pre-determined game plan - 2015

Coburn Ventures LLC of 50 September 15, 2015

ADOBE - MASTER FILE

MASTER FILE INTENTION: Master Files are intended as open compilations of our ongoing internal research process for a specific company. We don't believe in 'report writing' so much as documenting our clearest thinking in an organized methodical fashion as we work through our deliberate investment process. HOW TO USE MASTER FILES: Master Files begin with our current thinking, move into a description of how we feel the company fits into each of our 4 “Nodes”, and then lay out our detailed investment work chronologically from our initial “Quick Look” to our more recent thinking.

COMPANY: ADOBE DOMICILE: UNITED STATES COMPANY DESCRIPTION: Coburn Ventures has a LONG position in Adobe.

Pre-Determined Game Plan - 2015 OUR THESIS: ** Thesis: Adobe, the leading provider of software for digital media and marketing, is poised to profit from two key catalysts. In Creative (2/3 of its business), the company is enjoying the benefits of a forced migration of its installed base to a SaaS-based Creative Cloud having far higher long term margins as operating expenses for marketing and development drop and a potentially larger TAM will be generated as well. On the marketing side (1/3 of its business), Adobe has assembled the most comprehensive digital marketing suite amongst a fragmented, uncohesive set of options. Adobe is in the early stages of an extended adoption period of tools by marketers. Between these two changes, Adobe will see a catch up in revenue growth characterized by high incremental margins, translating to sizable earnings leverages and rising free cash flow generation. Slogan: SaaSy and Suite ** Burning Questions (July 2014) #1: TRANSITION: How fast will Adobe transition its Creative Suite base to Creative Cloud, and how high are incremental margins? Context: 4Q12-1Q14 Creative Cloud sub adds: 92K, 102K, 138K, 156K, 227K, 322K, 402K, 405K #2: MARKETING CLOUD: Does a true “marketing cloud” market actually develop or do marketers prefer using a collection of best of breed solutions? What signals (if any) that Adobe is becoming the standard? #3: ADDRESSABLE MARKET: Does Creative Cloud expand the addressable market for Adobe? Does Adobe’s recent segmenting of Cloud subscription to achieve this goal (e.g. a “premium” or “base” edition) Context: Currently 1.84m subs, Adobe has guided to 3m subs for FY14 and 4m subs by FY15 for individual and team subscribers. #3A: ENTERPRISE: How large is the incremental Enterprise Term License Agreement (ETLA) opportunity? #4: SALES AND MARKETING: Does Adobe’s existing user base in creative allow Adobe’s SaaS model to *actually* generate leverage at S&M over time?


Context: Post transition, Adobe shouldn’t have to spend as much to capture customers or on discounts in the channel. #5: CROSS SELL: Do Analytics (former Omniture) and/or Content Management (former Day Software) allow for a sticky foundation leading to greater cross-selling, higher ASPs, and increased penetration into the installed base? Context: Adobe has 6 software suites within Marketing, customers subscribe to 1.4 on average as of 1Q14. #6: EXCESS SUCCESS: What does Adobe’s management team do with its rising margins and free cash generation? ** Thesis Threats (July 2014) #1: MARGINS: If the expected operating margin expansion from the SaaS transition and Digital Marketing Suite never materializes. #2: ADOPTION: If the later stages of adoption of Creative Suite don’t materialize, making it difficult to forecast what steady state growth post-model transition looks like. #3: CHURN: If Adobe’s current user base doesn’t fully adopt Creative Cloud because the ability to pay for the service for shorter periods of time simply results in higher churn. #4: POINT OVER SUITE: If Adobe is unable to drive 20%+ revenue growth in digital marketing because customers prefer best of breed solutions, rendering its suite strategy ineffective. #5: CONSOLIDATION: If Salesforce.com, IBM, Oracle, or another well-funded competitor is able to more rapidly and successfully put together an integrated digital marketing platform behemoth. FOUR NODE CONSIDERATIONS NODE #1 (SOCIETAL SHIFT) Adobe is leveraged to multiple powerful NODE 1 shifts. For over 20 years, Adobe’s formats and technologies within its Creative Suite Software (e.g. Flash, Acrobat, Photoshop) has served as a Digital Ferryman in the Digital Demographic Revolution, enabling the creation and sharing of rich digital content. From this role, Adobe’s Creative Suite has emerged over time as a dominant tool (a Castle in our parlance) used by content creators to create compelling digital media (The Meaning of Life is to be Entertained), which has helped fuel the boom in online advertising (End of Advertising). Over the past few years, Adobe has put together the industry’s leading Digital Marketing Platform. Adobe’s Marketing Suite is aimed at reducing the pain of adoption for marketers/advertisers in working in the more analytical, complex, and increasingly mobile-driven digital world of online advertising. (End of Advertising meets Naked without Data meets Ultimate Mobility). A second set of NODE 1 shifts whose outcome is still not fully known involves Adobe’s transition of its business model from a traditional license/maintenance one to a SaaS subscription model. Here Adobe is testing its customers’ “Comfort with Change” by pushing through what amounts to a price increase on its to-date sticky customer base in exchange for the ongoing updates (Faster World) benefit that a SaaS Model confers. We think the SaaS version of Creative Suite fits nicely within the increasing rental society we live in; in this case, the ability to “rent” creative media creation software should help broaden the addressable market.

NODE #2 (MARKET OPPORTUNITY) Adobe’s business is dependent on two separate areas of software that are tied to attractive markets linked to powerful NODE 1 shifts: Digital Media and Digital Marketing. Its core Digital Media business (Photoshop, Illustrator, InDesign, and Premier Pro) address user crises around the proliferation of content being created: online video, mobile applications, and web publications that work multiple


platforms and devices. A second set of crises revolve around sharing and collaborating, and how to deliver content between partners. This market is large, but moving towards the mature end of its S-Curve: Gartner data pegs Digital Content Creation Market as grow at a 6% CAGR in 2012-2017, reaching a $4.9 B market size. This doesn’t quite capture the whole Digital Media and Print and Publishing divisions: Adobe pegs this addressable market at ~$8.5 billion, which includes $2.1 billion for document management. We have a thought that since Adobe has a dominant >50% market share in a content creation space growing mid-single digits, its shift to a subscription model has the benefit of effectively tacking on or extending the S-Curve itself by (a) bringing in a new group of users, and (b) seeing the impact of the price increase. The user crises around digital marketing have grown as (a) more ad dollars flow online, (b) sales tracking and marketing campaigns become more analytical, and (c) more integration with external partners (e.g. ad agencies/demand side platforms) is expected. To put some context around market sizing for just one of Adobe’s six digital marketing sub segments, marketing optimization, Gartner sees this as one of the fastest growing subsectors of enterprise software: growing at a 21% CAGR over the next five years, reaching $9.5 B by 2017. Marketing optimization refers to the process of capturing and analyzing data in order to optimize the how, what, and where of online ad spending (e.g. on paid search), in order to maximize web traffic, leads, and conversion into sales. While this is the largest segment within Digital Marketing, the overall market that Digital Marketing addresses is much larger (Adobe pegs its overall market opportunity in this space at $18.7 billion). While we tend to look at industry forecasts and company-provided TAMs with a grain of salt, the key takeaway is that Digital Marketing is a larger and faster growing market than the legacy Digital Media. NODE #3 (COMPETITIVE ADVANTAGE) We view Adobe having a dominant position in the content creation market; a position that has increased over time as one-time rivals have either been acquired (Macromedia), relegated to specific niches (e.g. Corel, Avid), or having never fully achieved its goals (Microsoft). Quite simply… if you are in the business of professional digital content creation today, you use Adobe’s tools. From this position as industry standard, Adobe’s tools have filtered down to other parts of the market (e.g. amateur creators, educational space, etc.) It is from this position of competitive dominance that Adobe has embarked on its transition to SaaS-based subscription pricing model for Creative Cloud. From a business model perspective, Adobe has removed the costs and risks associated with research and development and sales and marketing around 2-3 year product cycles, whereby Adobe was pressured to put a release out at a certain date, and potentially ramp up spending on sales and marketing to get customers to upgrade. Removing this tension should have the impact of allowing for a more focused and efficient organization. All Creative Cloud customers will now have the most up to date versions of the software; we think this will only increase stickiness to its platform. Importantly, this conversion to monthly subscription pricing has the benefit of expanding the overall user base; a somewhat controversial claim that Adobe’s management has made, but one supported by friends and fellows within our community. How so? We think lower pricing (~$50/month vs. $1300-2600 for a license) will have the impact of lowering the barrier to adoption for users where price was an issue: a freelance professional or students who can now effectively “rent” the software for 3-4 months at a time. Emerging Markets might see greater penetration due to lower pricing. We think the combination of lower monthly pricing and cloud based delivery will over time reduce piracy; management has estimated as much as 1/3rd of users may have used pirated versions. A key question is (a) how large is the current user base (Adobe put out a ~13m figure a year ago), (b) how large is the overall potential user base? Adobe’s management has stated that since the launch of Creative Cloud, it has seen upwards of 20% of subscribers as new to Adobe. On the Digital Marketing side of the house, we think Adobe has been a shrewd acquirer and efficient integrator of leading digital marketing technologies, from Omniture to Day Software to Neolane and Behance. Significantly, compared to rivals Salesforce.com (email-centric Exact Target) and Oracle (social-media centric-Vitrue), Adobe’s


approach has led with web design. We view this as a wise strategy as Adobe Experience Manager (AEM) becomes a sticky foundational element from which to sell additional modules; it is easier to switch out social media or analytics platforms as historical data lives on 3rd party platforms, while switching out one’s website is a higher barrier to exit; it is the equivalent of ripping out one’s ERP system. While Adobe’s portfolio of marketing software is not complete (its missing the key ingredient of email marketing for one) and there is no Creative Cloud-industry standard yet in the fragmented world of digital marketing, we think Adobe is best positioned in the space. Finally, we think it’s important to note that we see very little (if any) synergy between the Digital Media and Digital Marketing sides of Adobe’s business, despite management’s assertions. NODE #4 (OPERATING MODEL) As Digital Media is ~2/3rds of Adobe’s business, the key dynamic is the SaaS model transition of the Creative Suite to the Creative Cloud. Multiple benefits: To spur adoption of Creative Cloud, Adobe instituted pricing of ~$30/month, or $360/year, well below the former licensing prices of $1300-$2600 depending on the package. So on top of the declines in revenues that a subscription model transition entails (revenues recognized ratably rather than upfront), there was also a temporary price cut, which has now ended, with pricing set to revert to a ~$40+ monthly figure. As more users transition towards the SaaS model, Adobe’s revenue growth will accelerate significantly; or perhaps a better description is it will “catch up”, layering on recurring revenues year after year as more subscribers join. This growth that will come with high incremental margins (~50%) for the next few years: - Gross margins for Creative Cloud should improve back to historical levels of 96%+ as physical software

distribution costs are done away with. Hosting costs for Creative Cloud aren’t as high as other cloud delivery models because most of the processing is done on a user’s computer.

- R&D has increased ~6% / year for the past few years…this shouldn’t change much, cloud means more frequent updates, but less investment in BIG new releases every few years.

- S&M should see the most operating leverage as it has ramped up S&M to drive the transition to Creative Cloud, notably through promotional pricing. Overtime, this will decline…and it is cheaper to renew existing subscription clients than to sell a new version of software a user has.

- In the former model, Adobe sold largely through distribution channels, which often involved a degree of discounting (25-45% off list price was common). Selling directly through a SaaS model largely eliminates this.

