Adobe Systems (NASDAQ:ADBE) has a lot going for it. Its products, including Photoshop and Illustrator, have become industry standards, and its shift to subscription pricing has the potential to generate greater revenue in the long run if everything goes as planned. But there are risks associated with this strategy, and although there are plenty of reasons why Adobe's stock could rise in the long term, there are many reasons why it could fall. Let's look at a few.
Adobe has shifted away from perpetual licenses for its software, charging a monthly subscription fee instead. This has the potential to increase revenue, but that assumes customers are actually on board. For individuals and businesses that tend to upgrade infrequently, paying a monthly subscription might be too much to ask.
Adobe isn't the only software company embracing subscription-based pricing, but its strategy is more extreme. Microsoft (NASDAQ:MSFT) has racked up millions of users of Office 365, its subscription version of Office. However, the company still offers Office as a one-time purchase, as removing that option would risk pushing customers to the competition. Office 365 comes with some perks, like 1 terabyte of free cloud storage and continual updates.
Adobe has completely shifted away from one-time licensing fees, forcing subscription plans on its customers, and this has the potential to backfire. Adobe still sells older versions of its software, but it does everything in its power to persuade potential customers that its subscription plans are the way to go.
The risk for Adobe is that customers balk at paying a monthly fee. This could lead to reductions in Adobe's current revenue and earnings, brought on by the shift to the cloud, becoming more permanent than temporary, and that could have dire effects on the stock price.
Adobe's shift to the cloud might also have opened a door for competitors. Those unwilling to pay Adobe a monthly fee have plenty of alternatives available, although none are nearly as ubiquitous as Adobe's products.
One of the best-known Adobe competitors is Corel, and the company takes a dig at Adobe on the Web page for its CorelDraw Graphics Suite:
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Corel also offers subscription plans, but it expects a majority of its customers to stick with perpetual licenses, which is the default purchasing option offered by the company.
Corel's products are well reviewed, although generally accepted to be not quite as good as Adobe's. However, for customers who prefer one-time license fees, Corel is the best option available. In Adobe's haste to transition to subscription-only pricing, it may have inadvertently given the competition a major advantage. And if enough people shun Adobe's subscription plans, the company's market share, along with its stock price, could suffer.
Adobe's stock has had an incredible run over the past two years, but the current valuation suggests the market expects substantial earnings growth going forward. Along with the stock price, Adobe's P/E ratio has skyrocketed; compared to other software companies like Microsoft and Intuit, Adobe is priced at optimistic levels:
To be fair, Adobe's earnings declined sharply in fiscal 2013 due to the transition to subscription-based plans, so that P/E ratio may be a bit misleading. However, the stock still trades at about 140 times earnings earnings over the past year, so even ignoring the recent decline in profits, Adobe is priced for perfection.
If things don't go as planned for Adobe, this high valuation could be a ticking time bomb for the stock. Even if things do work out as intended, it's difficult to justify this high of a P/E ratio for a mature company such as Adobe. Analysts only expect earnings to grow roughly 12% annually over the next five years; while this could certainly be an underestimate, earnings growth would need to be far higher to justify Adobe's current stock price.
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Timothy Green owns shares of Microsoft. The Motley Fool recommends Adobe Systems, Apple, and Intuit. The Motley Fool owns shares of Apple, Intuit, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.