5 Tech Stocks' New Growth Engine

Big technology stocks have soared in recent years as their rapid earnings and revenue growth made them must-have holdings in many investors' portfolios. Now, a new engine is likely to drive tech profits and stock prices in the coming years: ongoing streams of revenues from customer subscriptions, The Wall Street Journal reports. Software was the first area within the tech sector to change its preferred pricing model from one-time sales to recurring annual fees, the Journal notes. Today, the subscription pricing model has become pervasive throughout the sector, and companies that have embraced it include Apple Inc. (AAPL), Amazon.com Inc. (AMZN), Microsoft Corp. (MSFT), Electronic Arts Inc. (EA), and Adobe Systems Inc. (ADBE).

Reducing Volatility

The S&P 500 Information Technology Index (S5INFT) has risen by 5.8% for the year-to-date and by 148% over the past five years, per S&P Dow Jones Indices. During this period the forward P/E ratio on the technology index has increased from around 15 times earnings to more than 18 times earnings, per Yardeni Research Inc. These high valuations mean big tech companies will need new, predictable sources or profits to drive their stocks higher. 

That's why they're expanding into subscriptions. Traditional one-time sales of products and services can be volatile and cyclical. By adopting subscription pricing wherever they can, tech companies are smoothing out their revenues and earnings over time. Per the Journal, these companies are being rewarded by investors with higher stock prices and higher valuation multiples. To be sure, it's debatable whether multiples can increase a great deal beyond their historically high levels of today.

Reinventing Apple

Apple is a leader in boosting subscription revenue from tech consumers. It's revenue from subscriptions, many of which are sold through its App Store, now exceed its device sales, the Journal reports. The respective figures in its most recent fiscal year were roughly $250 billion and $200 billion, per the Journal. Nonetheless, Toni Sacconaghi, an analyst at Bernstein, believes that Apple should be even more aggressive in moving to subscription pricing.

Sacconaghi suggests that they bundle various devices and services together for a monthly fee, and offer automatic upgrades after a set period of time. This would, he says, "lock in revenue streams and freeze the length of replacement cycles, likely leading to a material re-rating of the stock's multiple." (For more, see also: Why Apple Needs to Copy Netflix's Subscription Model: Bernstein.)

Amazon's Prime Example

While Amazon.com's core business remains merchandise sales, its own subscription services are growing rapidly and becoming larger pieces of the corporate pie. Amazon Prime, which offers free shipping and a video streaming service with a vast array of content, generated $9.7 billion of revenue in the company's most recent fiscal year, up 52% from the year before, the Journal observes. The company's cloud computing service, meanwhile, also is growing rapidly, and produced 52% more profits than its North American retailing operations, but on only one-sixth the revenue, the Journal adds.

Microsoft's New Game

Microsoft now has almost 30 million consumers subscribing to an online version of its Office software, and 59 million subscribers for its Xbox Live gaming service, per the Journal. Electronic Arts, another leader in the field of video games, now produces about 24% more revenue from its own subscription service than from traditional sales of gaming software on discs, the Journal says. Adobe, which offers widely used Acrobat and Photoshop software, derives 84% of its revenue from subscriptions, and each of the last 13 quarters has enjoyed revenue growth versus the one immediately prior, the Journal reports, adding that its market value has almost tripled in two years.

It's unclear whether these big technology companies will be able persuade often fickle consumers to switch from device purchases to subscriptions to a dramatically greater extent than today. But one thing is clear: tech stocks' future growth may depend on whether the strategy succeeds.