- G&A should see no material impact. At ~30% of revenues, Digital Marketing is the second growth engine for Adobe’s model, and should see accelerating revenue growth and operating leverage for a few reasons: - Integration and cross selling more modules to existing customers: there are 6 main modules and customers

purchase 1.4 on average right now…IF Adobe is right and it has put together the dominant advertising platform, it should be able to increase this over time, driving revenue growth.

- Two modules are themselves undergoing a subscription transition. - Many of the modules are priced based on usage…so if Adobe’s marketing cloud becomes more widely used,

more marketing dollars will flow over it. Finally, we see Adobe’s SaaS model transition as a significant positive for free cash flow. Rising EBIT margins will directly translate to FCF almost tripling between 2014 and 2016 and management has stated that it will increase its share buybacks over time; this is part of the impetus for the 76% and 60% EPS growth rates in 2015-2016. Model Snapshot (with current consensus estimates) 2010-2016E: Rev Growth: 29%, 11%, 4%, -8%, 3%, 20%, 24% Gross Margin: 91%, 91%, 91%, 88%, 87%, 87%, 88%


EBIT Margin: 37%, 38%, 36%, 23%, 20%, 28%, 37% EPS: $1.93 (+25%), $2.35 (+22%), $2.35 (0%), $1.34 (-43%), $1.23 (-8%), $2.10 (+70%), $3.31 (+57%) Balance Sheet & Cash Flow: The balance sheet is solid. Adobe has $3.2 B in cash and no debt. Forecasts for capex and FCF for 2010—2016: Capex: $137m, $210m, $271m, $164m, $154m, $213m, $268m FCF: $1B, $1.3 B, $1.2 B, $0.96 B, $1.0 B, $1.48 B, $2.1 B ***** HQ: San Jose, California ***** MANAGEMENT: Shantanu Narayen, CEO – Shantanu Narayen is president and CEO of Adobe. Prior to his appointment as CEO in December of 2007, Narayen was Adobe's president and COO. Previously, he held key product research and development positions within Adobe, including EVP of worldwide products, SVP of worldwide product development and VP & GM of the engineering technology group. Before joining Adobe in 1998, Narayen was co-founder of Pictra, an early pioneer of digital photo sharing over the Internet. Prior to that, he served as director of desktop and collaboration products at Silicon Graphics, Inc. and held various senior management positions at Apple Computer. Narayen holds five patents and is a frequent speaker at industry and academic events. Narayen holds a bachelor's degree in electronics engineering from Osmania University in India, a master's degree in computer science from Bowling Green State University and a master's degree in business administration from the Haas School of Business. Mark Garrett, CFO - With more than 25 years of financial management experience in the technology sector, Garrett has worked with many of the industry's leading companies. Before joining Adobe in February 2007, Garrett served as SVP and CFO of EMC's Software Group. Prior to working at EMC, he was EVP and CFO of Documentum.Previous accounting and finance management positions include tenures at IBM and Cadence Design Systems. Garrett currently serves on the board of directors for Informatica, Model N, a provider of revenue management solutions, the Adobe Foundation and the Children’s Discovery Museum of San Jose. He holds bachelor's degrees in accounting and marketing from Boston University and a master's degree in business administration from Marist College.

FUNNEL WORK

ROUND 2 - QUICK LOOK – (APRIL 2014) TIME ALLOCATION: THREE HOURS Adobe (Ticker: ADBE); $30 Bn Market Cap; Software 4.14.2014

Our investment process uses a discrete series of steps to funnel companies into our portfolio…beginning with a “quick look” and moving to more, and longer, “extended looks”, we gradually build our knowledge of a business. Each step is designed to answer any lingering questions we may have from our previous work and determine if more work on the company is worthwhile.


*****CONTEXT: We have looked at Adobe multiple times over the years and held a position for a while. We did a short relook in August 2013 that touched on the transformation, but we didn’t go further. The intention of a fresh quick look rather than a relook is to fully reframe this business, which has undergone many changes in the last 2 years. ***** CONCLUSION: Extended Long. I am positively predisposed right now. There are two changes with Adobe since we did serious work on this company that stand out as “Burning Question Buckets” to attempt to answer in the goal of determining if this is a potential great long candidate or a company actually destined for a Minority Report or Short future: (1) The shift towards a SaaS model, which is important to understand for how it impacts the operating model and financials – yes! But more important to understand (a) if this *truly* expands the TAM by lowering the barrier to adoption of the products or if it (b) reduces the market size and potential growth because it raises the barrier to adoption….the answer could also be (c) it doesn’t fundamentally impact the market opportunity. (2) The morphing of this business into one predicated on analytics in the marketing space. Essentially, Adobe has M&A-ed its way to a $1.4 billion business where one didn’t exist in 2010. The questions to answer are, (a) is THIS business where the action/change really is since it addresses a faster growing/larger S-Curve, (b) is there a true competitive advantage to pairing the Marketing Cloud with the core Creative Cloud under one roof, and (c) has Adobe (or can Adobe) effectively integrate multiple acquisitions into an effective product that becomes the STANDARD like Creative Suite was, or is it really just a collection of Apps? ***** FIVE MOST IMPORTANT THINGS TO KNOW #1) Dominant provider of content creation software. #2) Forcing a transition on its user base from license to subscription pricing. #3) In the last 3 years has made a series of acquisitions to build a $1.4 billion Marketing Cloud business. #4) Claims there will be synergies between its content creation business and the marketing optimization side. #5) Operating model is forecasted to see margins expand significantly over the next 2-3 years as the model transition takes hold. ***** COMPANY DESCRIPTION IN OUR OWN WORDS: Adobe Systems Incorporated develops, markets, and supports computer software products and technologies. The Company's products allow users to express and use information across all print and electronic media. Adobe offers a line of application software products, type products, and content for creating, distributing, and managing information. ***** FOUR NODE INVESTMENT PROCESS ** NODE 1: WHAT NODE #1 SOCIETAL SHIFTS ARE SHAPING THIS BUSINESS OPPORTUNITY?

• Faster World + Free World = Adobe changed from a license model to a subscription model. • Digital Demographic Revolution + Meaning of Life: Adobe caters to the manipulation and creation of

digital media. • Digital Ferryman + End of Advertising: Adobe’s Marketing Suite it has built up in the last few years is

aimed at reducing the pain of adoption for marketers/advertisers in working in the more analytical, complex, digital world of online advertising.

• Comfort with Change: Adobe has put forth the largest (to date) forced transition from License to Saas based software. For context of the speed of transition, it initiated the transition in 2012 and announced in May 2013 that Creative Suite 6 would be the last on-premise Adobe software. This has introduced a degree


of pushback/dissatisfaction from its to-date loyal customer base. We explore more in NODE 3 competitive advantage.

** NODE 2: WHAT ARE THE END MARKET DYNAMICS TO CONSIDER? ** Question: Who is the customer? Adobe’s core customer has always been content creators: web designers, app developers and digital media professionals. Over time, this customer base has expanded to included marketers, advertisers, agencies, publishers, merchandisers, and sales and marketing professionals. ** Question: What are the user crises to consider? Are they growing / intensifying? The change in user crisis that Adobe is seeking to address is the rising intensity of complexity within the chain of content creation and marketing. Let’s break these into two pieces: - Digital Media Creation: The user crisis has increased over the past 3-5 years due to the increase in the types of

content being created: e.g. video, mobile applications, web publications that have to work on a variety of platforms and devices. There are issues around sharing and collaborating, and how to deliver content between partners that the Creative Suite / Cloud seeks to address.

- Digital Marketing: This user crisis has probably accelerated faster and may be more acute for customers as the explosion of methods and platforms for advertising has accelerated in the last 3-5 years as (a) more ad dollars flow online, (b) sales tracking and marketing campaigns become more analytical, and (c) more integration with external partners (e.g. ad agencies/demand side platforms) is expected.

** Question: With what products or services is the company addressing this crisis? Adobe’s products fall mainly into two buckets that seek to address these two sets of user crises: Creative Cloud – collection of digital content creation tools like Photoshop, Illustrator, InDesign, and Premier Pro. The core of Adobe’s product offerings. Marketing Cloud – collection of services used for 6 functions: creating, managing, executing, measuring and optimizing digital advertising and marketing campaigns across multiple channels. The 6 products are Adobe Analytics, Adobe Campaign, Adobe Experience Manager, Adobe Media Optimizer, Adobe Social, and Adobe Target. Put together….the marketing cloud is meant to complement the creative cloud…solving the user crisis of integrating content creation and then measuring and optimizing how that content is utilized. ** Question: How is the product priced? This question gets at the heart of one of the two key changes with Adobe. Beginning in early 2012, Adobe began transitioning the pricing model for Creative Suite to a SaaS based model…transitioning the product to the current Creative Cloud. The pricing differences: - Creative Suite 6, the last major release, had prices ranging from $1,300 to $2,600. Each release tended to last a

user 3 years.

- The new Creative Cloud has had promotional ~$30/user/month for Creative Cloud for the past 18 months (this is tentatively scheduled to end in May 2014, but lets see if that happens). That pricing is expected to go to


$50/user/month once the promotions are lifted. So under promotional pricing Creative Cloud is $360/year, or $600/year without. Multiply x3 to get a closer comparison to the former pricing and you get $1080-$1800.

So what?

This is not an apples to apples comparison, because of the many differences between a license model and subscription product that gets upgraded constantly…and the proposed price increase from promotional $30 to full price $50 has implications also. We also haven’t addressed that Adobe previously sold point products and now only a suite…which plays into “perceived pain of adoption” issues around pricing. There is more to tackle on this pricing change. The Marketing Cloud price points are higher, and vary from component to component (it is not sold as a take it or leave suite). For example, Adobe Campaign, one of the 6 modules, just changed its pricing model to charge a flat “platform fee” plus a fee per customer profile. Many marketing cloud products tend to charge on a CPM rate (cost per thousand emails). ** Question: What perceived pains of adoption ought to be considered? There would seem to be pains of adoption around the forced subscription transition to the Creative Cloud. While the product reviews are solid, there has been a degree of pushback from different groups of users within Adobe’s user base. Some whose use cases were low frequency may not be compelled to switch, or may simply churn on and off a subscription model, while other users are concerned with proprietary issues. Brynne flagged an example last summer with photographers who were concerned about the storing and secure delivery of work to clients on a cloud service that is not under their control. Government agencies and other content sensitive users probably have similar concerns. Universities or businesses who in the past were able to re-use purchased licenses for students across different classes and semesters, or as employees came and left might have an issue too, though these types of customers might still have Enterprise Term License Agreements that can address these problems. ** Question: What are any other key S-curve attributes we ought to consider? E.g. Is the market large and growing? What are penetration level’s for this company’s product? A possible driver behind Adobe’s shift to (a) subscription pricing and (b) the series of acquisitions that led to the Marketing cloud is the differences in the sizes and growth rates of the underlying market opportunities. I’m going to cite some Gartner data to outline the differences. Adobe’s core Digital Content Creation Market (Gartner term) is forecast to grow at a 6% CAGR in 2012-2017, reaching $4.9 B market size. This doesn’t encompass all of what goes into Adobe’s Creative Cloud (no document management software is included for instance), but gives a rough idea. In Adobe’s analyst day presentation last year, it pegged its content creation TAM at ~$8.5 billion, which includes $2.1 billion for document management. By comparison, the marketing optimization segment is one of the fastest growing subsectors of enterprise software: Gartner pegs it growing at a 21% CAGR, reaching $9.5 B by 2017. Adobe pegs its overall market opportunity in this space at $18.7 billion; it attaches the following dollar figures to each of the 6 modules: - Experience Manager, $4.5 B - Campaign, $6.5 B - Target, $1.8 B - Social, $1.3 B - Media Optimization, $2.6 B - Analytics, $2.0 B So what?


