Adobe Revenue: Will A Subscription Model Work?

| About: Adobe Systems (ADBE)
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Adobe Systems (NASDAQ:ADBE) has been adopting a new, subscription model for its software, which results in a delay in recognition of revenue. Is that really the reason for its less-than-stellar revenue growth during 2012, or is the company perhaps using this story to cover other trends?

On March 19, Adobe reported revenue for the quarter ending March 1 at $1.008 billion, down 13% sequentially from $1.153 billion, and down 5% from $1.045 billion in the year-earlier quarter. Declining revenue usually results in low P/E ratios, but as I write, at a price of $43.57 per share, ADBE's trailing PE is 30.68, which is very high for a technology stock in this market.

Perhaps earnings are improving despite the revenue downtrend? No, GAAP earnings per share (EPS) were $0.13, down 70% sequentially from $0.44 and down 65% from $0.37 year-earlier. Nor were the poor earnings from strange GAAP rules; non-GAAP EPS was $0.35, down from $0.57 year-earlier.

Surely there must be some new source of revenue and profits that has impressed sell-side analysts that must be factored into future earnings. While Adobe's Digital Marketing segment had 20% y/y revenue growth, there are no known new initiatives that account for the optimism.

So it would seem to come down to the subscription model. In the past, Adobe sold its array of software products as versions available on disk. Photoshop is its best known product, but as the Internet has become the greatest driving force in our economy, a variety of products to help with Web site content production and management were introduced. Software products could be bought separately, but most designers needed multiple products, and they were packaged together in Creative Suite. Despite being sold in high volumes, Creative Suite (CS) has never been cheap. The cost of buying a full license for CS depended on the exact options chosen, but let's just ballpark it at $2000.

Over time CS improved, partly just to keep up with changes in the Internet. New versions of CS were introduced about every 2 years. If you already had a full copy of CS, you could buy an upgrade for, ballpark, $1000.

With the vast majority of Web designers dependent on CS, charging them $1000 every two years for upgrades was a nice source of recurring revenue. Only many designers found they could skip upgrades at least some of the time. If they had CS 3, they might skip CS 4 and buy the CS 5 upgrade. Wait too long (typically 2 full versions), and the ability to buy at the upgrade price went away.

Meanwhile, for many customers, the set of DVDs used to install CS receded into history, as the software package was downloaded from the Internet instead.

In 2012, Adobe decided to push a subscription model to replace the old system. Customers can pay a monthly fee and get upgrades automatically. Better still, instead of having to wait for 6.0 to replace 4.0, the upgrades come as they are available.

However, note the impact on cash flows. Someone who was going to buy CS 6.0 for hundreds or thousands of dollars instead starts a subscription at (rates vary) $49.99 per month.

At the end of a year, the subscription client will have paid $600 to Adobe. In two years, they will have paid $1200, more than the cost of an upgrade. If customers stop skipping versions, in effect the subscription systems become a major price increase. You see other companies doing the same thing, for instance, Microsoft with Office 365. The subscription service also cuts down on pirated software.

So the theory of bullish ADBE investors is that once we go through a full subscription cycle, revenue will ramp. There might even be some cost of goods sold decrease from the elimination of physical media (management says that would be quite minor).

The problem with betting on this outcome is that you are also betting on the continued dominance of Adobe in making software for Web design.

A year to two years ago, investors were not so confident in Adobe, and we should recall why. Apple, a long-time Adobe ally, had refused to allow Adobe's Flash product to be used on its smartphones and tablets. In addition, the industry was (and still is) making a transition to a new standard, HTML5. Since then, the emergence of other mobile hardware/software platforms has Balkanized the app world, meaning just creating Web pages is not longer the prime goal of developers for the Internet.

Adobe has responded well to this challenge. The new CS, at least in theory, can create Web pages and applications that work reasonably well on multiple device form factors. Being able to design once in CS and export to multiple formats (or to include code that senses the form factor and presents the page accordingly) is a big help to Web designers.

I would still be cautious about projecting out too much. Adobe is not the only company addressing the new Internet Tower of Babel that Apple created. Just for instance, Akamai provides data center software that can distinguish between requests from cellphones and computers and message the outgoing data automatically. Open source software that has many of the capabilities of Adobe products is available for free. While most designers, from freelancers to large enterprise design departments, find Adobe is worth the price because of its functionality, free could become more competitive in the future. In addition, several proprietary competitors exist in the Web design segment.

It is hard to imagine an Internet without Adobe, but there is danger as well as opportunity in the subscription model. Adobe management is confident that adoption will go well, and that assumption seems to already be built into today's stock price.

Disclaimer: I don't have a position in Adobe and won't take one for at least one week following the initial publication of this story. I do subcontracting work for Microsoft and am long Akamai.