Why Lower Revenues Are A Good Thing For Adobe

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Adobe Systems (NASDAQ: ADBE), one of the largest software companies in the world, has done a fantastic job of growing its revenues over the past decade (see chart).  The company has recently changed its business model significantly, shifting to subscription-based services, which has caused a lot of investors to become bearish on the company’s stock.  I, on the other hand, believe this to be a very good thing for Adobe over the long run, and investors might have a chance to get in at a discount before the transition is reflected in the company’s earnings.

Who is Adobe Systems?

Adobe creates software products for many types of consumers, and is best known for their Acrobat and Photoshop products.  Adobe’s products are well-known for their compatibility across different operating systems, devices, and printers, which ensures that documents and photos created with their software is of consistent quality on all machines.

The Strategy

As I mentioned earlier, Adobe’s main strategy right now is to shift their products to a subscription-based service structure.  This should have several benefits for the company.

First, it will virtually eliminate the problem of software piracy.  Subscription services are almost impossible to pirate, as opposed to software on a disk.  It will also allow Adobe to update their software more often, and at a lower cost (won’t have to manufacture and sell physical software). 

Also, subscription-based services create long-term customers. While it is definitely true that people will eventually buy new versions of useful software, making it automatic via a yearly charge is such a better option.  I love Microsoft’s (NASDAQ: MSFT) Word, however I still have a laptop running the 2003 version.  In other words, Microsoft hasn’t made any more money from me in 10 years!  If they had a subscription-based office program, they could have charged my credit card an annual fee whether I “needed” to upgrade or not.

Valuation/Competitors

Speaking of Microsoft, they are one of the closest competitors to Adobe based on the amount of software sold.  I actually wouldn’t be surprised if Microsoft switched to a subscription-based platform in the future, which I think would do the company wonders. 

The three largest software companies by sales are Microsoft, IBM, and Oracle (NYSE: ORCL).  However, I would call Oracle the closest to a pure software play whose paid products are non-essential (try taking a college course without access to Microsoft Word.)  Therefore, I think Oracle will be the fairest comparison to Adobe, valuation-wise.

Adobe trades for 16.6 times TTM earnings, however these are expected to drop considerably.  The shift in Adobe’s business model is expected to negatively impact revenues in the near term, and earnings are expected to drop from $2.35 in 2012 to a consensus of $1.39 for 2013.  As the new sales format catches on, earnings are expected to grow to $1.74 and $2.13 in 2015. 

So, Adobe is trading at a lofty 28 times forward earnings, however the projected forward growth rate works out to 23.8%, which would more than justify the valuation, if the company can achieve the projected results.  A word of caution:  If actual earnings come in even a penny less than the already low estimates, this could be taken as an extremely bearish sign by the market and cause shares to fall.  However, if this does happen it would create a nice entry point for long-term investors.

Oracle primarily manufactures all types of computer products for enterprise applications, however 70% of the company’s revenues come from software.  Oracle, quite frankly, seems like the safer play currently, trading at just 13.7 times forward earnings with 9% forward growth projected.  Adding to the safety factor is Oracle’s net cash position, as the company has over $30 billion in cash and just $13 billion in debt.  Oracle may be a better choice for those who either want stability or are not willing to wait.

Conclusion

While shares may suffer in the short term as a result of the company adapting to its new business model, the subscription-based platform should ultimately enhance the company’s value greatly over the long term.  I would wait until the lower earnings numbers start to pour in before making a move, since I have a feeling there will be a better entry point coming soon.


KWMatt82 has no position in any stocks mentioned. The Motley Fool recommends Adobe Systems. The Motley Fool owns shares of Microsoft and Oracle.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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