One thought is that since Adobe has a dominant >50% market share in content creation, a space growing 5%, so to grow faster than the market, Adobe put in this pricing shift as a means of generating a period of faster revenue growth (not to mention flipping the switch from $30 to $50) as the transition takes hold. An area worth exploring is whether the shift towards a subscription model (a) expands the TAM and reaccelerates the S-Curve a bit because the lower monthly price points may open Adobe’s products up to a wider user base, or (b) reduces the TAM and slows the S-Curve by shutting off some potential users. A second dynamic that serves as a secular tailwind towards Adobe is the increasing importance of digital media content creation and measurement in the economy in general. Increasingly, these tools are used in more job functions in the economy (Digital Demographic Revolution). ** NODE 3: DO THEY HAVE A SUSTAINABLE COMPETITIVE ADVANTAGE? ** Question: What is the company’s market share and is it growing / declining? One way to consider this question is to pair data from Gartner with some data from Adobe’s Analyst Day last year. Gartner pegged Adobe’s market share in content creation market at ~55%, with Microsoft a distant second at 16%. Corel, Apple, Avid are all at 3-4%. Adobe has the dominant position in content creation, especially for mainstream corporate users. On the marketing optimization side, Gartner pegs market Adobe as having the leading market share with ~19%, followed closely by IBM (~17%), SAP (~16%), SAS Institute (14%), Oracle (9%), Microsoft, and others. Again, this isn’t an exact mapping of where Adobe’s Marketing Cloud products sit, but does give an idea of the main players in the space. The interesting point is that the Digital marketing space is getting consolidated by the larger CRM companies who view this as a logical platform extension. Lets call this bucket Salesforce.com, Oracle, and IBM. An area to explore in a followup round is the competitive dynamics in this space and what it means? ** Question: What does the company suggest its competitive advantage is? ** Question: What is our take? Will this company’s competitive position get stronger or weaker in the next 2-3 years, all things considered … and why? Are there any “change frameworks” that can help us assess the competitive situation? Rather than rehashing Adobe’s competitive strength in the creative side, I’m interested in learning more about claims that Adobe makes: (a) Adobe has the most complete end to end marketing cloud, and (b) there are distinct synergies to be had between Creative Cloud and Marketing Cloud that will form the basis of a defensible competitive advantage vs. competing CRM software providers. On the second point, Adobe claims that by combining the entire digital workflow on a single platform, from make and manage to measure and monetize, it will make both platforms stronger competitively for multiple reasons. One example might be that by putting all these products together, Adobe becomes to a CMO what an ERP platform is to a CIO: a must buy product. I’m not sure this is good or bad…in many ways this may even run counter towards the approach that many SaaS companies take: make a software program cheap enough to be able to be bought on a credit card at a departmental level, rather than running it up the chain of command. On the first point, I have questions around what exactly was acquired to create this marketing cloud and how good Adobe is at integration. As a reminder, there have been five acquisitions in the last two years as the company cobbles together more marketing tools. The largest three (the three of the five that required purchase price) are: *Efficient Frontier, in Jan.2012, for $375mn.(web marketing) *Behance, in Dec 2012, for $130mn *Neolane, in July 2013, for $600mn. (marketing & cross-channel campaign management) ** NODE 4: IS THERE LEVERAGE IN THE MODEL (OPERATING / MULTIPLE)? Revenue split / segment mix:


Operating leverage?: ** Current headline #s: 2010 – 2016E: - Rev Growth: 29% 11% 4% -8% 2% 19% 25%

- Gross Margin: 91% 91% 91% 88% 87% 87% 88%

- EBIT Margin: 37% 38% 36% 23% 20% 28% 36%

- EPS: $1.93 $2.35 $2.35 $1.34 $1.17 $2.06 $3.29

- EPS Growth: 25% 22% 0% -43% -13% 76% 60%

Yes, there is significant operating leverage being forecast, mostly due to the SaaS transition, with an element of “bundled cross-selling” potentially thrown in by analysts who are giving Adobe some credit for the platform strategy. Sources of potential operating leverage include: - Rising ASPs - New users in an “expand the TAM” scenario. Adobe mentions that users who previously pirated Adobe might

be willing to pay $30/month. - Lower distribution costs (cloud based distribution) This is offset by some non-beneficial elements of a SaaS transition, such as rising S&M expense as sales people get paid upfront for revenue recognized ratably over time. Take a look at how the line items have progressed over the last few years from the “old” adobe in 2010 to the one in transition today: From a line item perspective for 2010-2013 (as a % of sales): S&M : 33% 33% 34% 40% R&D: 18% 18% 17% 20% G&A: 10% 10% 10% 13% One last point: the faster the migration of subscribers from on-premise to cloud, the more the pressure on earnings in the near term: smaller revenues recognized in the near term (a monthly subscription rather than a big license number), and higher expenses translate to lower margins. Plenty to dig into on the model side. Valuation leverage? Adobe is up 1% year to date. The stock trades at 52x forward price to earnings. EPS estimates for FY14 have come down 26% and FY15 have come down 9% in the past 6 months. Roughly flat in the past 3 months. **Short Interest: 1% of the float outstanding is short. ***** HQ: San Jose, California ***** MANAGEMENT: Shantanu Narayen, CEO – Shantanu Narayen is president and CEO of Adobe. Prior to his appointment as CEO in December of 2007, Narayen was Adobe's president and COO. Previously, he held key product research and development positions within Adobe, including EVP of worldwide products, SVP of worldwide product development and VP & GM of the engineering technology group. Before joining Adobe in 1998, Narayen was co-


founder of Pictra, an early pioneer of digital photo sharing over the Internet. Prior to that, he served as director of desktop and collaboration products at Silicon Graphics, Inc. and held various senior management positions at Apple Computer. Narayen holds five patents and is a frequent speaker at industry and academic events. Narayen holds a bachelor's degree in electronics engineering from Osmania University in India, a master's degree in computer science from Bowling Green State University and a master's degree in business administration from the Haas School of Business. Mark Garrett, CFO - With more than 25 years of financial management experience in the technology sector, Garrett has worked with many of the industry's leading companies. Before joining Adobe in February 2007, Garrett served as SVP and CFO of EMC's Software Group. Prior to working at EMC, he was EVP and CFO of Documentum.Previous accounting and finance management positions include tenures at IBM and Cadence Design Systems. Garrett currently serves on the board of directors for Informatica, Model N, a provider of revenue management solutions, the Adobe Foundation and the Children’s Discovery Museum of San Jose. He holds bachelor's degrees in accounting and marketing from Boston University and a master's degree in business administration from Marist College. ** Question: Relative to management, so what? Does anything stand out? ***** PRICE PERFORMANCE, VALUATION, GROWTH…

Stock Adobe Sys Inc Mkt Cap ($US) $30,113 Price US$ $60.50 1mo % -10 3mo % 2 12mo % 34 vs 50day 0.92 vs 200day 1.08 Rev Grw FY'14e 2% Rev Grw FY'15e 19% EBIT % '14e 20% EBIT % '15e 28% P/E FY'14e 52 P/E FY'15e 29

ROUND 3 – ADOBE EXTENDED LOOK – (APRIL 2014) TIME ALLOCATION: 3.5 HOURS Adobe Extended Look ADBE-US 4.21.2014 CONCLUSION: Two tracks. Model round on the long side. I’m still positively predisposed. But want to sort out the underlying drivers of this model in a state of flux. The drivers *seem* powerful, but this is not what I attempted to cover this round. Second (and related): since we know so many folks in the digital advertising world, I would *really* like to talk to a few to get a better handle on how powerful Adobe’s position in the marketing software world is. I have high conviction that Creative Cloud will continue to be the winner (it has sustained 50%+ market share). But I want to hear from a more knowledgeable source if what I learned this round is (a) true (Marketing Cloud is dominant too),


and (b) are the synergies put forth by the company real? So maybe we can ping some friends to talk to at the same time. ** WHAT IS THE PROPOSED MONUMENTAL CHANGE? Adobe will see NODE 4 operating model benefits from (1) shifting its creative suite product to a SaaS model and (2) the creating of a marketing business over the past few years will translate to (a) upside from a growing market opportunity and (b) synergies with the creative business. ** WHAT ARE WE ADDRESSING TODAY? Two buckets of investigation for this round: - The Creative Business, and how the SaaS transition might impact the addressable market. - The Marketing Business – what’s in it, what advantages are there? Q. Does Adobe’s shift towards a SaaS model (a) expand Adobe’s TAM by lowering the barrier to adoption of the products, (b) reduces the market size and potential growth because it raises the barrier to adoption, or (c) it doesn’t fundamentally impact the market opportunity? Management has made the case in the last year that the shift towards the SaaS model is expanding the addressable market. At its recent Digital Marketing Summit, which amounts to an Analyst Day, the company walked through how it now sees a 2016 TAM of $5.8 billion for the creative pro business, $1.7 billion for consumer, and $2.5 billion for Document Services (Acrobat). The takeaway is that at $7.5B, this is more than 2x market opportunity before the business model change. How does Adobe get there? Last May (the last Financial Analyst Day), the company sketched out that its active pro user base is 13.3m users, of which only 6-8m are on Creative Suite 5 or 6 and are likely to transition (CS3-4 aren’t likely upgrade candidates). This makes sense that most pro users on the most recent edition will transition once support ends for the older versions. This doesn’t really expand the TAM so much as transitioning existing customers at prices that over time will equate to a larger market. Management sees a handful of reasons that the pricing change might add customers: - Might lure back CS version 1-2 customers who have a way of re-attaching to the software. - Lower pricing might reduce piracy. Management estimates that as much as another 1/3rd of users may pirate the

software (~4.4m). - Freelance creative professionals who work on short term projects can now get Creative Cloud for a few months

at a time. - Increased penetration in Emerging Markets where price may have been a big issue. - Reduces the pain of adoption of moving point product users to suite users. To date, Adobe has seen greater

adoption of Creative Cloud from point product users than it had from point product to CSuite. So what? We could make a counter argument on all of these points that they might just result in higher churn, so this is a bit unknowable. But I tend to believe many of these arguments. *an interesting point to consider is that if Adobe is 50%+ of the content creation market, and its business model change earns it more money, it has effectively increased the overall TAM itself. Q. Adobe’s Marketing Cloud: (a) is there a true competitive advantage to pairing the Marketing Cloud with the core Creative Cloud under one roof, and (c) has Adobe (or can Adobe) effectively integrate multiple acquisitions into an effective product that becomes the STANDARD like Creative Suite was, or is it really just a collection of Apps?


As a reminder, Adobe has essentially M&A-ed its way to a $1.4 billion business where one didn’t exist in 2010. Between late 2009 (Omniture) and summer 2013, Adobe made 17 acquisitions, almost all in marketing. The 5 key purchases were: - Omniture in September 2009 for $1.6 billion, which got Adobe into Analytics. Omniture did a full range of

web-based analytics: paid search and content network optimization, behavioral targeting, and analyzing visitor traffic.

- Day Software in July 2010 for $176m, which brought Adobe a digital content management system for the web.

