Drilling Down on Adobe

After what seems like forever, we're back to looking at software companies here in the Rule Maker Portfolio. For those of you who can remember, in our last episode of Ye Olde Software Odyssey, we took a look at Adobe System's (Nasdaq: ADBE) impressive financials (see "Sizing Up Adobe").

Just to quickly recap, we found that in 1999 Adobe exceeded every one of our Rule Maker statistical criteria:

Adobe Rule Maker Metrics     FY '99
Annual sales                   1.0B
Sales growth                  13.5%
Gross  Margin                 90.6%
Net income                   237.5M
Net Margin                    23.3%
Cash-to-Debt                No debt
Flow Ratio                     0.47
Cash King Margin              24.5%

As impressive as the 1999 results were, the first quarter numbers this year were even better:

Adobe Rule Maker Metrics     Q1 '00
Quarterly sales              282.2M 
Sales growth                  27.1%
Gross  Margin                 92.7%
Net income                  64.565M
Net Margin                    22.9%
Cash-to-Debt                No debt
Flow Ratio                     0.43
Cash King Margin                N/A

Based on the numbers above, the stathead part of me is completely satisfied that Adobe belongs in the august company of Rule Makers. However, as much as I'm tempted to, we can't ignore the more subjective criteria of Rule Maker investing. So, let's spend some time reviewing Adobe's product lineup, the industry landscape, and see what we can come up with as far as identifying expanding possibilities for this company.

Adobe's operations can be divided into four segments: Web publishing software, which accounted for about $394 million of sales in 1999; Print publishing, accounting for about $354 million; ePaper Solutions, at $129 million; and "other," which generally includes revenues from original equipment manufacturers (OEMs) for pre-loading Adobe software on computers. The OEM and other category accounted for about $210 million in 1999, although the company expects income from this source to dwindle over time.

Because there is some crossover in product lines, let's review some of the company's major products:

Adobe Acrobat is probably Adobe's flagship product, and the one consumers are likely most familiar with. The suite of Adobe tools using Acrobat technology dominates the document management market. With Acrobat, customers can convert almost any kind of written information into Adobe PDF (Portable Document Format) files for storage or distribution, which has become the global standard file format for document management.

Here at the Fool we use Acrobat to convert all of our print products to PDF files before they go out the door. Since we know that you, our customers, can get for free the Acrobat Reader program needed to open and print PDF files, it is a very convenient way to distribute our information. For example, check out our latest Motley Fool Research Report on Oracle (it's free!).

The amount of print material being transferred electronically has increased dramatically in the last couple of years, but there is still a long way to go before the majority of printed material is distributed this way. Adobe reported that revenue from Acrobat products increased over 100% in 1999, and approximately 2 million people download Acrobat reader from the Adobe website every month.

Adobe Photoshop is the leading photo editing product on the market. In the Adobe annual report, the company noted an independent study which found that 89% of Web designers use Photoshop to design their Web pages. Photoshop likely has a similar market share for photo editing in the print publishing market as well.

Adobe Illustrator is the leading graphics software on the market, though it hasn't achieved the status as the "market standard," primarily due to strong competition from Freehand, which is a Macromedia (Nasdaq: MACR) product. Still, Adobe's powerful position established with Photoshop becomes quite an advantage in the positioning of Illustrator. The best guesses I've seen would give Illustrator 60% of the graphics software market, which ain't too bad.

I took the opportunity during the week to grill our graphics Fool, David Ostroff, who uses Photoshop and Illustrator every day to draw all of the art you see on Fool.com. I came away very impressed with the technology, but more so because of my impression that -- especially in the case of Photoshop -- these products have serious mindshare. David can't imagine life without Photoshop. He's used both Illustrator and Macromedia's Freehand product, and he says that the products are very comparable, with neither company having a huge advantage in features or usability over the other.

Adobe InDesign is the company's great white hope to capture the estimated $500 million annual market for page layout software. Page layout has long been noted as a competitive weakness at Adobe, and previous efforts haven't been able to unseat a rival product from Quark called QuarkXpress. (I was able to download a copy of the QuarkXpress brochure at their website -- as an Adobe PDF file, by the way.)

Adobe has devoted considerable effort to this new product, which it claims is the first new page layout program in more than a decade to be designed from the ground up. The company appears quite confident that InDesign will allow Adobe to capture some market share from QuarkXpress and others going forward. I know that here at the Fool, we use the Quark product to design the layouts of all our print products, and then use Acrobat to convert it to a PDF file.

Adobe GoLive, LiveMotion, Premiere, and AfterEffects are used in website layout, design, animation, and film production. The only interesting tidbit of information I can add here is that I found out from Dave that the LiveMotion product transmits the finished product in a file format called shockwave, or SWF. The shockwave file format was developed in 1995 by a competitor, Macromedia.

There are a bunch of other Adobe products out there, which you can check out at Adobe.com. From what I've found out so far, my conclusion is that Adobe holds a dominant position with its Acrobat, Photoshop, and Illustrator products. The company does not have -- at least from what I can tell -- the dominant position in the other areas where it competes, but it does have a strong presence in those markets. Adobe is certainly gunning for domination of those markets, and may well achieve significant headway with the new InDesign product.

Next Friday, we'll continue our look at Adobe within the context of our subjective Rule Maker criteria. Of course, the qualities we especially want to see will be a dominant brand, a repeat purchase business model, and expanding possibilities. I am pretty satisfied that Adobe has achieved a dominant brand. I do want to convince myself about the company's possibilities for future growth in some more detail.

It is also going to be worth our time to look at the company that appears to be Adobe's main competitor, Macromedia. As is usually the case, the folks that hang out on our Rule Maker Strategy discussion board are already way ahead of me. I've pulled out some of the more interesting posts for you to link to below. If you've got some thoughts on the subject, please feel free to join in the conversation!

Have a great weekend!

Rule Maker Strategy Posts on Adobe: