Adobe Systems Completes A Successful Cloud Transition

  • Adobe Systems has reported good Q3 FY 2015 earnings that topped analysts' estimates.
  • Adobe's key metrics including customer growth are showing strong signs of having reached maturity.
  • Adobe has officially become the first software company to successfullly transition to a cloud-based model thus offering hope for old-line software companies such as Microsoft and Oracle which are undergoing a similar transition.

The world’s largest maker of photo-editing software, Adobe Systems (NASDAQ:ADBE) has officially become the first software company to transition successfully from the traditional software revenue model of selling perpetual licenses to a new cloud subscription model. Adobe’s successful transition to a cloud model makes it a shining beacon for old-line software companies such as Microsoft (NASDAQ:MSFT) and Oracle (NYSE:ORCL) which are deep in the throes of ongoing cloud restructuring.

Adobe Systems reported its Q3 FY 2015 earnings a few days ago that managed to top both top and bottom line consensus estimates, marking the seventh straight quarter that Adobe has topped earnings estimates. The company’s revenue of $1.22 billion for the quarter represented a healthy 21.2% Y/Y growth and topped consensus estimates by $10 million. EPS of $0.54 was $0.04 better than estimates and good for 93% Y/Y growth.

Adobe Completes Cloud Transition

While not 100% complete, Adobe’s cloud transition is, for all intents and purposes, a success. Adobe embarked on a move to the cloud in 2011 after the global economic meltdown of 2008 forced many traditional software giants to change the way they sold their software products. Adobe used to charge a hefty $700 for its flagship Photoshop software prior to the cloud. Now users only have to pay $10 per month. Much lower entry costs have been a two-edged sword for Adobe—its customer revenue base has expanded rapidly while its earnings have contracted dramatically.

Adobe realized revenue of $4.2 billion and net income of $833 million in 2011. The much lower subscription rates for its software, however, meant that the company realized lower net income over any given fiscal period. Meanwhile, the company’s push to the cloud led to a gradual decline of its license revenue while its subscription revenue expanded. The net effect was that Adobe’s bottom line fell pretty dramatically while its top line showed anaemic growth. Adobe finished 2014 with net income of just $268 million while its revenue of $4.1 billion was still below where it stood in 2011.

But the latest quarter now proves that Adobe’s cloud ambitions really have started bearing fruit. The company’s current annual revenue run-rate of $4.88 billion is about 16% above where it stood before the move to the cloud while net income run-rate of $697.9 million is 160% better than the net income in 2014. Meanwhile, Adobe’s subscription revenue now accounts for 68.1% of its revenue compared to 51.5% a year ago while license revenue now accounts for 21.1% of overall revenue compared to 22.6% 12 months ago.

Low Sales & Marketing Expenses

Adobe’s top line growth of 21% during the quarter marked the first time that the company’s revenue expanded in the 20s percentages since 2011.

What is happening here is that Adobe cloud growth has reached a point where its customer base is large enough to generate sufficient cash flow for the company on an ongoing basis. So Adobe can now afford to slam the brakes on its customer acquisition spree. Indeed, Adobe’s S&M expenses grew just 3.8% during the last quarter, much slower than top line growth. Marketing expenses is usually the biggest line item for SaaS companies, and for Adobe it’s not any different. The company spent 34.7% of its revenue on marketing expenses during the last quarter. While this might seem like much, consider that most SaaS companies spend 50%+ of revenue on marketing expenses as they attempt to grow their customer bases as wide as possible. Salescforce.com (NYSE:CRM) spends around 50% of its revenue on marketing expenses, despite being one of the most mature SaaS companies. In fact, ultra-high marketing expense is the chief reason why most SaaS companies are either in the red or sport razor thin margins. The fact that Adobe’s S&M expenses are growing much slower than top line growth is a very positive sign for the company and its investors.

Good upside potential for Adobe stock

Despite the fact that Adobe’s earnings took a hit due to the cloud move, investors did not punish its shares mainly because the company was able to control its costs and remained solidly profitable throughout the transition. Adobe shares are up 150% over the past three years, far outpacing gains by Salesforce (87%), Microsoft (46%) and Oracle (15.6%) over a similar period.

ADBE stock chart

Source: Adobe stock price comparison chart by amigobulls.com

Adobe’s lower earnings and healthy share gains have led to a valuation that seems to be out of whack with reality. But analysts project that the company’s robust earnings growth will return the shares to a more palatable valuation in two years’ time.

Adobe Forward PE ratio chart

ADBE-3

Source: NASDAQ

Adobe Srock remains a prime long-term holding. Meanwhile, cloud wannabe’s such as Microsoft and Oracle can borrow a leaf from Adobe's as they continue to transition to a cloud model.

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