- Efficient Frontier in November 2011 for $375m, an ad buying platform used for managing search engine marketing, display advertising, and social media campaigns. Used by marketers and agencies.

- Behance in December 2012 for $130m, an online portfolio platform for creative professionals to share content.

- Neolane in June 2013 for $600m, software that manages direct marketing campaigns, leads, resources, customer data and analytics. The software also allows companies to design and orchestrate targeted and personalized campaigns from direct mail, e-mail, SMS, and MMS.

So at first, it would be rather safe to say this was a collection of apps. Adobe was selling 27 different point products in “Marketing” software, and any single customer only used 1-2 of these products. Beginning in late 2012, early 2013, Adobe made 2 key changes: consolidating the many offerings into 6 products with standardized pricing structures that were appropriate for the product: - Adobe Analytics: all products related to performing big data style analytics on the volumes of internal data a

company might generate, sometimes paired with external, 3rd party data. The product is priced per millions of transactions.

- Adobe Experience Manager: allows a marketer to deliver Hyperpersonalization of an advertisement depending on the device, form factor, or the type of visitor (e.g. determining in the visitor might be a sports fan based on coming to your site from ESPN, they might get pitched the more “sports-related” version of an add). Just released a new version (6.0) with mobile app development features. This has lots of cool stuff: it works with Apple’s iBeacon technology for instance. This software is priced by seats or instances.

- Adobe Target: analytics related software used to optimize websites and marketing campaigns. Transaction-

based pricing.

- Adobe Social: software used for marketing on social media. Priced based on the # of mentions on social sites.

- Adobe Media Optimizer: media buying software for Social, Search, and Display (that’s the distinguishing part…it does all 3). Priced based on a % of Media Spend (independent of type of media which is different from other solutions)

- Adobe Campaign Manager: the Neolane product; personalized marketing messages. Priced by # of messages.

There is a lot more behind each of these one bullet point summaries. Pulling from our work on Palo Alto Networks, and recent thinking about how important reducing complexity in selling is….I think simplifying these 27 products into 6 suites and reducing the pricing structures is important. It also reduces the friction of adding more modules. Previously, each product had separate contracts and time lines for procurement, shrinking the number of products to 6 can speed the sales process while also enabling upselling. The last point? Since many of these products are priced on a transaction based pricing or per # of mentions, potential customers could simply sign up for all these products, and start using specific components for a project here and there over time, without having to commit to large outlays at first.


*PROTO BURNING QUESTION: Does the bundling of products enable Adobe to leverage one popular product to increase breadth of usage and thereby platform stickiness, or does this turn off potential customers who don’t want to pay for more products than they might need/use? In my reading, I was struck by the breadth of products that Adobe has in its marketing cloud. I personally wasn’t aware that Adobe has (by far maybe?) the most complete amount of marketing software technology under one roof. There seem to be a handful of particularly KEY products. One is its content management system, called “Adobe Experience Manager” (AEM) which *seems* to function as an ERP-ish system for all of digital marketing. Adobe acquired this from Day Software, and the general idea is that this is what a marketer uses as its digital content library. From here, the marketing optimization software might choose an image or video to launch on a website. Importantly, *this* Digital Content Library would appear to be the link between the Creative Cloud side of the business and the Marketing Cloud. PROTO BURNING QUESTION: Is the AEM content management system a distinguishing “glue” that might bind together the Creative and Marketing Cloud? The company has held a Digital Marketing Summit the past two Marchs through which I’ve been able to get a relatively fuller understanding of what Adobe is aiming to do with its Marketing Cloud. KEY POINTS: - Management believes that in today’s digital marketing world, marketers are expected to deliver the user

experience from a website in 300 milliseconds. This means marketing software has to be able to (1) listen to all the data a company has collected in multiple silos, (2) predict the experience a visitor wants, (3) assemble personalized content (e.g. video, pictures, or data), and (4) deliver on any device/form factor and any bandwidth (course correcting for bandwidth – e.g. replace a video with a picture). The most effective way to manage these 4 tasks is to do so with the same platform (adobe’s value proposition) rather than manage integrating multiple products. The other takeaway is that over time, companies that might be focused on 1 or 2 of these 4 points will be compelled to participate in all 4.

- Management compared what Adobe is doing with the Digital Marketing Suite to the move from point solutions to ERP products in which the complete process is delivered by a single product.

- Adobe believes it is uniquely positioned to build the dominant suite vs. IBM/Oracle/Salesforce.com because

marketing is content related and Adobe always has worked with content professionals while the others are more IT centric.

- Marketing Cloud customers have on average 1.4 suites, allowing for higher penetration through cross/upselling. So what? A lot of this makes sense, but I’m not sure that Adobe’s content DNA makes it more likely to have a better marketing suite or not. Its not like Adobe created these companies, it bought all of them! That said, Adobe has certainly executed a fairly well considered M&A strategy to put together what is viewed as the most complete marketing platform, and it *appears* to be somewhat integrated, based on the reframing of 6 products from 27. I would certainly like to talk to some of our industry friends to check on this point, as I don’t have much conviction. As we pointed out in the first round, Adobe does have the leading market share in marketing optimization software. And it does have the Creative Cloud difference – which none of the other three can claim. This leads to the last set of questions….what does management posit this Creative Cloud Difference is? What are the so-called synergies? KEY POINTS: - Management claims marketing firms will be able to create and collaborate on projects with creative

professionals through the cloud via the integration between the Digital Marketing Cloud and the Creative


Cloud. Example: Marketing software (for a car company) pulls creative content from a 3rd party (an advertising agency). This has the added benefit of forcing ad agencies and other contractors to upgrade from Creative Suite to Creative Cloud.

- Any content creation business that seeks to extend into marketing (a natural adjacenty in the shifting advertising environment) will be more likely to choose Adobe, since they already use this software for content creation and it offers the lowest pain of adoption due to easier integration.

- According to management, the % of Creative Cloud customers that use the Marketing Cloud is “high single

digits.”

- Over time, Adobe will have the only integrated “content supply chain” that can manage and move content through an organization and its partners. The key here would seem to be the dominance of Creative Cloud in content creation. My question is…why couldn’t Oracle integrate with Creative Cloud and also become a content supply chain?

PROTO BURNING QUESTION: What % of Creative Cloud users ALSO use marketing optimization software? Meaning…is there actually a large synergy opportunity here? PROTO BURNING QUESTION: How powerful is the incentive to for a Creative Cloud user to also use Marketing Cloud? Are the barriers to adoption of say…Oracle’s marketing software prohibitive for an Adobe Creative user? Or is it more that the integration is just “easier” Last point…for an internet based business, Adobe’s software now covers almost the entire spectrum of needs for marketing, with the exception of ecommerce related closing the sale type stuff. It just announced a partnership with SAP to cover this last mile of the online marketing suite; it will integrate with SAP’s Hybris ecommerce product, and also integrate with HANA to run allow for all Adobe Marketing software to run through HANA databases. In return, SAP will become a reseller for Adobe’s Marketing cloud…and give Adobe access to data from SAP’s ERP and CRM software suites (this appears to be more important than being a reseller). I’m unclear how *important* this is, but there was a flurry of articles about it about a month ago.

ROUND 4 – MODEL – (APRIL 2014) Adobe Model ADBE-US 4.30.2014 Conclusion: Followup on the Long side. We wanted to put together a list of questions for our industry fellows so as to judge the likelihood of Adobe’s Marketing Cloud becoming dominant AND potentially some other areas around the likelihood that Creative Cloud subscriptions might end up closer to 10m rather than closer to 5 million. Looking at the operating model without the context of valuation, one would say…well geez, that’s an awesome operating model, of course I would want to invest in a business like that if I had high conviction in the underlying business fundamentals. Let’s work on growing conviction – if we can. Context: 2010-2016E Rev Growth: 29% 11% 4% -8% 2% 19% 25% Gross Margin: 91% 91% 91% 88% 87% 87% 88% R&D 18% 18% 17% 20% 20% 18% 16% S&M 33% 33% 34% 40% 39% 37% 34%


G&A 10% 10% 10% 13% 12% 11% 10% EBIT Margin: 37% 38% 36% 23% 20% 28% 36% EPS: $1.93 $2.35 $2.35 $1.34 $1.17 $2.06 $3.29 EPS Growth: 25% 22% 0% -43% -13% 76% 60% Balance Sheet & Cash Flow: The balance sheet is solid. Adobe has $3.2 B in cash and no debt. Forecasts for capex and FCF for 2010—2016: Capex: $137m, $210m, $271m, $188m, $179m, $222m, $321m FCF: $1B, $1.3 B, $1.2 B, $0.96 B, $0.85 B, $1.3 B, $2.1 B Stock Data: Adobe currently trades at 29x 2015 earnings. The stock is up 36% over the last year and 3% year to date. SUMMARY: The key dynamic is the SaaS model transition of the Creative Suite to the Creative Cloud. (**Digital Media is ~2/3rds of Adobe’s business). The most important thing? Creative Cloud is essentially a price increase over time….which will be very high incremental margins. Additionally, if one believes the transition reduces piracy and ropes in more part time users, the addressable market served will increase. How does this shift hit costs? - Gross margins for Creative Cloud should improve back to historical levels of 96%+ as physical software




- G&A should see no material impact. This is a powerful operating model dynamic. OK, lets hit those 5 key cells: Key Cell #1: 1Q14 Creative Cloud Average Recurring Revenue Points: Revenues and EBIT margins have declined as subs move from license to subscription due to revenue recognition. Over time, as the pace of subs shift, there is a tipping point where more revenues come from subscription than license, which means revenues will begin growing YoY going forward, and EBIT margins will begin expanding. 1Q14 was this tipping point: $987m in ARR or 52% of revenues were recurring, and the Creative Suite business showed QoQ growth for the first time since 2012...the transition began in 2Q12.


NOTE: If we include Document Services (the other ~30% of Digital Media Segment revenues), ARR is only 44% of total segment sales, so the overall segment should hit the tipping point in 2Q14. Bottom line…revenue growth and margin expansion going forward. Key Cell #2: 2015 Creative Cloud Subs Points: The pace of revenue growth and margin expansion is dependent on the pace of adding subs. Adobe has been exceeding its guidance and consensus estimates for sub growth for the last few quarters. The pace of sub additions has been accelerating noticeably in the last few quarters: 8 quarter Creative Cloud sub add trend line: 92K, 102K, 138K, 156K, 227K, 322K, 402K, 405K Currently, Adobe has 1.84m subs on Creative Cloud. So why do I say 2016 as the key cell? Adobe stated a year ago that there are ~13m users of one of the Adobe Creative products….roughly 8.4m on suites (half at the time were on CS6), and another 4.4m on point products (roughly 1.5m on CS6 era versions of Acrobat/Reader). If we believe Adobe’s contention that the shift to subscription brings in more customers (e.g. pirated users or those who couldn’t afford the upfront costs of a full license), one could add another ~2m potential users. Now, its unlikely all users CS1-4, but 5and 6 would seem like a reasonable expectation as potential customers, which is ~8m users, tack on another 2m from lower piracy/part time users and you get to a ~10m sub market. The point here…the more subs that switch to Creative Cloud, the greater the operating leverage. Adobe is currently guiding next quarter to 2.2m subs (implying similar +405K sub growth pace) and 2014 to 3M subs for Creative Cloud. The KEY question? What is the endgame figure for Creative Cloud Subs? As we sketched above…R&D is essentially the same no matter what number of cloud subs join, same for S&M…so this is very high incremental margins. We have a working scenario analysis tab in our model where one can play with some assumptions of R&D and S&M. In one scenario, where we hold current spending levels as a % of revenues flat (no operating leverage), incremental margins for each additional 1 million users is 52%. If we actually hold absolute spending levels flat, incremental margins are 95% (essentially gross margin). So figure there is something in between here. I think the key point here is incremental users transitioned means major operating leverage. Key Cell #3: 2014 Digital Marketing Revenue Growth Points: We spent a good amount of time on the Digital Marketing business last round, so rather than rehash that, lets recognize this is the OTHER big growth engine for Adobe, at 30% of revenues, its growth rates are open to a wider range of outcomes for a few reasons: - Integration and cross selling more modules to existing customers. As we pointed out, there are 6 main modules

and customers purchase 1.4 on average right now…IF Adobe is right and it has put together the dominant advertising platform, it should be able to increase this over time, driving revenue growth.

