Adobe Systems (ADBE +6.55%) reported solid third-quarter earnings earlier this month, beating analyst estimates for earnings while coming up slightly short on revenue. The company's transition to a subscription-only business model is making progress, with recurring revenue now making up the bulk of the company's total revenue. Here are five things that management said during the company's conference call that shed some additional light on the state of the business.
Creative Cloud is growing fast
Adobe is best known for its creative software products, including Photoshop and Illustrator, and traditionally they've been sold as one-time perpetual licenses, either separately or as part of the Creative Suite. This ended with Creative Suite 6, and going forward Adobe will only sell new versions of its creative software as part of the Creative Cloud, a subscription product that carries a monthly fee.
Adobe is working on transitioning existing Creative Suite customers to the Creative Cloud, and the result has been extremely rapid growth in the number of subscribers. This has been counteracted by a decline in one-time license sales, but the progress so far is impressive. CEO Shantanu Narayen gave a rundown of the numbers:
We exited Q3 with $1.4 billion of Creative Annualized Recurring Revenue, or ARR, which now includes more than 2.8 million Creative Cloud subscriptions and reflects a record increase of more than 500,000 from the prior quarter.
Adobe is winning big in digital marketing
Along with its creative software, Adobe's other main business is digital marketing and analytics. The subscription product in this segment is the Marketing Cloud, and according to Narayen, it's also performing well:
We are the leader in this category. We achieved strong Adobe Marketing Cloud bookings in Q3, and have a healthy pipeline heading into Q4. The volume and size of engagements with our customers is growing. In Q3, the number of customers with annual contract value of greater than $500,000 grew by more than 40% year-over-year.
Narayen gave a bunch of examples of large customers that Adobe added during the third quarter, including Adidas, Ford, the U.S. Treasury, H&M, and many more. Adobe is the self-proclaimed leader in the digital marketing space, although Salesforce (CRM +4.72%) is hot on its heels. Salesforce is on track to generate $1 billion in annual revenue from its digital marketing products, putting it very close in size to Adobe's offerings.
Revenue doesn't tell the whole story
Moving to subscriptions has caused Adobe's total revenue to decline precipitously. In fiscal 2013, Adobe's total revenue fell to $4.055 billion, down from $4.404 billion in 2012. While this may seem like a bad result, the method in which subscription products are accounted for is the real culprit.
When a customer buys an annual subscription to one of Adobe's products, Adobe recognizes the revenue over the lifetime of the subscription, even if it was paid in full at the start. This revenue is deferred, and over time this deferred revenue is converted into real revenue that shows up on Adobe's income statement. For companies that have subscription business models, keeping an eye on the deferred revenue gives a good indication as to the health of the business, as CFO Mark Garrett explained in response to an analyst question:
And then just to add on to that one more time, what that does ... is it helps drive deferred revenue, we had a record deferred revenue quarter. It also helps drive the unbilled backlog, which we've got roughly $2 billion of contracted business waiting to be recognized in the form of revenue. So it just makes for a much healthier business over all.
Weakness in Japan is temporary
Japan has been a strong market for Adobe's creative products in the past, but Creative Cloud hasn't gained much traction in the country so far. Part of the problem is that, through the second quarter of this year, Creative Suite was still being sold as a one-time perpetual license.
This is no longer the case, and Adobe believes that Japanese adoption of Creative Cloud will now accelerate going forward as customers are pushed into subscriptions. Narayen had this to say about Japan:
Asia as a percent of total revenue was low given Creative Cloud adoption in Japan has been slower than other geographies. With the removal of perpetual licensing from the channel in Japan, we are confident the transition toward Creative Cloud will begin to accelerate.
Going forward, Creative Cloud adoption in Japan could provide a nice boost to subscriber numbers, assuming Narayen is correct about the problem not being a lack of demand.
Subscription customers are sticking around
When asked by an analyst about retention rates for its creative subscription products, Narayen responded:
... we told you approximately 80% [retention rate]; we're ahead of that... So we think that gives you the right color to understand that the business is very healthy.
Adobe is retaining customers at a rate above 80%, which means that, on average, a customer has an 80%+ likelihood of remaining a customer for another year. Of the current 2.8 million Creative Cloud subscribers, then, somewhere around 500,000 will drop the subscription instead of renewing over the next year, meaning that Adobe must attract this many new customers just to keep subscriber numbers level. This hasn't been an issue so far, as Adobe is adding this many new net subscribers every quarter, but as the Creative Cloud matures, a high retention rate will be critical for the success of Adobe's subscription strategy.
