Wall Street analysts and investors can be an exceptionally stubborn bunch, and it sometimes takes several whacks with a 2x4 to make them see reason. That seems to have happened with Adobe (Nasdaq:ADBE), though, as the Street now seems quite enthusiastic about the company's philosophical shift in digital media and its opportunities in digital marketing. With the stock up more than 35% over the past year, this is the first time in quite a long time where I can say that Adobe's stock no longer looks like much of a value.
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Decent Results, Relative To Expectations
Adobe's fiscal second quarter was the sort where you need to know what analysts and investors were expecting to understand why the stock is indicated up in premarket trading.
Revenue declined 10% from the year-ago period, but basically matched expectations. Digital Media revenue was down 18% as the transition towards the subscription model continues (along with the resulting turbulence to user numbers and revenue recognition). Digital Marketing revenue was up 11%, though, with Marketing Cloud revenue up 17%.
With the new revenue realities, Adobe's margins and earnings plunged. Gross margin (GAAP) dropped by almost two points, while GAAP operating income fell almost two-thirds. Non-GAAP operating income fell 39%, though, and although non-GAAP operating margin fell almost 12 points from last year, it was still 140bp higher than the average analyst expectation.
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Pulling The Plug On The Past
Adobe isn't messing around with its business shift towards a cloud/subscription-based model for Digital Media. The company recently announced that it was discontinuing further development of Creative Suite, in favor of Creative Cloud. What that means is that users will no longer have the option of buying a “box” of software for a one-time price and then using it for as long as it meets their needs.
Instead, new users will have to sign up for a subscription plan. This will allow Adobe to constantly update and refine the products, and it should mean that there are fewer big transitions from one version to the next (and, instead, more of a continuous evolution/improvement). But it also means that customers will have a near-constant bill to pay, and that's going to irritate some users.
The reality, though, is that there are few if any real alternatives for commercial/professional users. While the offerings of companies like Apple (Nasdaq:AAPL) and Microsoft (Nasdaq:MSFT) may be fine for being just messing around at home, there are few challengers to Adobe at the professional level. As such, seeing net subscriber adds for Creative Cloud grow from 153K in the last quarter to 221K this quarter doesn't surprise me.
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Marketing Getting More Of The Attention It Deserves
Whether it is due to the underlying growth of the business or the attention that has come to digital/cloud marketing as a result of recent moves from Oracle (Nasdaq:ORCL) and Salesforce.com (NYSE:CRM), Adobe seems to be getting more interest and respect for its Digital Marketing business.
Adobe is quite strong in areas like web development, creative design, and application development, but it also has a presence in areas like analytics, customer management, targeting, and optimization. The company will certainly find that IBM (NYSE:IBM), Oracle, Google (Nasdaq:GOOG), Hewlett-Packard (NYSE:HPQ), and Salesforce.com are fierce competitors here, but an addressable market for Adobe of over $12 billion gives the company ample growth opportunities. While this is putting the cart well ahead of the horse, I do wonder if there will come a point where Adobe splits up these businesses, as Media is likely to be a slower-growing, margin and cash-rich business, while Marketing is the growth opportunity.
The Bottom Line
Sentiment on Adobe has certainly improved, and I'm glad to see the shares getting the valuation they deserve. In fact, I'm starting to wonder if enthusiasm is shifting a little too far to the optimist side – while shifting to a subscriber/cloud model ought to be good for long-term revenue management, a quick look at other cloud business models shows rather weak operating leverage. Now there's only so far you can go in comparing a business like Adobe to Salesforce.com, but I think the point stands that there is the risk that analysts have gotten too hopeful with the potential long-term margin leverage.
I'm looking for Adobe to grow both revenue and free cash flow (FCF) at a mid-to-high single digit rate for the long term. That leads to a price target around $45 and a stock that could still do well from here (particularly on positive/bullish analyst sentiment), but no longer reflects an undervalued business.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
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