- Two modules are themselves undergoing a subscription transition. - Many of the modules are priced based on usage…so if Adobe’s marketing cloud becomes more DOMINANT,

more marketing dollars will flow over it. The main point here is I would tend to have rather low conviction in the projected trendline for Digital Marketing. This is the top of the list for questions I would want answered. 2010-2016 Digital Marketing Revenue Growth: 26% 17% 13% 13%E 21%E 15%E Key Cell #4: 2016 Sales and Marketing as a % of revenue Points: The single line item forecast to generate the most operating leverage. Straightforward rationale:


- Adobe has to spend more on marketing right now to incentivize the transition to Creative Cloud, especially through promotional pricing and other discounts.

- Over time this goes away and as the power of the subscription model kicks in, S&M should generate significant operating leverage.

But isn’t elevated S&M a permanent feature of most SaaS models? In this case, I don’t think Adobe will see the same permanently high levels of SaaS marketing spend, because they aren’t seeding a new base of users, they are transitioning a huge existing user base, so this isn’t an example of getting salespeople to go out and bag big new sales so much, where they are heavily compensated. Key Cell #5: 2016 Free Cash Flow Points: This one might even merit being higher on the key cell list. The thinking here is that as Adobe works its way through the Creative Cloud transition and Marketing Cloud revenues ramp, the model should generate a fundamentally higher level of free cash flow than it previously did. FCF is forecast to almost triple between 2014 and 2016: 2010-2016 FCF: $1B, $1.3 B, $1.2 B, $0.96 B, $0.85 B, $1.3 B, $2.1 B Management has stated that it will increase its share buybacks over time, this is part of the impetus for the 76% and 60% EPS growth rates in 2015-2016.

ROUND 5 – FOLLOWUPS – (JUNE 2014) Context: We had a series of discussions with industry friends around Adobe. Here are two sets of notes from these calls: Call with David Knox, Rockfish Interactive 6.11.2014 TOPIC: Adobe Digital Marketing Suite Creative cloud/marketing cloud – not a lot of synergy between the two in terms of the users. They are almost different sides of the same cloud. In creative cloud, rockfish is the client in that case. On marketing cloud, the people buying that are the brand marketers and technologists, both are tools used for marketing. Rockfish isn’t writing checks for marketing cloud, but they do for creative cloud, and for this reason, it’s a smart move for Adobe. The marketing cloud piece is the bigger discussion point: its an interesting terminology…its like Xerox…”Marketing Cloud” is a salesforce.com term, an Adobe term, and so forth, dilutes the term. Adobe is doing the most interesting work within the space; its acquisitions work well together and are complementary. Buddy Media renewal rates are abysmal, radian 6 and exact target don’t go well together. Adobe’s products are thought of as Adobe, not the brand before them. If you look across the board, most people are trying to get you to buy a lead element. Salesforce.com believes you will choose your marketing cloud based on your email provider (exact target), oracle thinks its based on your social media (vitrus), while adobe thinks its going to be your web site as the lead product of choice.


Rockfish has 6-7 clients that use adobe marketing cloud, because they have made the switch to AEM. Most clients will say they are switching to an AEM…its their Trojan horse in a lot of ways .from a platform perspective, its not all that differentiated and actually a bit of a pain in the ass to work with it. It’s a unique skill set to learn and optimize…which makes the employees expensive. Aem is more expensive initially, but more efficient over the long run. You can build 3 websites on your own, it will be 1 mil each, but if you use AEM, you will spend 2.3m up front, but Word press is a CMS (there are modules you can pull from)…it’s a java based cms. Word press is based on Adobe is creating a lot of efficiencies between the different parts…it’s a STICKY FOUNDATIONAL element. I’m not going to go redo my website every 6 months. I can switch my social media or analytics platforms if I like, cause my historical data lives on 3rd party platforms, while the website lives on AEM. Ibm and oracle want to be in the discussion, but they aren’t really there. Google analytics gave them an unfair advantage and hten kind of blew it. The creative cloud and marketing cloud really isn’t much of a synergy at all. Marketing cloud are strategists and the creative cloud. Creative cloud? Wait and see right now. The studio remains the only game in town, there is no macromedia around, there is no other option. Their market share is completely dominant. Everyone has lived in pricing fear from adobe. As an agency, you could make a purchase and upgrade, and you could time it when your business’es margins or cash flow or good…with the SaaS model, you lose control to Adobe, there is no alternative, and they have the power. Amateur creative at times…he had a license for photoshop on his computer; adobe made money on that. In today’s world, he wouldn’t go through the hassle of getting a license for a1 month subscription. Maybe there are students who couldn’t Pirated versions…this will cut down on pirated version. 1998-2010 he used a pirated version. They have the most tempting start and making the right first steps and are missing significant pieces of the pie No email marketing piece!!! They are missing the boat on marketing automation….could marketo be this piece? SAP hybris…AEM isn’t a great component for ecommerce. Adobe has a big presence at cannes film festival…no one at salesforce.com/ibm. Notes from Bob Gilbreath Conversation 6.19.2014 Marketing saas world overall is in massive flux right now. A lot of noise, a lot of VC money, a lot of M&A, but no one has it nailed down. A lot of advertising and marketing for it. The only time he sees the Adobe Marketing cloud His clients (Mercedes, proctor and gamble, Kellogg), don’t use Adobe and haven’t seen any progress. Compares adobe to google plus with its marketing cloud. Could be a lot of companies using some sliver of a lot of the cloud tools, but not really using the whole thing. Salesforce.com sucks in his mind Ibm’s coremetrics isn’t very good either. Web 1.0ish, type of user experience, sluggish, not close to the newer tools from startups that are faster and slicker. Legacy situation where its hard for them to adapt; leaky bucket with startups coming in and plugging in.


Can you get a human being to change their habits? You have to make what they are doing today much more effective and efficient. The reason that salesforce.com works is that it took something that was a horrible habit (spreadsheets over email), and put it in the cloud. That helped salesforce.com The marketer’s habit is to hire an outside agency to do the brand marketing, they don’t want to use a tool themselves. Buddy media/virtue/etc. were a saas company on paper, but really an agency that specialized in Facebook. Overtime, companies realized that they don’t really need this product over time, they can have a few people internally do this, and facebook itself offeres better tools to do this. now what you say on facebook doesn’t matter as much because reach has declined so much. Email marketing works. Exact Target works. There is no proof that Facebook works at all….even with all the media budget that goes to Facebook. Theres no real synergy of a marketing cloud, hes kind of the view that its still best of breed marketing…theres really an opening to have a 3rd party that ties together Bloated company without the best engineers. A and B level developers don’t want to go work on their marketing cloud. They will choose sexy startups or Google over Adobe. Let alone the IBM cloud. Once buddy media gets purchased, all the good engineers leave. Good question for salesforce.com about buddy media is whats the retention of employees and retention of clients. Marketo is just hoping to be acquired. Percolate is another one. There aren’t a lot of buyers for those companies still left hanging, because the value these companies provide isn’t much, and integrating. Enough substitutes for Adobe that its getting close. Photoshop is really expensive, and there is pushback. Creative people still use the Creative Suite because it’s the best tool. There are startups (pick monkey) that are cloud based and trying to take hold. You can’t call yourself a designer if you can’t use Creative Cloud.

ROUND 6 – PREDETERMINED GAMEPLAN – (JUNE 2014)

Conclusion: I’ve become increasingly positive towards Adobe as a long the more we’ve worked on it and the more people we speak to/hear from. I see a three part followup that should put us in position to take a position if we so choose. (1) Adobe reports earnings tomorrow, June 17th. Lets run earnings against this PDGP. (2) 3-way valuation exercise, and (3) Lets talk to our friend Bob Gilbreath who was less than enthusiastic about Adobe’s prospects and see if these prompt enough weight on the thesis threat side to alter our thinking. Adobe Predetermined Game Plan ADBE-US June 16, 2014 ** Thesis: Adobe, the leading provider of software for digital media and marketing, is poised to profit from multiple catalysts in coming years. The benefits of the SaaS business model shift for Creative are significant: Adobe is


smartly capitalizing on its dominant position by effectively pushing through a price increase that comes with very high incremental margins. Additionally, we believe the subscription model effectively expands the addressable market by bringing in more part time users and reducing piracy. Second, Adobe has put together the most comprehensive digital marketing suite and will drive incremental suite adoption due to the sticky foundational nature of its Adobe Experience Manager. Creative Cloud’s SaaS transition combined with widening adoption of Adobe’s Marketing cloud will accelerate revenue growth and drive significant operating margin expansion. Slogan: SaaSy and Suite ** Burning Questions (June 2014) #1: TRANSITION: How fast will Adobe transition its Creative Suite base to Creative Cloud, and how high are incremental margins? Context: 4Q12-1Q14 Creative Cloud sub adds: 92K, 102K, 138K, 156K, 227K, 322K, 402K, 405K #2: ADDRESSABLE MARKET: Does Creative Cloud expand the addressable market for Adobe? Does Adobe segment levels of Cloud subscription to achieve this goal (e.g. a “premium” or “base” edition) Context: Currently 1.84m subs, Adobe has guided to 3m subs for FY14 and 4m subs by FY15 for individual and team subscribers. #2A: ENTERPRISE: How large is the incremental ETLA opportunity? #3: SALES AND MARKETING: Does Adobe’s existing user base in creative allow Adobe’s SaaS model to *actually* generate leverage at S&M over time? Context: Post transition, Adobe shouldn’t have to spend so much to capture customers. #4: MARKETING CLOUD: Do Analytics (former Omniture) and/or Content Management (former Day Software) allow for a sticky foundation such that Adobe indispensable to CMOs? #5: CROSS SELL: Do customers choose to take more Marketing Modules over time leading to greater cross-selling, higher ASPs, and increased penetration into the installed base? Context: Adobe has 6 software suites within Marketing, customers subscribe to 1.4 on average as of 1Q14. ** Thesis Threats (June 2014) #1: MARGINS: If the expected operating margin expansion from the SaaS transition and Digital Marketing Suite never materializes. #2: CHURN: If Adobe’s current user base doesn’t fully adopt Creative Cloud because the ability to pay for the service for shorter periods of time simply results in higher churn. #3: POINT OVER SUITE: If Adobe is unable to drive 20%+ revenue growth in digital marketing because customers prefer best of breed solutions, rendering its suite strategy ineffective. #4: CONSOLIDATION: If Salesforce.com, IBM, Oracle, or another well-funded competitor is able to more rapidly and successfully put together an integrated digital marketing platform behemoth? #5: NODE 5: If Adobe’s stock price high multiple misstates the case for steady state growth post-model transition. FOUR NODE CONSIDERATIONS NODE #1 (SOCIETAL SHIFT) Adobe is leveraged to multiple powerful NODE 1 shifts. For over 20 years, Adobe’s formats and technologies within its Creative Suite Software (e.g. Flash, Acrobat, Photoshop) has served as a Digital Ferryman in the Digital Demographic Revolution, enabling the creation and sharing of rich digital content. From this role, Adobe’s Creative


Suite has emerged over time as a dominant tool used by content creators to create compelling digital media (The Meaning of Life is to be Entertained), which has helped fuel the boom in online advertising (End of Advertising). Over the past few years, Adobe has put together the industry’s leading Digital Marketing Platform. Adobe’s Marketing Suite is aimed at reducing the pain of adoption for marketers/advertisers in working in the more analytical, complex, and increasingly mobile-driven digital world of online advertising. (End of Advertising meets Naked without Data meets Ultimate Mobility). A second set of NODE 1 shifts whose outcome is still not fully known involves Adobe’s transition of its business model from a traditional license/maintenance one to a SaaS subscription model. Here Adobe is testing its customers’ “Comfort with Change” by pushing through what amounts to a price increase on its to-date sticky customer base in exchange for the ongoing updates (Faster World) benefit that a SaaS Model confers.

