Adobe Systems Incorporated (NASDAQ:ADBE) continues to seamlessly climb the wall of worry surrounding the stock. It may seem bizarre for me to argue this case if you look at how well the stock has done over the last year, but I happen to think there is still plenty of upside in the company. Its transition to cloud based sales is working and has further to run. In addition its performance confirms the attraction of the software as a service (SaaS) model, and I think investors should approach this investment theme with confidence.
How to Judge Adobe
Naturally when any company makes a transition in its business model the inherent risk and change in operational metrics will attract naysayers. Of course if you are a yea-sayer than you will get a built-in buying opportunity. Such is the case with Adobe. I’m going to try to cover the salient points here as I’ve discussed the development of the company in articles linked here and here.
Essentially what investors need to understand is that shifting from a perpetual model to cloud based subscription will have a negative short term effect on the top line but should generate larger lifetime values (LTV) for the company. In addition it should encourage more people to sign up with Adobe and lead to lower customer acquisition costs.
The key factor in generating higher LTV is to keep the retention ratio high. Indeed, Adobe was asked about this issue on the recent conference call. No number was given, but I believe its management had previously cited a figure of around 80%.
To put this crudely one perpetual customer generates $780 in one year. Now turning to the subscription model, he will generate $480 in year one of a subscription, and assuming an 80% retention rate this turns into .8*480=$384 in year two. In other words the subscription model generates $864 over two years, but the perpetual generates only $780. The problem is that in the first year the revenue generated is a lot less, hence all the fears over declining revenues.
Indeed, Adobe Systems Incorporated (NASDAQ:ADBE) is facing a trough year in terms of revenues. No matter, the key is the ongoing shift to subscribers and long term retention.
What to Expect From Adobe in 2013
In order to track how the key metrics are developing here is a chart of creative cloud subscribers and something that Adobe calls its creative Annualized Recurring Revenue (ARR):
The ARR is simply the number of current and team subscribers multiplied by average revenue per subscription (annualized) and then including Enterprise Term License Agreements (ETLA).
This may sound complicated but it’s not really. The subscriber numbers just represent how well Adobe Systems Incorporated (NASDAQ:ADBE) is shifting people to the cloud model, and the ARR is a way of reflecting future revenues generated by the model. For 2013 Adobe is aiming to finish on 1.25 million subscribers and an ARR of $685 million. To put this into context total digital media revenues for 2012 were $3.1 billion.