As an Adobe Systems shareholder, I dread the day before its quarterly earnings announcements. That’s because I realize that its shares could lose 10% of their value within minutes of Adobe’s earnings release due to a slight disappointment in its reported revenues, profits, or financial outlook.
When I checked the movement in Adobe’s stock price after-hours on June 17, I was fully prepared for that disappointing plunge. Instead, its shares were up about 8% in after-hours trading. With Adobe’s shares at an all-time high — reaching a market capitalization of $33.6 billion before the earnings announcement — are they poised to melt up or is now the time to take profits?
Adobe — with $4 billion in sales (down 8%) in the last 12 months and net income of $272 million (down 65%) — makes software for creative professionals such as Illustrator and Photoshop. Marketing departments use its software for graphic design and software developers use it to build websites and mobile applications.
Those numbers don’t sound like they should belong to a company that is hitting all-time highs in the stock market. But a look underneath them reveals that Adobe is in the middle of a CEO-led transition in its business model — from selling desktop software for $2,600 to providing $50 a month subscriptions for its Creative Cloud software, according to Bloomberg.
Though slashing results in the short-run, the logic for this transition is that it will boost revenues and profits in the long run. Of course, it does not hurt that this software-as-a-service (SaaS) model has been pioneered and proven effective in the minds of customers and investors.
One example of this is customer relationship management software vendor Salesforce.com which is growing at 34% a year to $4.4 billion and sports a $35.5 billion market capitalization despite losing $261 million in the last year.
One nice feature of this successful transition is that it puts the lie to the dogma of disruption from HBS’s Clayton Christensen, that was so elegantly debunked in the latest New Yorker by Harvard history professor, Jill Lepore, with whom I chatted occasionally when we both worked for HBS’s Michael Porter.
Christensen’s dogma requires companies to set up separate subsidiaries to manage disruptive technologies like SaaS. As I pointed out in my January 2000 article, The Dilemma of the Innovator’s Dilemma, that dogma is for the dogs.
And Narayen’s success in managing Adobe’s transition to SaaS — as well as Netflix’s effective move from DVD-by-Mail to Online Streaming about which I wrote in October 2013 – reinforces the case I made 14 years ago.
I hope Lepore is more effective than I was at bursting the disruption bubble.
Adobe has communicated this strategy shift effectively and in recent quarters, its stock price has responded positively to better than expected numbers of creative cloud subscribers.
On June 17, Adobe exceeded estimates for creative cloud subscriptions, revenues, and earnings per share. Specifically, Adobe added “464,000 customers for its Creative Cloud Web software for the quarter, bringing the total to 2.31 million. That exceeded the 2.3 million subscriber-estimate of Mark Moerdler, an analyst at Sanford C. Bernstein & Co.,” according to Bloomberg.
Adobe’s 5.7% increase in revenue to $1.07 billion was $40 million more than analysts expected and its EPS of 37 cents a share beat expectations by seven cents, according to Bloomberg.
Adobe raised its outlook for Creative Cloud subscribers. It now expects 3.3 million subscribers by the end of 2014 — 300,000 above an earlier forecast. Adobe CEO Shantanu Narayen said on a conference call, “A number of the people that are signing up for Creative Cloud are new customers. Therefore that’s expanding the available opportunity.”
Will Adobe shares keep rising or have they peaked out? The argument for selling the shares is that its Price/Earnings ratio of 128 fully reflects all the possible earnings surprises that the company could deliver to investors. But since that P/E exactly matches analysts’ expectations for 128% EPS growth to $1.42 in the fiscal year ending November 2015, the shares may be fairly valued.
The question for investors in Adobe is whether investors will raise their expectations above the level that Adobe can beat.
Brent Hill of UBS has a buy rating on its shares. As he told Bloomberg, “It’s time for Adobe to smell the roses. All the hard work in this business model transition is starting to pay off.’”
Regrettably, the debate over disruption does not represent a fundamental change to what will determine how Adobe shares behave. It will all come down to whether it can report results that exceed Wall Street expectations each quarter.
Deutsche Bank analyst Nandan Amladi implied as much to Reuters when he said, “All key metrics were above consensus and the company’s transition to subscriptions is proceeding well ahead of plan.”
My stomach will be churning in about three months as I wait to see whether Adobe can repeat that performance.