NODE #2 (MARKET OPPORTUNITY) Adobe’s business is dependent on two separate but related areas of software that are tied to attractive markets linked to powerful NODE 1 shifts: Digital Media and Digital Marketing. Its core Digital Media business (Photoshop, Illustrator, InDesign, and Premier Pro) addresses user crises around proliferation of the types of content being created: online video, mobile applications, and importantly web publications that have to work on a variety of platforms and devices. A second set of crises revolve around sharing and collaborating, and how to deliver content between partners that the Creative Cloud seeks to address. This market is large, but moving towards the mature end of its S-Curve: Gartner data pegs Digital Content Creation Market as grow at a 6% CAGR in 2012-2017, reaching a $4.9 B market size. This doesn’t quite capture the whole Digital Media and Print and Publishing divisions: Adobe pegs this addressable market at ~$8.5 billion, which includes $2.1 billion for document management. We have a thought that since Adobe has a dominant >50% market share in a content creation space growing mid-single digits, its shift to a subscription model has the benefit of effectively reaccelerating the S-Curve itself by (a) bringing in a new group of users, and (b) seeing the impact of the price increase. The user crises around digital marketing have grown as (a) more ad dollars flow online, (b) sales tracking and marketing campaigns become more analytical, and (c) more integration with external partners (e.g. ad agencies/demand side platforms) is expected. To put some context around market sizing for just one of Adobe’s six digital marketing sub segments, marketing optimization, Gartner sees this as one of the fastest growing subsectors of enterprise software: growing at a 21% CAGR over the next five years, reaching $9.5 B by 2017. The overall market that Digital Marketing addresses is much larger (Adobe pegs its overall market opportunity in this space at $18.7 billion). While we tend to look at industry forecasts and company-provided TAMs with a grain of salt, the key takeaway is that Digital Marketing is a larger and faster growing market than the legacy Digital Media. NODE #3 (COMPETITIVE ADVANTAGE) We view Adobe having a dominant position in the content creation market; a position that has increased over time as one-time rivals have either been acquired (Macromedia), relegated to specific niches (e.g. Corel, Avid), or having never fully achieved its goals (Microsoft). Quite simply… if you are in the business of professional digital content creation today, you use Adobe’s tools. From this position as industry standard, Adobe’s tools have filtered down to other parts of the market (e.g. amateur creators, educational space, etc.) It is from this position of competitive dominance that Adobe has embarked on its transition to SaaS-based subscription pricing model for Creative Cloud. From a business model perspective, Adobe has removed the costs and risks associated with research and development and sales and marketing around 2-3 year product cycles, whereby Adobe was pressured to put a release out at a certain date, and potentially ramp up spending on sales and


marketing (more on this in the NODE 4 business model) to get customers to upgrade. Removing this tension should have the impact of allowing for a more focused and efficient organization. All Creative Cloud customers will now have the most up to date versions of the software; we think this will only increase stickiness to its platform. Importantly, this conversion to monthly subscription pricing has the benefit of expanding the overall user base; a somewhat controversial claim that Adobe’s management has made, but one we have confirmed through talking with friends and fellows within our network. How so? We think lower pricing (~$50/month vs. $1300-2600 for a license) will have the impact of lowering the barrier to adoption for users where price was an issue: a freelance professional or students who can use the software for 3-4 months at a time. Emerging Markets might see greater penetration due to lower pricing. Finally, we think the combination of lower monthly pricing and cloud based delivery will over time reduce piracy; management has estimated as much as 1/3rd of users may have used pirated versions. A key question is (a) how large is the current user base (Adobe put out a ~13m figure a year ago), (b) how large is the overall potential user base? Adobe’s management has stated that since the launch of Creative Cloud, it has seen upwards of 20% of subscribers as new to Adobe. On the Digital Marketing side of the house, we think Adobe has been a shrewd acquirer and efficient integrator of leading digital marketing technologies, from Omniture to Day Software to Neolane and Behance. Significantly, compared to rivals Salesforce.com (email-centric Exact Target) and Oracle (social-media centric-Vitrue), Adobe’s approach has led with web design. We view this as a wise strategy as Adobe Experience Manager (AEM) becomes a sticky foundational element from which to sell additional modules; it is easier to switch out social media or analytics platforms as historical data lives on 3rd party platforms, while switching out one’s website is a higher barrier to exit; it is the equivalent of ripping out one’s ERP system. While Adobe’s portfolio of marketing software is not complete (its missing the key ingredient of email marketing for one) and there is no Creative Cloud-industry standard yet in the fragmented world of digital marketing, we think Adobe is best positioned in the space. Finally, we think it’s important to note that we see very little (if any) synergy between the Digital Media and Digital Marketing sides of Adobe’s business, despite management’s assertions. NODE #4 (OPERATING MODEL) As Digital Media is ~2/3rds of Adobe’s business, the key dynamic is the SaaS model transition of the Creative Suite to the Creative Cloud. Multiple benefits: To spur adoption of Creative Cloud, Adobe instituted pricing of ~$30/month, or $360/year, well below the former licensing prices of $1300-$2600 depending on the package. So on top of the declines in revenues that a subscription model transition entails (revenues recognized ratably rather than upfront), there was also a temporary price cut, which has now ended, with pricing set to revert to a ~$50+ monthly figure. As more users transition towards the SaaS model, Adobe’s revenues will come with high incremental margins: - Gross margins for Creative Cloud should improve back to historical levels of 96%+ as physical software




- G&A should see no material impact. At ~30% of revenues, Digital Marketing is the second growth engine for Adobe’s model, and should see accelerating revenue growth and operating leverage for a few reasons: - Integration and cross selling more modules to existing customers: there are 6 main modules and customers

purchase 1.4 on average right now…IF Adobe is right and it has put together the dominant advertising platform, it should be able to increase this over time, driving revenue growth.

- Two modules are themselves undergoing a subscription transition. - Many of the modules are priced based on usage…so if Adobe’s marketing cloud becomes more widely used,

more marketing dollars will flow over it.


Finally, we see Adobe’s SaaS model transition as a significant positive for free cash flow. FCF is forecast to almost triple between 2014 and 2016 and management has stated that it will increase its share buybacks over time, this is part of the impetus for the 76% and 60% EPS growth rates in 2015-2016. Model Snapshot (with current consensus estimates) 2010-2016E: Rev Growth: 29%, 11%, 4%, -8%, 2%, 19%, 25% Gross Margin: 91%, 91%, 91%, 88%, 87%, 87%, 88% EBIT Margin: 37%, 38%, 36%, 23%, 20%, 28%, 36% EPS: $1.93 (+25%), $2.35 (+22%), $2.35 (0%), $1.34 (-43%), $1.18 (-12%), $2.06 (+74%), $3.27 (+59%) Balance Sheet & Cash Flow: The balance sheet is solid. Adobe has $3.2 B in cash and no debt. Forecasts for capex and FCF for 2010—2016: Capex: $137m, $210m, $271m, $188m, $173m, $219m, $330m FCF: $1B, $1.3 B, $1.2 B, $0.96 B, $0.86 B, $1.3 B, $2.3 B ***** HQ: San Jose, California ***** MANAGEMENT: Shantanu Narayen, CEO – Shantanu Narayen is president and CEO of Adobe. Prior to his appointment as CEO in December of 2007, Narayen was Adobe's president and COO. Previously, he held key product research and development positions within Adobe, including EVP of worldwide products, SVP of worldwide product development and VP & GM of the engineering technology group. Before joining Adobe in 1998, Narayen was co-founder of Pictra, an early pioneer of digital photo sharing over the Internet. Prior to that, he served as director of desktop and collaboration products at Silicon Graphics, Inc. and held various senior management positions at Apple Computer. Narayen holds five patents and is a frequent speaker at industry and academic events. Narayen holds a bachelor's degree in electronics engineering from Osmania University in India, a master's degree in computer science from Bowling Green State University and a master's degree in business administration from the Haas School of Business. Mark Garrett, CFO - With more than 25 years of financial management experience in the technology sector, Garrett has worked with many of the industry's leading companies. Before joining Adobe in February 2007, Garrett served as SVP and CFO of EMC's Software Group. Prior to working at EMC, he was EVP and CFO of Documentum.Previous accounting and finance management positions include tenures at IBM and Cadence Design Systems. Garrett currently serves on the board of directors for Informatica, Model N, a provider of revenue management solutions, the Adobe Foundation and the Children’s Discovery Museum of San Jose. He holds bachelor's degrees in accounting and marketing from Boston University and a master's degree in business administration from Marist College.

FOLLOWUP – (JUNE 2014) ADOBE FOLLOWUP ADBE-US 6.18.2014


Conclusion: Lets talk, but I think this merits a position in the Buckeye Long Portfolio, barring some disqualifying information from our chat tomorrow with our friend Bob. This round is two parts: A bit on valuation and a quarterly review. This quarter fit firmly with what we’ve been projecting/expecting in our research work and conversations with industry friends. PART 1: VALUATION Adobe trades at 57x forward PE (we are now halfway through this FY) vs. 27x for the short side of our portfolio. As a result of the SaaS transition, Adobe’s valuation appears artificially high. As the transition enters its latter stages, earnings will grow rapidly and Adobe’s multiple will “normalize” If we calendarize things, its 33x 2015 and 21x 2016. So not quite as high a multiple, especially vs. our portoflio. A 50% upside case would require PEs of 49x CY2015 and 31x CY2016 Running Adobe through the DCF engine, using a 16% growth rate and 36% EBIT margins, which assume no further expansion from 2015-2016’s consensus gets us to an upside that would put Adobe towards the top of the 2nd cheapest quintile in our portfolio. This actually surprised me a bit, so I ran the model through with 10% growth and that only dropped it to the 3rd quintile. Valuation wise, Adobe seems to grade out as reasonable vs. our existing portfolio.

