Adobe's Earnings: Can Flash Platform Revenues Compensate for Frugal Corporate Spending?

Adobe Systems (ADBE) is well known for its Creative Suite (CS) and Acrobat family of products but some promising new technologies from Adobe were viewed with burgeoning interest as having the potential to replicate the success stories of Acorbat and CS products. With this in mind, I was eagerly expecting Adobe's results for the May 09 (2Q09) quarter.

I just finished reading Adobe's 2Q09 earnings call transcript and was disappointed with the results, especially the top-line performance. But before the reason for the disappointment, a brief summary of the results.

Performance Snapshot

Quarter revenues of $704.7M and diluted EPS of 24 cents came near the mid-point of company guidance while operating margins of ~23% was within guidance range but much below margins achieved in any of the last five quarters.

Exhibit I - Adobe: Performance Snapshot - Recent Quarters

click to enlarge

Source: Gridstone Research

So unless revenue picks up, margins of ~25-30% which Adobe achieved in FY2008 looks difficult to achieve in 2009, since cost rationalization has been largely completed. The chart below shows the decline in operating expenses over the last two quarters as a result of restructuring. For software companies like Adobe, personnel costs are the largest operating costs and Adobe has rationalized these costs by moving more jobs to low-cost geographies though headcount has increased this quarter (Source: 2Q09 Earnings Call Transcript).

Exhibit II: Operating expenses have declined in last two quarters

Source: Gridstone Research

Now to the reason for the disappointment. The days of expense reduction to achieve bottom-line expectations is over and I expected Adobe to focus on increasing revenues from 'sunrise' segments such as the Platform business (Flash and FlashLite). Adobe's expectation (and mine too!!) was that the increase in 'Flash-enabled' devices would trigger demand for tools to develop 'flash-based' content and for service providers to deploy the 'Flash Platform' infrastructure to cater to the demand for more digital video content. My expectation was also that the Platform business would compensate for the declines in the Creative Solutions and Acrobat( classified under 'Business productivity' segment) business which are largely dependent on one specific workforce group - Creative Professionals. But that doesn't look likely this year at least.

Platform business looks unlikely to compensate for other segment declines

In the recent past, Adobe continually highlighted the 'phenomenal' growth in Flash penetration in PCs and mobile devices. Here are some commentary snippets related to that from Adobe's SEC filings (10Qs/10K) and earnings transcripts, in the last year or so, which I was able to extract using Gridstone Search.

Exhibit III: Some Adobe Commentary On Flash Penetration and Revenues

Source: Gridstone Search Platform

Note how Adobe talks about the penetration achieved by FlashPlayer and FlashLite client in terms of number of devices which are flash-enabled. The 'burst' in flash-enabled devices conjured up images (in my mind at least!) of solid revenue streams in the near future through OEM licensing fees and also through revenue from sales of tools to develop and deploy flash content.

However,in the midst of the search, I noticed an interesting 'snippet' from their 10Q filing for 1Q09 (Second snippet from top in exhibit III above). With the newer versions of Adobe Flash, the OEM's will stop paying license fees for bundling Flash technologies with their devices. Therefore the only way Adobe could generate more revenues in this emerging business is to sell more tools. This at a time when corporate spending on such 'productivity' tools has been significantly hit as the other revenue stream (OEM license fees) will decline and then vanish soon.

Exhibit IV: Adobe Segment Revenue Split In Last Eight Quarters

Source: Gridstone Research

The two primary revenue generating segments - Creative Solutions and Business Productivity (primarily Acrobat and LiveCycle products) have declined in the last two quarters. The Platform business was relatively small (~$36M in May09 quarter) compared to these segments but was growing fast and I was expecting an encore, in this segment, similar to what Adobe did with Acrobat family - Seed the 'content distribution/viewing' application by giving it free (Adobe Reader) and sell the 'content creation' application - Adobe Acrobat. In addition, it also had the added attraction of generating license fees (not now though!) as more devices shipped with Flash.

Now, that seems quite an optimistic scenario with Platform segment revenue growth declining on relatively miniscule base!

Exhibit V: Platform segment revenue growth has fallen sharply...

Though the Platform segment is the only one to have positive YOY growth in the last two quarters, it still cannot compensate for the decline in revenues from other segments. Just to give a perspective, CS and Business Productivity (Acrobat) revenues (combined) in May 09 are ~150M lesser than May08 and Platform revenues have increased by $6M YOY in May09. At such tepid growth rates, the Platform segment will continue to be dwarfed by the other two segments and cannot compensate for the growth declines in these 'mature' business segments.

As Adobe itself admits (Source: 2Q09 Earnings Call Transcript), the decline in upgrade rates to newer versions of CS and Acrobat products and the overall decline in number of creative professionals(which mirrors the squeeze on corporate marketing spends) will put pressure on any meaningful increase of CS and Acrobat revenues to 2007-08 levels. Adobe now finds itself in a situation where the two main segments have lesser revenue run rates and the 'sunrise' business slowing down in terms of revenue growth.

Focus on Flash Platform tools penetration is essential... not Flash Player penetration

Clearly, the days of deriving satisfaction from the increase in Flash penetration is over and Adobe needs to get back to figuring out ways to increase Flash Platform tools adoption and thus Platform revenues. In essence it's back to basics!

Disclosure: No Positions

Comments

[bbaker6212:]

I don't see how you can do a thorough analysis without talking about the Flex/AIR platform and potential for tool sales there. This has less to do with the creative types and marketing than programmers and the software market which is increased by higher Flash penetration. Clearly it's a big deal since Microsoft is going after them via Silverlight.

Jun 19 01:15 AM

[foo2u:]

You also fail to mention the OSP project and failed to point out that revenue is generated from that...do some better research

Jun 19 02:17 PM

[foo2u:]

aka...OSP=platform growth/revenue on mobile devices, etc

Jun 19 02:19 PM