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Adobe is another example that the future favours the subscription model

Tong Kooi Ong
Tong Kooi Ong • 6 min read
Adobe is another example that the future favours the subscription model
(July 19): US stocks continue to outperform the rest of the world this year. The Dow Jones Industrial Average, Standard & Poor’s 500 and Nasdaq Composite all hit fresh record highs this month. The three benchmark indices are currently up between 16.7% a
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(July 19): US stocks continue to outperform the rest of the world this year. The Dow Jones Industrial Average, Standard & Poor’s 500 and Nasdaq Composite all hit fresh record highs this month. The three benchmark indices are currently up between 16.7% and 23.4% for the year-to-date.

This latest rally was fuelled by rising expectations for lower rates. The chairman of the US Federal Reserve all but confirmed an imminent cut in policy rates in his recent testimony to Congress, likely as soon as the end of this month. Lower interest rates will lift overall stock valuations, especially for high-growth companies.

Meanwhile, the underlying economy remains on solid ground, with the latest job market report beating expectations. Lower interest rates will extend the life of this economic expansion and, importantly, should underpin stronger wage gains.

Real wage growth has been tepid for the better part of this current upcycle, as productivity gains came mostly from capital investments and technology advancements. Thus, much of the economy’s gains have accrued to capital owners. Extending growth even as the job market tightens will give labour a chance to catch up and enjoy a larger slice of the pie. This, in turn, bodes well for household incomes and consumer spending going forward.

We are now into the start of the 2Q2019 reporting season. Earnings for the first quarter turned out better than market estimates, with S&P 500 companies falling just 0.3% compared with the initial -4% forecast.

Expectations are still muted, with profits forecast to decline about 3% in 2Q2019. If history is any guide, actual earnings should exceed initial forecasts. The current low hurdle rate could give the rally more legs, if companies can, once again, beat expectations.

The decision to favour US stocks in my Global Portfolio, especially the US consumer, is paying dividends. To read more about my rationale, check out the first two issues of The Edge in April.

I added three consumer and housing related stocks to the portfolio back then. All have performed well, with gains ranging from 8.8% for Home Depot to 14.7% and 16.8% for Builders FirstSource and The Walt Disney Co respectively.

I remain convinced that this is a good strategy for the rest of the year. In fact, I recently acquired more shares in Disney and Home Depot. The most recent addition to my portfolio is Adobe a couple of weeks back. The stock is up 6.5% in the short period since acquisition.

Software companies are fairly insulated from the effects of ongoing trade conflicts. In fact, I suspect that, as the business environment gets more competitive, companies will increasingly rely on technology and automation to manage costs and enhance efficacy.

I like Adobe’s scalable business model. Software as a service, just like platform as a service, is the trend of the future — giving governments, small businesses and big corporates greater flexibility in planning while allowing them to save on high upfront purchase-development costs as well as recurring expenses for maintenance, upgrading, hosting and so on.

Adobe is an early mover in transforming itself from a primarily OEM-perpetual product licensing to subscription-based business model, which started about six years ago. Most readers should be very familiar with its desktop tools such as Photoshop and Acrobat. Roughly 91% of the company’s revenue is now derived from subscription for its suite of cloud-based platforms. This business model provides a steady, recurring income base.

Revenue grew at a compound annual rate of 21.5% between FY2014 and FY2018, and 25.1% in 1HFY2019. Management guidance provided for revenue to grow more than 22% in the upcoming 3QFY2019 and ending with a seasonally stronger 4Q, with improved margins and earnings per share.

In fact, the market currently expects top-line growth to remain well above 20% for the next few years — underpinned by new products and subscriber acquisition. In addition to in-house software development, Adobe has also been acquiring other software companies to complement and strengthen its product offerings.

Creative Cloud is its biggest revenue generator, contributing to roughly 60% of total revenue. Products such as Illustrator, InDesign, Stock, After Effects, Premiere Rush, Lightroom and Photoshop remain the go-to software for students, teachers, enthusiasts, social media creators (YouTubers) as well as creative professionals.

Document Cloud is riding on the trend of going paperless, as a way for people to scan, edit, collaborate, sign and share documents in the cloud and mobile era. Some of the apps include Acrobat Pro, Document Cloud and Adobe Sign. The business accounts for just over 10% of total revenue currently.

Creative Cloud and Document Cloud are housed under the Digital Media business segment, which has shown consistent quarterly growth and is expected to expand at a clip of more than 20% annually.

Its new Digital Experience business is also the fastest-growing, accounting for the remaining 30% of revenue. Experience Cloud provides an end-to-end platform for marketing, advertising, analytics and commerce, and is used by many of the largest global financial institutions, auto manufacturers, media companies, hotel chains, internet retailers and airlines.

The one-stop platform allows companies to collate and analyse customer data, leveraging machine learning and artificial intelligence, and through the use of Adobe’s creative suite to create content, design and deliver multi-channel digital marketing campaigns. It also provides companies with feedback data on the effectiveness of its marketing strategies, improving customer experience and, as a result, conversion rates.

In addition, Adobe has strategic partnerships with other companies, including Microsoft, LinkedIn, SAP and ServiceNow, to strengthen its market positioning. This business segment is expected to grow at more than 30% a year.

In short, the stock’s higher-than-market average valuations are justified by strong growth prospects. For the past 10 years, Adobe has generated positive free cash flow every year. FCF topped US$3.76 billion in FY2018 and US$1.91 billion ($2.6 billion) in 1HFY2019. While it does not pay dividends, Adobe has an US$8 billion share buyback programme for 2018 to 2021. It has so far utilised about US$1.4 billion of the approved sum.

My Global Portfolio gained 0.3% for the week ended July 18, faring better than the MSCI World Net Return Index’s 0.1% decline. Shares in Alibaba Group Holding and Home Depot were among the gainers. Last week’s gains lifted total returns since inception to 10.9%. The portfolio is outperforming the benchmark index, which is up 7.8% over the same period.

Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports

This story first appeared in The Edge Singapore (Issue 891, week of July 22) which is on sale now. Subscribe here

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