2Q14 RESULTS – (JUNE 2014) PART 2: ADOBE RESULTS & THESIS ASSESSMENT 6.18.2014 Aaron. We don’t hold a position. CONCLUSION: Adobe reported 2Q14 results on June 17, 2014. Strongly supportive of our thesis. BULLET POINT #1: THESIS SUPPORTING: CREATIVE CLOUD: management increases subscriber forecast by 10% for FY14 and ups expected average recurring revenue from $1.85B to $1.925 (~4%). The difference is due to some lower priced promotional bundles. Management wants to drive the transition before it drives ARPU. BULLET POINT #2: THESIS SUPPORTING: DIGITAL MARKETING: 23% YoY Revenue growth BULLET POINT #3: THESIS SUPPORTING / THREAT: WHAT HAPPENED? Adobe reported revenue of $1,068 m, up 6% YoY, and 4% ahead of expectations. Gross margin was 88%, a 130bps decline YoY, while EBIT margins declined 100bps YoY to 23%. EPS came in at $0.37, nicely ahead of consensus at $0.30. Free cash flow was $340 m, up 35% YoY. The stock reacted positively to earnings, up 8%. WHAT IS THE NEXT THING THAT SIGNIFICANTLY MATTERS? Two points stand out:


1. The company holds a “Creative Cloud” event this week, where it said it will unveil what amounts to the biggest release of new features since CS6 (even though updates come regularly now that its SaaS). The company is intent on segmenting the market (as a means of expanding the addressable market) for Creative Cloud to include versions for consumers and hobbyists. How much might this accelerate the # of subscribers? What impact does this have on the overall addressable market?

2. The next quarter is forecast to be the trough for revenue growth, as the percent of revenue that is perpetual revenues will be “de minimis” going forward, and now that recurring revenues are 52% of the total, the “operating model” should now start looking like a normal software company – meaning, revenue growth and corresponding operating leverage going forward. While this doesn’t sound like a *big* deal from a security analysis perspective, removing an element of complexity for investors to look at this company (even if the dynamic is understandable)

THE BUSINESS THESIS: ** Thesis: Adobe, the leading provider of software for digital media and marketing, is poised to profit from multiple catalysts in coming years. The benefits of the SaaS business model shift for Creative are significant: Adobe is smartly capitalizing on its dominant position by effectively pushing through a price increase that comes with very high incremental margins. Additionally, we believe the subscription model effectively expands the addressable market by bringing in more part time users and reducing piracy. Second, Adobe has put together the most comprehensive digital marketing suite and will drive incremental suite adoption due to the sticky foundational nature of its Adobe Experience Manager. Creative Cloud’s SaaS transition combined with widening adoption of Adobe’s Marketing cloud will accelerate revenue growth and drive significant operating margin expansion. Slogan: SaaSy and Suite ** Burning Questions (June 2014) #1: TRANSITION: How fast will Adobe transition its Creative Suite base to Creative Cloud, and how high are incremental margins? Context: 4Q12-1Q14 Creative Cloud sub adds: 92K, 102K, 138K, 156K, 227K, 322K, 402K, 405K #2: ADDRESSABLE MARKET: Does Creative Cloud expand the addressable market for Adobe? Does Adobe segment levels of Cloud subscription to achieve this goal (e.g. a “premium” or “base” edition) Context: Currently 1.84m subs, Adobe has guided to 3m subs for FY14 and 4m subs by FY15 for individual and team subscribers. #2A: ENTERPRISE: How large is the incremental ETLA opportunity? UPDATED ASSESSMENT: TRANSITION CONTINUES AHEAD OF SCHEDULE, MANAGEMENT UPS 2014 GUIDANCE BY 10% UPDATED ASSESSMENT: MANAGEMENT REITERATES 20% CUSTOMER EXPANSION FIGURE This quarter Adobe added 464K Creative Cloud customers (for what its worth, the consensus was at 412K). It finished the quarter with 2.3m subs, and upped its FY guidance from 3m subs to 3.3m subs. It expects adoption to accelerate in the 2nd half of the year, with ~1m sub adds. Management said it intends on updating its FY15 guidance (4m) at some point later this year. Some important nuance to tease apart: The Digital Media segment came in 6% above expectations, and was responsible for the revenue beat this quarter. What drove that beat was that this quarter was the last that Adobe’s channel partners were allowed to sell perpetual volume licensing of Creative Suite 6, so some existing customers wanted to add to their perpetual seat capacity. (Adobe itself had stopped offering CS6). Going forward, the channel will only be selling Creative Cloud. The subscriber figures for Creative Cloud also count some Photoshop Bundles (Lightroom/Elements) that are lower ARPU than the full Creative Cloud suite. The subscriber figures do not count ETLAs either.


I mention this so that we recall why we should focus on ARR (average recurring revenue) as the metric to judge the business on (and perhaps a reason to rework some of these burning questions to make this more straightforward). Creative ARR is a metric that counts the # of CC subscribers x ARPU x 12 + Annual Digital Publishing Suite Contract Value + Annual Creative ETLA Contract Value. This quarter it came in at $1.2 billion, a 20% increase QoQ. Management also upped its FY14 ARR guidance from $1.85B to $1.925B, a figure that when paired with the increased subscriber guidance is thesis affirming; more users are more rapidly adopting the cloud version. In terms of expanding the addressable market, management reiterated a comment it made about a month ago about ~20% of Creative Cloud users being new to Adobe. They also noted that retention levels remain “above expectations”…without giving a figure. #3: SALES AND MARKETING: Does Adobe’s existing user base in creative allow Adobe’s SaaS model to *actually* generate leverage at S&M over time? Context: Post transition, Adobe shouldn’t have to spend so much to capture customers. Related Thesis Threat #1: MARGINS: If the expected operating margin expansion from the SaaS transition and Digital Marketing Suite never materializes. UPDATED ASSESSMENT: NO LEVERAGE THIS QUARTER, BUT LEVERAGE SHOULD START KICKING IN BY THE END OF THE YEAR. One part of our thesis is that the cloud model should allow Adobe to recognize significant operating leverage going forward. This quarter, sales and marketing spending rose inline with revenues, so there was no operating leverage (flat as a % of sales at 40%). However, this quarter saw a burst of sales from the channel in CS6, which goes away next quarter. Also, as revenues should begin growing faster now, and sales and marketing should grow slower, leverage should begin kicking in. Adobe did see 50bps of leverage at the R&D line. #4: MARKETING CLOUD: Do Analytics (former Omniture) and/or Content Management (former Day Software) allow for a sticky foundation such that Adobe indispensable to CMOs? UPDATED ASSESSMENT: MARKETING GROWS 23% YOY, AEM CITED AS STRENGTH Management emphasized that it is seeing increasing recognition that the Adobe Experience Manager (AEM) is the #1 product in the web experience management market – this refers to when enterprises re-platform their web infrastructure to deliver personalized content on multiple devices (e.g. you get a targeted ad on your mobile device that’s different than my targeted ad on my desktop). They cited a recent Forrester report on Web Analytics that called Adobe the leader in the space and a Gartner magic quadrant on Multichannel Campaign management that had Adobe as the leader with the highest scores in completeness of vision. Now let’s recognize that we don’t always put big stock in the industry analyst reports, but these are two data points that confirm our thinking that Adobe is on its way to having the most complete Digital Marketing offering. #5: CROSS SELL: Do customers choose to take more Marketing Modules over time leading to greater cross-selling, higher ASPs, and increased penetration into the installed base? Context: Adobe has 6 software suites within Marketing, customers subscribe to 1.4 on average as of 1Q14. UPDATED ASSESSMENT: NO UPDATE Management was asked this specific question on the call, and mentioned that it is seeing traction but didn’t provide an update to the # of modules per subscriber. The company did reiterate that it expects to see 20% revenue growth and 30% bookings growth for Digital Marketing this year, inline with our model’s figures. One wrinkle we’ve mentioned in our work…AEM itself is


undergoing a transition from license to subscription, which is actually a drag on the revenue growth for this segment. Helps explain the differential between bookings and revenue growth forecasts. ** Thesis Threats (June 2014) UPDATED ASSESSMENT: #2: CHURN: If Adobe’s current user base doesn’t fully adopt Creative Cloud because the ability to pay for the service for shorter periods of time simply results in higher churn. UPDATED ASSESSMENT: MANAGEMENT NOTED RETENTION REMAINED ABOVE EXPECTATIONS AND INLINE WITH THE PAST 2 QUARTERS. VALUATION AND MOVING AVERAGES Adobe trades at 57x forward PE vs. 27x for the short side of our portfolio. As a result of the SaaS transition, Adobe’s valuation can appear artificially high. As the transition enters its latter stages, earnings will grow rapidly and Adobe’s multiple will “normalize” Context: FY2 is 33x. It trades at 1.07x its 50 day moving average (vs. 1.04 portfolio average) and 1.14 its 200 day (vs. 1.03 portfolio average).

FOLLOWUP – (JULY 2014) Context: We wanted to explain WHY revenues grow so much in 2015-2016 and WHY this generates operating leverage and WHY this generates a jump in FCF. Model Snapshot Reminder: Model Snapshot (with current consensus estimates) 2010-2016E: Rev Growth: 29%, 11%, 4%, -8%, 2%, 19%, 25% Gross Margin: 91%, 91%, 91%, 88%, 87%, 87%, 88% EBIT Margin: 37%, 38%, 36%, 23%, 20%, 28%, 36% EPS: $1.93 (+25%), $2.35 (+22%), $2.35 (0%), $1.34 (-43%), $1.18 (-12%), $2.06 (+74%), $3.27 (+59%) Balance Sheet & Cash Flow: The balance sheet is solid. Adobe has $3.2 B in cash and no debt. Forecasts for capex and FCF for 2010—2016: Capex: $137m, $210m, $271m, $188m, $173m, $219m, $330m FCF: $1B, $1.3 B, $1.2 B, $0.96 B, $0.86 B, $1.3 B, $2.3 B Q1. Why does revenue increase so much? During a SaaS transition, revenue drops initially. Users are no longer paying a big chunk up front. An example:


CS5 was released in 2010. The standard version cost $1300. The Premium Version cost $1800. The highest end – the “Master Collection” was $2600. If you owned CS4, your upgrade price was much lower:$500 for standard and $600 for premium. If you owned CS2 or CS3 it was $700 or $800. If you were upgrading from a point product, there was a few hundred dollar discount. So lets use the example of Premium. $1800. Year 1 – Adobe gets $1800 up front vs. Adobe gets $30/month for the 1st year discount of Creative Cloud ($360) Year 2 – Adobe gets $0 up front from traditional customer, but $50/month for 2nd year of Creative Cloud ($600) Year 3 – Adobe gets $0 up front from traditional customer, but $50/month for 3rd year of Creative Cloud ($600) Year 4 – Adobe gets $600 up front for an upgrade to CS6, but $50/month for 4th year of CC ($600) But lets say that customer didn’t upgrade in Year 4 when the new version came out and instead waited a few more years – which is common. Through 3 years, its $1800 vs. $1560. In the 4th year, the CC model starts generating more revenues assuming no immediate upgrade. But this comparison really changes when we introduce the many iterations and variations on the traditional model: - Channel Discounts – Creative Suite was often sold through the channel with up to 45% discounts off that list

price; you cut that $1800 in half, and the payback period gets much quicker. And no channel discounts being paid.

- Different price points – We just laid out 3 pricing levels….but there are tons more. I’ll show you some pricing sheets I printed out. In SaaS pricing, there are far less price points.

