Why Investors Like Adobe Diving Into Subscriptions

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Adobe Headquarters

Adobe Systems is at the beginning of its biggest shift in two decades.

We'll take a deeper dive when I interview Adobe CEO Shantanu Narayen on Tuesday following the company's earnings report. The numbers themselves probably won't be too surprising: analysts expect 31 cents in earnings per share on revenue of about $986 million. Both the EPS and revenue numbers are down from a year ago — so why is the stock near all-time highs?

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Because the company is doing what looked impossible just a couple of years ago. It's successfully moving its biggest business to a subscription model.

Rather than just sell Creative Suite software for $700 to $2,500 upfront, with Creative Cloud Adobe charges a subscription fee of $30 to $50 per month for access to its full library of creative software.

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That has some negative short-term effects — there's no short-term revenue pop when a hot new version of the software comes out. But the longer-term benefits are worth it. A subscriber doesn't buy software and use it without updating for more than two years, the way traditional software purchasers do. So if they sign up for the $50 per month level and stay there for a couple of years, it's worth it.

But the biggest thing happening at Adobe growth-wise is its Digital Marketing business. Adobe wants to be the go-to analytics company for measuring the effectiveness of digital content and advertising. That's business it is already a quarter of Adobe's annual revenue, and it's by far the fastest growing.

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I sat down with Adobe CFO Mark Garrett last week to talk about the company's changing business model and what investors should expect. A few of the most important nuggets:

• The Creative Suite/Cloud business is roughly $2 billion out of Adobe's $4 billion annual revenue. Starting next year, when the transition to subscriptions normalizes a bit, it will grow at about 15 percent per year.
• The Adobe Marketing Cloud business is on a run-rate to achieve $1 billion in revenue, and it should grow over 20 percent per year.
• Adobe expects to have 1.25 million Creative Cloud customers moved to the subscription model by the end of 2013, and four million by the end of 2015.
• Adobe's biggest rivals in the digital marketing game are some of the marquee names in tech: Google, IBM, Oracle and Salesforce.
• About 70 percent of Adobe's digital marketing business comes from the U.S.
• Adobe's digital marketing business today fits into five rough categories: web management, social media monitoring, analytics, testing and targeting, and spend optimization.
• Video tools are a sixth category that doesn't fit cleanly into the others, but is a huge growth opportunity.

So what are the risks for Adobe?

It's not so much the Creative Cloud business, though there are some unknowns there. Adobe might be miscalculating how willing its customers will be to continue monthly subscriptions. It will take a couple of years before we see what the "churn rates" are for Creative Cloud subscriptions — what percentage of subscribers don't renew their monthly or annual subscriptions.

The bigger risk is in digital marketing. There Adobe faces off against the biggest company in digital advertising (Google), the biggest in databases (Oracle), the biggest in business services (IBM) and the hottest in cloud software (Salesforce).

Adobe, with its relatively modest cash balance, will have to move quickly.

Corrections:
An earlier version of this story said the Creative Suite/Cloud business is roughly $3 billion out of Adobe's $4 billion annual revenue. In fact, the unit accounts for $2 billion of Adobe's annual revenue. That version also said the Digital Marketing business makes up the other $1 billion in revenue, and it should grow 25 percent per year. In fact, the Adobe Marketing Cloud business is on a run-rate to achieve $1 billion in revenue, and it should grow over 20 percent per year.