Adobe's Candy Coated Earnings Report
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Until Adobe's (NASDAQ: ADBE) fiscal Q2 earnings were released last Tuesday, I had never before encountered a presentation so short on traditional financial metrics but long on invented metrics. It was as if Adobe's management wanted to distract investors from certain inconvenient truths. Judging by the market reaction the day after the report was released, Adobe succeeded, if briefly.
Don't ask, don't tell
Adobe's slide presentation contained the bare minimum of hard financial data: quarterly revenue and earnings per share (GAAP and non-GAAP). Investors interested in operating profit, gross margin or any kind of year-over-year comparison were forced to pore over a supplementary table. I doubt that many did. Even Microsoft, which at times I have accused of obfuscation, provides more concrete information in their earnings slides.
It's as if Adobe regards investors as mere children, to be distracted or placated with colorful lolipops of data. These lolipops took the form of estimates of annualized subscription revenue for things like Creative Cloud, Adobe's cloud-based successor to Creative Suite. Adobe could easily have provided actual quarterly revenue for Creative Cloud, as it did for Document Services and Marketing cloud, but this was never revealed even in the supplementary data table.
These estimates of Annualized Recurring Revenue (ARR) were scattered liberally throughout the earnings slides and even the supplementary data table as if they were accomplished fact rather than forward-looking estimates. Even if we accept these ARR's as accurately predictive, it's virtually impossible to know what they really mean, since Adobe provides no basis for comparison.
For instance, how does the ARR for Creative Cloud compare with revenue in previous years for Creative Suite? How does Creative Cloud revenue for the current quarter compare with Creative Suite revenue for the current quarter? I guess it's best not to ask.
The inner core
Best not to ask, because the inner core of reality is just so much worse than the candy coating. But it's there if you really look for it in the data, which I've summarized in the chart below.
Quarterly revenue has fallen year over year by 10%, but what is worse, operating income and net income are down by 63% and 65%, respectively. The operating margin has collapsed from a reasonable 27% in Q2 2012 to just 11%.
Adobe was very proud of the fact that Creative Cloud subscriptions jumped from 479,000 in Q1 to 700,000 in Q2, but it's not clear why, since it comes on the heals of Adobe's announcement that it is pulling the plug on future licensed versions of Creative Suite. The announcement provoked resentment among current Creative Suite users, as documented in a recent CNET article. More than 30,000 people have signed an on-line petition urging Adobe to change its policy on change.org.
I'm pointing out the deficiencies in Adobe's financial performance not to argue that Creative Cloud is a failure but that its success has not been demonstrated. It could work, since it has the advantage of lower initial cost for users. What hasn't been demonstrated is whether it's revenue neutral, let alone revenue enhancing. Adobe is engaged in a massive experiment that other software companies, notably Apple (NASDAQ: AAPL) and Microsoft (NASDAQ: MSFT), have been unwilling to undertake.
Are subscriptions the future?
It's one thing to distribute software over the Internet. This is something Apple pioneered with the App Store for iOS devices. But here Apple has the advantage of its relatively secure and protected ecosystem of devices and can provide a seamless buying experience with one click shopping and almost instant downloads. At WWDC in June, Apple celebrated the App Store's 5th year. The App Store has over 575 million accounts, most with credit cards and simple one-click purchasing. Customers have downloaded 50 billion apps, and Apple has paid developers $10 billion.
Clearly, this is the future of software distribution. Apple is currently shifting Mac OS software to Internet distribution as well with the Mac App Store, eliminating optical disc drives from its most recent computers, as well as distributing its most recent Mac OS version exclusively via download.
But not a single app is sold on a subscription basis, excluding things like on-line magazine subscriptions. Apple now reports all digital content sales revenue, including iTunes, the App stores and traditional software media in its iTunes/Software/Services (iTSS) category. In Q1 iTSS made $4.1 billion in revenue, about what Adobe expects for its entire fiscal year.
At WWDC Apple announced a beta of iWork in iCloud, but it isn't clear whether Apple even intends to charge for the service.
Although Microsoft is still in the process of establishing its mobile device app and content stores, most of its extensive software offerings are available for digital download. Where Apple has tended to shy away from web apps, Microsoft has embraced them fully with Office 365 as well as its developer tools for cloud-based apps, Windows Azure.
Office productivity suites such as Office 365 have relatively modest computing requirements, so they've become a popular focus of web app development. But Microsoft hasn't tried to cajole Office users to abandon conventional licensing for cloud subscriptions by pulling the plug on licensed apps. Given what happened with Xbox One DRM, I doubt that Microsoft has the stomach for any more consumer backlash.
In its last Q1 earnings report, Microsoft didn't have a lot to say about Office 365, except that it had "momentum," a word that frequently stands in for less flattering characterizations in MS-speak. I doubt that Office 365 subscription revenue will be reported by Microsoft any time soon. But for Microsoft this is okay. It's understood that MS isn't betting big on 365.
Adobe, however, is betting big on the Cloud, and Adobe investors owe it to themselves to make the best assessment they can of the success of this bet. Adobe has made this even more difficult by a recent reorg, so now there's effectively no way to perform year-over-year comparisons by segment. The best investors can do is continue to track Adobe's fundamentals and watch for a trend, either up or down. Both operating income and net income were up slightly from last quarter, but I don't consider the change large enough to be significant. However, if income begins to recover to 2012 levels in Q3 and Q4, that would be a good sign that Adobe's Big Bet has begun to pay off.
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Mark Hibben has a position in Apple. The Motley Fool recommends Adobe Systems and Apple. The Motley Fool owns shares of Apple and Microsoft. 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!