By Zeke Ashton (TMF Centaur)
June 5, 2000

Welcome back to the Rule Maker software tour, Fool! Today, we'll wrap up our analysis of Adobe (Nasdaq: ADBE) and Macromedia (Nasdaq: MACR).

In the past two columns, we have compared Adobe, which looks to be an up and comer with strong Rule Maker potential, with Macromedia, a strong competitor in the Web graphics software market. Let's do a quick recap of the financial comparison, based upon reported results from the most recent quarter from both companies.

• Adobe produced $282 million in sales in the first quarter, versus Macromedia's $89 million.
• Adobe's sales growth in the most recent quarter was 24.4% year-over-year, while Macromedia grew revenues by 95% in the quarter.
• Adobe's gross margins were 92.7%, versus Macromedia's 88.5%.
• Adobe's net margins were 22.9%, versus Macromedia's 14.0% (on a pro forma basis).
• Adobe had over $640 million in cash on the balance sheet, versus $187 million for Macromedia.
• Neither company had any debt.
• Adobe's Flow Ratio was 0.57, versus 0.86 for Macromedia.
• Adobe's Cash King Margin was 15.8%, while Macromedia's cash flow data is not yet available.

It is clear by the financial comparison above that Adobe's statistical profile is much more aligned with our Rule Maker criteria than Macromedia's. But, it's important to note that while Adobe and Macromedia are both gunning for the Web and graphics designer markets, to my mind these companies are very much different breeds of animal.

Adobe's traditional strength is the print design and print graphics market, where their PDF file format is the industry standard. The company's print publishing products produced $353 million in sales during fiscal 1999, and the company has guided this segment's growth estimates towards a 10-12% range for the coming year. The ePaper solutions products, which includes the flagship Adobe Acrobat product series, grew 163% year-over-year in the first quarter, and management expects further annual growth of about 40%. Adobe has tremendous brand awareness and very high market share in these markets. In contrast, Macromedia doesn't even play in these markets.

Then there is the Web design and graphics market, where Adobe's Photoshop has a huge mind and market share advantage over it's competitors, which include Macromedia's Freehand and Corel's Draw. But again, Adobe's dominance with Photoshop is a carryover from Adobe's strength in the traditional print graphics area.

With Macromedia, the entire company and business model is totally centered on the Internet, and it shows in the quality of the products. Macromedia's Flash is the gold standard in live motion graphics, much as Adobe's PDF is the gold standard in print documents. Macromedia's Dreamweaver has 73% of the market in the HTML authoring market, versus 23% for Adobe's GoLive.

In short, when it comes to high-end Web design, Macromedia is the entrenched leader, and is aggressively pushing the envelope with its software. I have come to this conclusion in large part based on the insightful feedback on the Rule Maker Strategy board from the many Web design professionals who have been almost unanimous in their praise for Macromedia's Dreamweaver, Flash, and Fireworks products.

I'm also quite impressed with Macromedia's move into e-business tools that corporations can use to build and manage websites and the assets represented by their online content. This strikes me as a very logical extension of their market leadership in corporate website design and would appear to be a very large and rapidly growing market. It also allows the high profit margins and repeat purchase business model that we like to see in our Rule Maker companies.

On the other hand, I'm not convinced about the shockwave.com business model, and I would be concerned that it will draw capital spending that could be better used to buttress the company's defenses against what is sure to be a vigorous attack from Adobe to capture some of Macromedia's juicy core Web design market.

Finally, I submit that while Adobe fits the mold of a Rule Maker, Macromedia doesn't yet qualify for consideration. Macromedia just simply hasn't achieved the size, profitability, and control of cash that Adobe has achieved, nor has it earned the brand awareness and influence. That said, this certainly doesn't mean that Macromedia might not be a great investment. Macromedia just hasn't reached the maturity required of a Rule Maker.

Macromedia strikes me as more of a Rule Breaker candidate due to its fast growth and first mover advantage in high-end Web design products (see Rule Breaker Principles.) To achieve true Maker status, Macromedia will need to successfully defend its Web design turf from Adobe and other competitors in the coming years.

One last time, let's run Adobe through the Rule Maker Criteria, both qualitative and quantitative:

1. Dominant brand -- I think it is clear that Adobe has established a dominant brand.

2. Repeat-purchase business -- Absolutely. Every time Adobe sends out a new version of Photoshop or Acrobat, users buy the upgrade.

3. Convenience -- Definitely. The free availability of Acrobat Reader software and the established standardization of PDF makes downloading and opening documents a snap.

4. Expanding possibilities -- Yes. I think it's pretty clear that there will be more websites, more documents being transmitted electronically, and more opportunities in the future for Adobe.

5. Your familiarity and interest -- Up to you, Fool.

6. Sales growth of 10% or more -- Adobe delivered 24.3% sales growth in the most recent quarter.

7. Gross margins of at least 50% -- Adobe's gross margin exceeded 92% in the latest quarter.

8. Net profit margins of 7% or greater -- Yup. Adobe is up over 20%.

9. Cash no less than 1.5x debt -- Adobe has $640 million in cash and no debt.

10. Flow Ratio below 1.25 -- Adobe aces this one with a Flow of 0.57 in the most recent quarter.

11. Cash King Margin of at least 10% -- Adobe did 15.9% in the latest quarter after more than 20% in 1999.

Adobe passes every one of our criteria with flying colors, and the company qualifies (just barely) for our minimum of $1 billion in annual revenues. Even so, Adobe is definitely still in the emerging Rule Maker stage, and is therefore slightly riskier than some of our tried and true Rule Makers. To give you an idea of where Adobe stands in relation to our portfolio's other software holding, Microsoft (Nasdaq: MSFT) had enough cash on its balance sheet in the most recent quarter to purchase Adobe almost three times over!

That's about it for today. Here's some links to more articles in our Rule Maker Software Series: