Adobe's Transition Is Necessary, But A Little Turbulent

By Stephen D. Simpson, CFA | September 21, 2012 AAA

Another of the many quirks of Wall Street is that pretty much everybody can know what's going on, and yet still show some surprise when it shows up in the financials. Adobe (Nasdaq:ADBE) is in the middle of a business model transition as it shifts customers from licenses to subscriptions, and that process is messing with the reported revenue numbers. While the pre-market indications do not suggest that investors are too worried about Adobe's performance, the valuation still suggests something less than a full buy-in to Adobe's ongoing growth prospects.

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Third Quarter a Little Murky, but Basically OK
Adobe's third quarter results were a bit mixed and a little confusing, largely due to revenue impacts from the company's ongoing transition to a subscription model. This matters because subscription revenue is recognized on a ratable basis (that is, over time) as opposed to the one-time nature of licenses.

Reported revenue rose 7% from last year and fell about 4% from the prior quarter, with organic annual growth of about 5% and a 4% organic sequential decline. Digital Media grew 3% (due to the subscription transition), while Digital Marketing grew 21% with 40% growth in Digital Marketing Suite.

Profitability was likewise a little mixed. On a GAAP basis, operating income rose about 2% from last year (and fell 9% from the second quarter), while non-GAAP accounting saw a 7% increase.

SEE: A Primer On Investing In The Tech Industry

Slow Progress Is Still Progress
While the model transition is weighing on reported revenue, it looks like Adobe added about 110,000 net new subs this quarter. That's faster than expected, and an encouraging sign that Adobe's customers are accepting the new model. What's also interesting to me is that about 40% of the subs were new to Adobe - which makes me wonder if Adobe would have gotten that business at all under the old model.

Higher subscription transition comes at the cost of lower reported revenue, and it looks like Creative revenue may actually decline for the fiscal year. Again, this isn't a real loss (it's a transition), but investors can sometimes be a little too mechanical or literal in how they respond to declines in reported growth. It's also worth noting that Adobe's guidance does seem to imply some additional macro/market sluggishness, so it wasn't a perfect quarter.

Marketing Still the Future of Growth
I'm not sure what more is to be said about Adobe's Digital Media Business. Creative Suite remains at the top of the game and I don't know of any serious competition, apart from some lower-end offerings from Apple (Nasdaq:AAPL) and Microsoft (Nasdaq:MSFT). And once again, a big part of the bearish thesis rests on the idea that Apple, Microsoft, Google (Nasdaq:GOOG) and Facebook (Nasdaq:FB) will lead or push a transition away from Flash.

Even if the worst does not come to pass for Flash and the rest of Digital Media, Digital Marketing looks like the growth engine for Adobe - particularly as there hasn't been all that much organic growth at Adobe in a while. Lucky for Adobe, there should be real opportunities here in providing tools to allow companies to optimize content (and ads) for their audience/customers. Analytics and optimization are increasingly important to developers, particularly with the transition to mobile devices (what works/looks good on a big screen doesn't necessarily translate to a smaller device).

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
Adobe shares have outrun the market over the past year, but still don't look too expensive. A forward free cash flow growth assumption of 6% over the next decade works out to a fair value target in the low to mid $40s - not a bad return for a company with such a large installed (and presumably captive) base. What's more, if the company can really develop/exploit the opportunities in Digital Marketing, there could be some upside to that growth.

The ongoing transition to a subscription model could lead to a few more noisy quarters at Adobe, but this continues to look like a solid company in the tech space.

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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