced to change its revenue model, but its products and target customers as well, to reflect the new reality in the software world. As a result, ADBE has come a long way from a company that made pricey photo-editing products aimed primarily at mainstream professionals, to a company that now offers products for even the most greenhorn hobbyists. This gives Adobe new-growth runways that its former model did not afford it.
The market has been very forgiving to Adobe during its cloud transition and has not punished the shares even as earnings took a squeeze. Although lower earnings catapulted ADBE stock’s price-to-earnings ratio to 103 in 2014, ADBE stock is up 139% over the past three years, handily outperforming the technology services sector, as well as sector peers MSFT and ORCL.
Moreover, analysts estimate that healthy earnings will return the valuation of ADBE stock back to its historical norm by 2017.
With the storybook ending to the cloud transition, things can only get better for Adobe and its investors, which is why ADBE stock is a good long-term holding.
As of this writing, Brian Wu did not hold a position in any of the aforementioned securities.
