How Adobe Became the New, Top Cloud Play

NEW YORK (TheStreet) -- Adobe's (ADBE) transition to a pure, software-as-a-service (SaaS) company is unfolding at a smooth and rapid pace that's silencing the skeptics of this move. Adding to the positive sentiment is the company's proof that it can hold its own in the marketing cloud against tech titans such as Google (GOOG).

"Adobe sees the cloud as the entire future of its franchise," says Norman Young, a senior equity analyst at Morningstar. So far, financial results are backing up this vision.

Adobe's young, Marketing Cloud, which was used by NBC in February to analyze viewership statistics during the Sochi 2014 Olympic Games, saw a revenue jump of 24% during the fiscal first-quarter. This comes in spite of well-funded digital analytics competitors such as Google Analytics, Salesforce (CRM), and comScore (SCOR). The 24% increase came in ahead of Morningstar's expectations, and was on pace with growth in the digital marketing space. If the Marketing Cloud can at least maintain an in-line pace of growth with the overall market, the business should be able to keep double-digit revenue growth per quarter over the next couple of years, Young noted.

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On Adobe's core, Creative, which caters to large content creation and publishing places, it's been successfully shepherding droves of customers to the cloud subscription service, away from legacy software licensing. The transition began only about a year and a half ago, but the results have been compelling, though in an unexpected manner.

First quarter Digital Media revenue consisting of the Creative Cloud, Creative Suite (license sales) and Document Services declined 6.9% to $641.4 million, from a year ago. "When you look at these results, it's important to realize that they look bad, but that's actually a good thing," said Young.

The drop means customers are jumping over to Adobe's Creative Cloud subscription services because of cheaper upfront costs, and moving away from the expensive licenses of the legacy, packaged Creative Suite software, which the company no longer makes box sets for. These products can now only be purchased at places such as cheap channel resellers, who still bring revenue to Adobe when they buy licenses for reselling.

Any of the larger enterprises that are still renewing Creative licenses under licensing agreements are expected to turn over to the cloud soon. As of the end of the first-quarter, Adobe saw a 28% improvement in total paid subscribers to about 1.84 million from the last quarter. Young expects that at this rate of double digit, although natural decaying growth, Adobe is easily on schedule to hit its target of bringing 3 million customers on as total paid subscribers in the Creative Cloud by the end of this year and 4 million by the end of fiscal 2015; which means that the company is well on its way to making up for the difference between the lower upfront costs of the subscription model and the much higher prices of the prior, packaged software products.

If enough people are paying $50 a month versus $2,500 for a license that is renewed every two to three years or more, the gap will be closed, delivering Adobe towards the powerful lock-in advantages of the subscription model.

"I think at this point the market is assuming that Adobe, one, is going to continue to be able to capture additional incremental users above and beyond the 4 million that they expect to get by the end of the fiscal year 2015 because it's a cheaper product, has cheaper upfront costs -- and I should say because it locks you in even more," summarizes Young. "Not only are you using Adobe because everyone else is using Adobe, but you're using Adobe because all your projects are saved on the cloud now too. If you stop paying, you lose access to the software completely. You can't work if you're a production person."

"Instead of taking their sweet time to figure out if they want to make an upgrade for an expensive piece of software, customers are going to be paying all the time," says Young. "Everybody will be current, everybody will own a version."

Based on the first-quarter results, total Creative annualized recurring revenue (ARR) representing subscription customers on an annual basis has been $987 million, a good, 29% increase from the $768 million in Creative ARR from the fourth quarter. Total digital media ARR came in at $1.151 billion. These roughly $1 billion figures are a rough estimate of the base level from which Adobe's annual subscription revenues could grow.

As the lock-in effect gets stronger, Adobe is expected to be able to within reason raise its average revenue per user per month from the current $35 to $37 that right now includes discounts.

While the cloud is the business model by which Adobe is expected to realize steady, robust revenue in the coming years, it's of course, equally important to note that the core, underlying product delivered by the cloud will continue to keep the company shielded from competition.

The Creative business has no competitors of note that it can be compared with in the stock market. While Corel also makes production products, it's a private-equity owned company. Microsoft (MSFT) once tried, but failed to compete with Adobe's Creative business through "Microsoft Expression," which was launched in Sept. 2005 but terminated in Dec. 2012 after failing to gain traction.

There are also a couple of free, open source digital content creation, editing and publishing tools in the market, but again, none of them approach anywhere near the market share of Adobe's premier, industry-standard setting product consisting of a full suite of applications. The apps for tablets and smart phones that offer only quick, point photo editing can at worst nibble at Adobe in the lowest end of the spectrum. Apple (AAPL) has plenty of content editing and content creation-type software, but they're not typically used in a professional setting.

In assessing its core, Creative Cloud and Marketing Cloud positioning, Young says he considers Adobe as a wide moat company with a "fantastic business."

"I think they have incredible barriers to entry," he said. "If you're somebody who is in digital design, content editing, and video editing, you're almost certainly trained on Adobe products in school. And because of that, you almost certainly use Adobe products when you leave school. They're almost what I like to call it a de facto industry standard, right. Adobe is a good way also to play the digital content creation and measurements side of the business of technology, which is incredibly compelling right ... this is what you consume on the Internet -- it's hard to separate the Internet from that and so it's kind of an interesting way to play that."

After Adobe's quarterly report Tuesday, Deutsche Bank technology analyst Nandan Amladi hiked his price target on the stock to $75 from $65, maintaining his "buy" recommendation. Jefferies's Ross MacMillan reiterated his "buy" view with an $80 price target. Sterne Agee's Robert Breza also kept his "buy" rating with an $80 target.

-- Written by Andrea Tse in New York

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