Everything is Telling Me to Avoid this Stock, But …

As a longtime user of Adobe (ADBE) products, I had doubts on the monthly software subscription model they announced in late 2011. Yet it looks to be working well.

Very well, actually.

Last quarter, Adobe added 400,000 new clients and now has over 1.8 million customers paying monthly subscription fees. More important, it now makes more money selling monthly Creative Cloud subscriptions than from outright sales of these layout, design and photo-editing products.

This software as a service ("SaaS") delivery model, now used by many cloud-based technology providers, has transformed both how customers use products and how companies generate revenues.

One of the benefits will be more predictable earnings and cash flows. And it’s not just Adobe …

There’s no nice way to say it …

The latest GDP reports were dismal.

According to the latest release, the economy only grew by 0.1% in the first quarter … the worst showing since 2012.

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Internal Sponsorship

Cloud Software Adoption Curve Improving

Apple (AAPL) just revealed that it currently has 800 million iTunes accounts and that most of them have registered a credit card. Furthermore, Apple said its App Store generated 85% more revenue than Google (GOOGL) Play in Q2 2014, with total app downloads reaching the 70 billion mark.

However, with over a million apps in the iPhone store, it’s hard for a product to stand out.

To get noticed in the download avalanche, Microsoft (MSFT) released Office for the iPad free in read-only mode. It quickly moved to the top of the iPad download charts in a few days. Word, Excel and PowerPoint apps also made the top 10 list, thanks to the ubiquity of these products.

To entice new users, Microsoft went with a "freemium" monetization model with the Office for iPad apps. Advanced features require a valid annual subscription to one of the many Office 365 plans. The initial price dropped to $6.99 per month for a Personal Edition.

If Microsoft were a start-up company, I would suggest you avoid its stock.

After all, Homeland Security came out and suggested people stop using Internet Explorer indefinitely, due to a serious security flaw that could compromise users’ operating systems.

This certainly didn’t do the stock any favors.

Of course, a billion people are already using Microsoft Office, and most will continue using it for the foreseeable future.

Additionally, with 90% or more of the world’s 1.5 billion PCs running Windows, the company has a dominant position in homes, schools and industries.

Microsoft is uniquely equipped to leverage its core software and enterprise strengths, build on its puny 1.8% share of the mobile market, and wage war on this previously ignored battlefield.

As Satya Nadella, the new CEO of Microsoft blogged  …

"The cloud is how a phone, a tablet, a computer and a TV all get on the same page, and enables movement between them without extra effort.

"The cloud is how a device becomes your device. And the cloud is how your device becomes part of your life, by connecting to all the people, information and experiences that matter to you."

Nadella is also setting the stage for the transformation of Microsoft’s revenue stream. This new vision will help the company pivot away from its Windows based OS shackles to a Microsoft Cloud that competes with Google (GOOG) and Apple for a share of the world’s computing.

That is not how most of the investment community views Microsoft today.

Investors want higher returns. The MSFT annualized total return with reinvestment for the last five years ending 4/30/2013 was 17.7%, well below the 21.7% for the average tech stock in the QQQ ETF.

Cash balances continue to build. During the last five years, MSFT has used 41% of its excess cash to either pay dividends or repurchase shares. Meanwhile the cash balance still exceeds $88 billion and is growing.

So, the flip side of the predictable cloud-based revenue is that the valuations for these stocks depend more on cash flow and less on having the hot product of the moment.

This makes the sector more-boring to the average tech investor, yet it also points to some very valuable opportunities that may have been overlooked by the market in general.

This chart compares current and forecasted multiples for MSFT relative to other large software players. The chart is from Infinancials, which uses Factset estimate data:

The market is applying a small 10%-15% enterprise value/EBITDA cash-flow measure discount to MSFT shares, implying both an advantage on software and maybe a disadvantage in other areas.

A recent JPM Global Technology Survey highlighted MSFT as one of the top five vendors most likely to benefit from cloud adoption — and also one of the top five most likely to experience reductions.

The losers list included Oracle (ORCL), EMC (EMC), NetApp (NTAP) and IBM — all large firms whose larger systems are becoming less relevant with distributed processing and new traffic/security management approaches.

As more companies adopt these recurring revenue models, the existing customer base will become a more significant feature in the valuations of cloud-based companies.

I think that for smaller, specialized software providers, the cloud is a great way to further cement a lead and expand market share.

For example, AutoDesk (ADSK) just announced its AutoDesk Design Suite 2015. Could it find similar success to Adobe?

It’s possible. Initial reviews are positive as developers and designers gain access to a wider variety of tools.

Bottom line: For larger, more diverse organizations, the cloud is a necessity — as is paying attention to all the cash it will generate and the returns to shareholders.

Happy Trading!

Rudy

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