Ever since software giant Adobe (NASDAQ:ADBE) warned three weeks ago that unexpectedly soft demand during what it called the "spring holiday periods" would dampen second-quarter earnings, its shares have fallen in value by some 25%. But even though investors aren't quite getting the tearing growth they've been used to, I'm surprised that the disappointment has been so extreme. For longer-term Fools impressed with the ubiquity of Adobe and Flash products in PCs, Flash's potential in mobile phones, and the potential of converting paper documentation to electronic form, today's stock price might be considered a flash of opportunity.

Ubiquitous cash cows
Adobe acquired Macromedia in 2005 believing that Macromedia's Flash would be a good fit -- not a bad thought, when you consider that 40% of Macromedia users have Adobe's Creative Suite, and 43% of Adobe Creative Suite users have Flash. It's simply a software application that allows for the use of animation and advanced graphics on a website, but its popularity is overwhelming.

Today, Adobe's three cash cows -- Acrobat, Photoshop, and Flash -- contribute an estimated 75% of the company's annual revenues. Photoshop's popularity is well-known. As for Acrobat, everybody knows about the reader, which Adobe has wisely distributed for free for years -- it's on more than 500 million PCs worldwide and is pretty much considered the default electronic-document industry standard. Yet Adobe still makes money on the product by selling a beefed-up version of the Acrobat reader, as well as the Acrobat writer, which allows for the creation of those ubiquitous electronic documents knows as PDF files. Consider Quickbooks, which creates PDF invoices: For each shipment of Quickbooks, Adobe collects a tiny bit of cash -- little bits that add up quickly.

As for Flash, you may have seen it being used and didn't even know it. I didn't realize it was installed in my computer till I realized my 8-year-old had downloaded it to play a game! As with Acrobat, we all get Flash for free and take it for granted, while Adobe sells a more sophisticated version to content developers. Flash is available on more than 700 million PCs, mobile phones, and other devices and is one of the preferred software products for animation, video streaming, or any kind of rich content. And Adobe's betting that with Internet users wanting increasingly more animation and graphics in online content, Flash will become the default for richer delivery.

One of Adobe's key objectives since the Macromedia merger has been to pin down the customer who buys all three leading products -- Acrobat, Photoshop, and Flash. Creative Suite, Adobe's existing product bundle, already caters to that demographic, but the new version expected in May 2007 hopes to integrate the three products better and address compatibility complaints.

Converting mountains of paper
As widespread as Adobe's products are, I think it's only scratched the surface when it comes to taking over things still traditionally done on paper. For example, this past April, the federal tax man accepted my paper W-2s, but New York state made me fill out the same information on an online electronic form. Or consider this: Last year, I came across estimates that said electronic filing for mortgage documentation -- titles, insurance, application forms, and so on -- was as little as 5%. There's about $8 trillion worth of mortgage debt in the country, and then you have securitizations, assignments, court filings, and . well, you get the picture.

Flashing the mobile
Using the same strategy it did for Acrobat, Adobe has contracts with six handset manufacturers to install Flash-Lite, a version of Flash geared toward mobile phones. Management didn't disclose exact revenues, but the beauty of this business is that even at this early stage, there are three recurring revenue streams. First, Adobe gets a per-handset payment each time a phone is shipped with Flash-Lite installed on it -- and 65 million such phones have been shipped out thus far. Second, besides phones, Adobe gets the same per-unit revenue from gaming devices such as Sony's (NYSE:SNE) PlayStation Portable. And third, Flash is being used by phone carriers such as NTT DoCoMo (NYSE:DCM) to power news, sports, and weather on mobile phones. Here, Adobe makes money per subscriber, takes a share of premium content download, and also takes in revenue from FlashCast Technology, which NTT DoCoMo pays for as licensing fees.

Three areas of concern
All of the good news aside, however, there are a few things Adobe needs to keep in mind.

  • Compatibility problems. Reading through some of the complaints from users at BusinessWeek Online makes it appear as though making Acrobat and Photoshop more compatible with Flash is not going to be easy. Flash has more tech-savvy users who are not likely to take weak service lightly. For Adobe, and CEO Bruce Chizen, appeasing the average Flash user represents a new frontier. This is a tougher customer who can spot product and service deficiencies much more readily than a typical Acrobat or Photoshop user might.

  • A hugely competitive growth market. Naturally, when your market is hot, you're going to have giants like Microsoft (NASDAQ:MSFT) and Apple (NASDAQ:AAPL) along with specialized software players jostling for space. Accordingly, Adobe dutifully lists about 12 competitors each for Acrobat, Photoshop, and Flash and Microsoft's new Vista operating system is likely to include at least two programs to compete with Acrobat and Photoshop. Ajax, Google (NASDAQ:GOOG) uses to power Google Maps, is a good example of a small upstart that could wreck 10 years of Flash if Adobe isn't careful.

  • Nothing unique about electronic documentation. I asked a techie about my electronic form-filing experience, and he pointed out that Adobe offers nothing that any medium-sized corporation couldn't gear up on its own, using its own tech team.

Don't let go of this Acrobat
On the other hand, with a market cap of $17.4 billion and $2.1 billion in cash, Adobe is hardly going to get kicked around by the likes of Microsoft and Apple, for whom portable document files, photo editing, and video animation make up small slices of their pies. Not to dismiss the competition, but to Mr. Softy, Google is probably a lot more "evil" than Adobe is, and we know that Apple's first priorities are the iPod, the iPod Video, and, I suppose, Disney.

Even with such a hot market attracting competition (Internet advertising grew 29% last year, and predictions abound of high growth for the next five to 10 years), I don't see any one player as focused as Adobe in this space. Nor do I see the smaller players having the capacity to scale up. I'd say that in terms of scale, distribution, marketing, and management experience, Adobe can boast of the commercial smarts of Microsoft and the geek credentials of Apple. That's a winning combination.

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Fool contributor Bobby Shethia owns shares of Adobe and Microsoft. He wonders whether belly flops qualify as acrobatics. The Motley Fool is investors writing for investors.