Adobe Proves Its Transition Requires Acrobatic Precision

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

Wall Street analysts have always given software giant Adobe (NASDAQ: ADBE) the benefit of the doubt. Its current transition from selling individual pieces of software to a subscription model – as Microsoft (NASDAQ: MSFT) has recently done with Office 365 -- is disrupting its sales figures. But remarkably, investors appear to care very little about those unimpressive revenue numbers. With free alternatives from rivals threatening its software stronghold, does Adobe really deserve this degree of deference?

The company's stock currently rests near its 52-week high, with a P/E of 22. At other companies, that figure might look pricey -- especially with adversaries such as search giant Google (NASDAQ: GOOG) providing several Adobe-type products for free through its Google Apps and Google Docs platform. With more companies starting to adopt Google’s Gmail as their main email platform, as opposed to MS Exchange, Google’s apps are certain to gain more traction overall. I suppose one can say that Microsoft has an equal amount about which to worry.

However, unlike Microsoft, Adobe does not have the benefit of a dominant enterprise presence – one that can offset potential loss revenue. I think this should merit some concern for current Adobe investors – particularly since its recent earnings report served to only create more doubt.

The quarter that was
The company reported a 7% increase in revenue with roughly 5% in organic growth. While that might be perceived as OK, it represented a 4% revenue decline from the previous quarter, and also a 4% sequential decline in organic growth. Its digital media segment grew 3%, while its digital marketing segment produced a decent growth figure of 21%.

The company saw only a modest 2% increase in operating income on a GAAP basis. The numbers overall were good, but far from great, as it appears that Adobe's transition to subscriptions has impacted some of its revenue – particularly in digital media. This is certainly an area of concern, as investors must wonder from where the growth will come during this transition.

Although Adobe is performing adequately now, for a stock that is trading at a relatively high valuations, “adequately” is not enough. It is still too early to see how this transition will unfold, and what benefits it presents down the road. In the meantime, Adobe must execute with precision.

Google’s free alternative will certainly force Adobe to lower its prices, so Adobe has to make an adjustment if it wishes to grow revenues. But while it may secure a few more customers, its adverse impact on margins will be significant. Then there’s also the risk that should Adobe lower its price point to acquire new customers, its existing customers may become unhappy. Cable companies are notorious for this. Google can then step in and offer a cheaper alternative.

On the positive side, the company has an exceptional management team – one that is capable of making the necessary decisions. But as the change in model progresses, that is all that investors have to bet on.

Bottom line
There is no denying that Adobe is a solid company. But business model transitions are never easy – much less when the company has to compete with “free” alternatives. What’s more, until the company can show that it can alleviate prolonged market skepticism around its ability to transition its digital content and monetize it well enough to show growth, I don’t see immediate value in the stock.

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rsaintvilus has no positions in the stocks mentioned above. The Motley Fool owns shares of Google and Microsoft. Motley Fool newsletter services recommend Adobe Systems and Google. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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