Adobe Systems Subscription Model Reverse Engineered

Adobe-Acrobat-43180732Recently, Adobe announced a huge adjustment to their business model. They are shifting from a fixed sale model, which involves selling software licences to businesses for thousands of dollars at a time, towards a model that charges companies on a monthly basis indefinitely.

This is a very dramatic shift, in that it changes the company from being a vendor, to a cloud services provider. It also means that the company is going to start churning out cash like it never has before, in a way which suggests that perhaps the company is setting itself up for some big changes into the future. Whether it be the issuance of a dividend, re-investment into other platforms, or simply an improvement to the company’s overall efficiency, we’re going to look into adobe’s financial statements today to figure what kind of capacity this will free up for the company moving forward.

In digging through Adobe’s financial statements to determine the benefits of a subscription based model, the first thing we can see is that there is certainly an argument to be made for the ability of the cloud-based model to create growth. Specifically, the company has seen nearly subscriptions increasing by nearly 50% over the last three months alone. Seeing how it is that these revenues will then materialize to a greater degree in the actual cash accounts of the company, it creates a situation where the company is not only improving the size of its subscription revenues, but also their tangibility.

Despite a decrease in material size from 2012, during which time people were buying their latest version of software for thousands of dollars at a time, the growth in the subscription services shows us that the foundation model that creates predictable cash flows is growing in a way which favors stability. The question is then one of how much the company is generating today that it can use towards increasing the value it creates for its investors.

In reviewing the financial statements of Adobe over the last quarter, it becomes apparent that they are generating roughly $0.53/quarter in free cash flow that is available for equity holders. This implies that the company could theoretically pay out all of its earnings as a $2.12/year dividend to its investors. Even though such a practice would be fairly unreasonable, as it would essentially strip the company bare, it does illustrate a base-point for our evaluation. Specifically, if we were to compare this sort of distribution to a similar type of company, such as apple, we would realize that the stock price of adobe would be worth, on paper mind you, about $80/share to the markets today.

Today, since the price does not reflect an actual dividend, the price point instead reflects a discount on those cash flows at a rate of a fairly reasonable 5%, suggesting that investors are so comfortable with the predictability of these earnings that they are willing to value them at only a 2% premium against what they would if they were actually being paid out as dividends.Adobe stock chart However, if we then factor in the way in which the company’s stable earnings from subscriptions are growing at an extremely rapid rate, and creating a stable baseline for the company to use for either supporting its continuing operations or paying out a dividend, it becomes reasonable to assume that this implied 5% distribution rate is actually representative of a much greater expectation than it really demonstrates, and is therefore worth our consideration for further evaluation.

While Adobe’s improved subscription base does not necessarily guarantee the payment of a dividend to investors, it does provide us with a perfect example of how it is that investors can evaluate the ability of a company to pay a dividend as being a function of its fundamental value. From there, we can look at how it is that the company’s shift towards a more stable revenue model facilities the predictability of the cash flows that will then support this income stream, and assure us of fundamental value going forward.

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