Adobe Designs High Margins

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If you've ever been to a website -- including this one -- you’ve tasted the fruits of Adobe’s (Nasdaq: ADBE) creative software.

Name a site, and its logo, interface elements, rich-media ads, and PDF files were almost certainly created with Adobe software. In many cases, Adobe tools were used to author the underlying HTML code as well.

Adobe predates the World Wide Web, of course, but over the last 10 years it has moved beyond the professional creative community to become a nationally known brand among photographers, hobbyists, and digital enthusiasts of all types. Even my 90-year-old stepfather has a copy of Photoshop. (Whether he uses it effectively is another story …)

Simply put, Adobe is synonymous with creative software for new media and design.

Consolidation
Through its 2005 acquisition of Macromedia, maker of Flash, Flex, and Fireworks, Adobe co-opted its closest competition, widening its competitive moat. And to date, efforts by Microsoft (Nasdaq: MSFT) to position its Silverlight product as a challenger to Flash -- the technology that currently delivers a majority of Web video worldwide and which is installed on 99% of connected computers -- have fallen flat with both consumers and content creators.

Ubiquity is not enough
Yet despite its solid market position, Adobe has taken hits during the economic downtown. It posted third-quarter revenue of $697.5 million, down from $887.3 million for the third quarter of fiscal 2008 and $704.7 million for the second quarter of 2009.

Of Adobe’s five business segments, Creative Solutions does the heavy lifting, pulling in 57% -- some $400.4 million -- of the company’s Q309 revenue. But that represents a disappointment after the $508.7 million the segment contributed in Q308, and the $411.7 million it pulled down in Q209.

The shortfall is largely attributed to the weaker revenue performance of Adobe’s flagship Creative Suite 4 family of products, compared to the equivalent CS3 products over a comparable period. No surprise: When businesses and consumers are watching their pennies, they may decide that incremental feature enhancements aren’t worth the price to upgrade, especially when the products are already so darn good.

Strength in numbers
Fundamentally, though, Adobe is strong: strong enough to have produced gross margins of 89% or higher for more than a decade; to have relatively little debt ($350 million); and to have amassed a war chest of $2.6 billion in cash and investments.

It was with that war chest that Adobe shook up analysts on Sept. 15 by announcing a definitive agreement to acquire Web analytics company (and three-time Stock Advisor recommendation) Omniture (Nasdaq: OMTR) for $1.8 billion (the deal closed Oct. 23). “Shook up” actually understates the case: Many analysts were left scratching their heads, noting that Omniture sells to different buyers and that its software as a service (SaaS) business model differs from Adobe’s transactional one.

But Adobe CEO Shantanu Narayen maintains that:

… Adobe's Creative Suite products and Flash platform help customers create and deliver engaging experiences. The addition of Omniture's online marketing suite will help customers measure, analyze, and optimize the impact and value of those experiences, creating a continuous feedback loop to maximize business results.

It remains to be seen whether Narayen’s vision pans out. But it is clear that Adobe, with its high margin, fat bankroll, low debt, brand equity, and increasingly dominant position in its critical digital niche, remains a software force to reckon with. And in my book, that makes it a stock to watch.