This is the absolute revenue trajectory 2011-2015E: $4,216,258 $4,403,677 $4,055,240 $4,172,842 $4,986,546 What happens? 2012 is the last year of the former model. Revenues begin falling in 2013 as the transition begins to work…less up front payments and discounted ($30 vs. $50) monthly payments to incent the transition. FY13 sales fall 8%. FY14 (this year) the transition is taking hold. This past quarter recurring revenues reached 52% of all sales. 3Q (the current quarter) is supposed to be the trough for revenues for Creative. That means going forward, revenues will be growing. Why? Layering – think of the SaaS revenues as building.as more users transition, more revenues recur each month, and you lose the “chunks up” every few years. Increase Revenue per user – to incent the transition, Adobe had $30/month initial pricing. That number goes up to $50 in year 2 (its now $50 even for first timers now)….so you have an embedded price increase that juices revenue growth even further. **Technically, Adobe is guiding to an ARPU of $40 right now to take into account point products in addition to the suites. But the dynamic holds; $40 is still a ~33% price increase on $30. Increase the Number of Users – revenues increase because you expand the installed base. Renting software means more users. Increase the ability to upsell incremental features – if something costs you $40/month, you may be inclined to pay an extra $10/month for a bunch of features….while you may have been able to live without the features when you were faced with spending $2600 instead of $1800.


BETTER MONETIZATION – a key point I’ve not discussed enough so far….Adobe customers may have been undermonetized all along. Customers often skipped upgrading a version. CS3 would skip CS4 and get CS 5. Or skip both and then get CS6. Subscription model eliminates the ability to skip upgrades. KEY KEY POINT. WHY Operating Leverage: Less reliance on the channel and sales and marketing to drive upgrades; adobe now has a direct relationship with the customer who just pays $50/month to rent the software. Stable R&D spending. WHY FCF JUMPS? Most of it is due to operating margin expansion. FY14 EBIT margin is 20% FY16 is 35%. The absolute difference in EBIT is $820m to $2.15B. The absolute jump in FCF is $0.86 B, $1.3 B, $2.3 B Some points to frame our discussion later today. ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ 3Q14 EARNINGS The focal point of Adobe’s quarter was the impact of the increasing rate of the SaaS transition of the two foundational elements of Adobe’s Marketing Cloud: Adobe Experience Manager and Adobe Campaign Manager. While this may not be as well-known an element of Adobe’s investment as the Creative Cloud’s SaaS transition...the same dynamic applies: The sooner a SaaS transition occurs, the faster revenue growth and margin expansion *should* transpire on the back end…and the faster our thesis should materialize. So I’m willing to take this quarter’s revenue “miss” vs. consensus with a grain of salt. The other point that stood out to me was the announced deal where Publicis is standardizing all of its ad agencies on Adobe’s Marketing Cloud. A key part of our long thesis is that Adobe *seems* to be the best positioned of the evolving marketing clouds to becoming the de facto standard, much like Creative Cloud is for digital content. Because of the amount of “cross pollination” that seems to happen in the ad agency world, becoming part of the infrastructure at one of the largest holding companies is a good signal. Aaron

EARNINGS – SEPT 2014 ADOBE RESULTS & THESIS ASSESSMENT 9.17.2014 Aaron. We hold a long a position. CONCLUSION: Adobe reported 3Q14 results on September 16, 2014. Mostly supportive of our thesis. BULLET POINT #1: THESIS SUPPORTING: Marketing Cloud’s transition to SaaS is accelerating: expected to be at 75% by next quarter, ahead of previous 60% transition. Lighter revenues near term, but should translate to faster revenue growth and margin expansion down the road. BULLET POINT #2: THESIS SUPPORTING: Publicis standardizes all ad agencies on Adobe Marketing Cloud BULLET POINT #3: THESIS SUPPORTING: Creative Cloud adds 502K subscribers, continuing to shift customer base; rate of growth in the quarterly adds is slowing though. WHAT HAPPENED? Adobe reported revenues of ~$ billion, essentially flat YoY, and just a touch below expectations. Gross margin was 87%, a 100bps decline YoY, while EBIT margins declined 350bps YoY to 19%.


EPS came in at $0.28, two cents ahead of consensus at $0.26. Free cash flow was $214 m, up 27% YoY. Guidance for next quarter (FY4Q14) was for revenue growth of 1% at the midpoint, and a penny higher EPS at the midpoint. The forecast has been trimmed a touch, as for the same reason that revenue this quarter was below expectations: The two key components of Adobe’s Marketing Cloud are shifting from perpetual to term licenses faster than expected, which reduces revenues in the near term as is typical of a SaaS transition. WHAT IS THE NEXT THING THAT SIGNIFICANTLY MATTERS? I’d like to see a more refined set of figures around retention, ARPU, and expectations for how much Creative Cloud is expanding the market. This sort of information was absent on this conference call. In particular, I’d like to see when Adobe expects to see ARPUs start to rise significantly from rolling large chunks of its Creative Cloud customers off the introductory pricing. THE BUSINESS THESIS: ** Thesis: Adobe, the leading provider of software for digital media and marketing, is poised to profit from two key catalysts. In Creative (2/3 of its business), the company is enjoying the benefits of a forced migration of its installed base to a SaaS-based Creative Cloud having far higher long term margins as operating expenses for sales, marketing and development drop and potentially a larger TAM will be generated as well. On the marketing side (1/3 of its business), Adobe has assembled the most comprehensive digital marketing suite amongst a fragmented, uncohesive set of options. Adobe is in the early stages of an extended adoption period of tools by marketers. Between these two changes, Adobe will see a catch up in revenue growth characterized by high incremental margins, translating to sizable earnings leverages and rising free cash flow generation. Slogan: SaaSy and Suite ** Burning Questions (June 2014) #1: TRANSITION: How fast will Adobe transition its Creative Suite base to Creative Cloud, and how high are incremental margins? Context: 4Q12-2Q14 Creative Cloud sub adds: 92K, 102K, 138K, 156K, 227K, 322K, 402K, 405K, 464K Related Thesis Threat #3: CHURN: If Adobe’s current user base doesn’t fully adopt Creative Cloud because the ability to pay for the service for shorter periods of time simply results in higher churn. UPDATED ASSESSMENT: ADOBE GROWS CREATIVE SUITE ADDITIONS 55% YOY AND 8% QOQ – INLINE WITH UPPED GUIDANCE FROM LAST QUARTER. NOT DRIVING OPERATING LEVERAGE YET – STILL WAITING FOR THE IMPACT OF ARPU INCREASES TO KICK IN. This quarter Adobe added 502K Creative Cloud customers (consensus was 495K), finishing the quarter with 2.81m subs, but did not change its FY guidance of 3.3m subs, though management expects to exceed this quarter’s additions by a bit, which could be viewed as a slight deceleration in the pace of additions. Last quarter saw 15% QoQ growth in subs and this quarter was 8%, with next quarter likely below 8% (based on the rough estimate). This was a bit of quirky quarter. If we recall, last quarter was the last one that the channel was allowed to sell perpetual licenses of Creative Suite 6, which led to a bump in revenues (and perhaps a pull-in from this quarter) as some existing customers wanted to add to their perpetual seat capacity. More importantly that meant this quarter was the first that the channel was selling exclusively Creative Cloud, and management said that subscriptions through the channel were below its expectations. I’m inclined to believe that the first quarter that channel partners are selling a product exclusively might not be their strongest performance, but lets keep an eye on this. As for the margins, its hard to get a precise answer without some more information. This quarter, Creative Cloud’s Average Recurring Revenue (ARR) was $1.4m, a bit below consensus; the reason provided was a slight tick down in ARPU due to higher sales to education (typical for 3Q seasonally) and a promotion of a Photography bundle.


Over time, Adobe seems to be willing to sub segment parts of the Creative Cloud to drive greater overall adoption – and these initial deals are discounted to incentivize adoption. Management reiterated that it is seeing greater than 80% retention even as customer roll off the introductory pricing, so we should see ARPUs rise over time…but not necessarily in the next quarter or two…they expect ARPUs to be flat for the next quarter as the promotions come to an end. As a reminder about *why* we expect margins to rise substantially as a result of this dynamic, recall that promotional pricing for Creative Cloud is ~$30/month, while full price is $50/month (team subscriptions is $39-$49 vs. $70 full price). #2: MARKETING CLOUD: Does a true “marketing cloud” market actually develop or do marketers prefer using a collection of best of breed solutions? What signals (if any) that Adobe is becoming the standard? Related Thesis Threat#4: POINT OVER SUITE: If Adobe is unable to drive 20%+ revenue growth in digital marketing because customers prefer best of breed solutions, rendering its suite strategy ineffective. UPDATED ASSESSMENT: FASTER TRANSITION FROM LICENSE TO TERM SKEWS REVENUE EXPECTATIONS; POSITIVE SIGNALS OF GROWING ADOPTION Digital Marketing Revenues grew 8% YoY to $337M; of which $255m (+14% YoY) came from the Digital Marketing Cloud. The key issue on the call was that management explained that its Marketing Cloud is shifting more rapidly from perpetual to term than it expected, specifically its two foundational components: Adobe Experience Manager (AEM) and Campaign Manager (ACM). In FY13, 45% of marketing cloud bookings were SaaS, and management had previously guided this figure to 60% by the end of this year. It now sees that figure as closer to 75% (and ultimately perhaps at 80% - some customers will always want on-premise). The impact is the same as the Creative Cloud’s SaaS transition: more revenues are recognized as deferred, and near term revenue is reduced a bit. Management explained the impact as ~$60m for FY14…and without this impact, revenue growth would’ve been well above 20% this quarter (in line with what we are expecting). Management also reiterated its view of a 3 year Marketing Cloud revenue CAGR of 25% for FY14-FY16. This would imply accelerating revenue growth going forward – which makes sense when we consider how the dynamics of a SaaS transition work (a building of revenues over time). We have flagged in our work that the Marketing Cloud’s own SaaS transition is often underappreciated as folks tend to focus on the Creative Cloud transition, but based on the focus of the questions on the call, the magnitude of the impact seemed to catch some by surprise. Separately, there were some positive signals of Adobe becoming an increasing part of the “infrastructure” of digital marketing. As a reminder, in March Adobe signed a deal with SAP to resell Adobe Marketing Cloud with their HANA platform and hybris Commerce Suite. Yesterday, they announced a partnership with Publicis Group where all Publicis agencies will standardize on Adobe Marketing Cloud, the first of the large agency groups to do so. Management also talked about a rising level of deals with system integrators who are using Adobe as their standard marketing cloud for customers. A partnership with Wipro was announced this quarter. Finally, the number of marketing cloud customers with annual contracts over $500K grew 40% YoY. So what? I view the Publicis deal as particularly important. Getting the large ad agencies to standardize on Adobe’s Marketing Cloud is an excellent way to become infrastructure. From my experience with friends I know in the industry, people tend to move around from ad agency to ad agency, and knowledge and experience using Adobe Marketing Cloud might get “cross pollinated” amongst other ad agencies …which might increase the likelihood that Adobe becomes the standard over time.


#4: SALES AND MARKETING: Does Adobe’s existing user base in creative allow Adobe’s SaaS model to *actually* generate leverage at S&M over time? Context: Post transition, Adobe shouldn’t have to spend as much to capture customers or on discounts in the channel. Related Thesis Threat: #1: MARGINS: If the expected operating margin expansion from the SaaS transition and Digital Marketing Suite never materializes. UPDATED ASSESSMENT: MARGINS DECLINE 350BPS OWING IN PART TO THE FASTER SAAS TRANSITION FOR THE MARKETING CLOUD One part of our thesis is that the cloud model should allow Adobe to recognize significant operating leverage going forward. This quarter, sales and marketing spending rose YoY a bit faster than with revenues, owing mostly to the difference in revenue recognition because of the faster SaaS transition in the marketing cloud. That was worth 130bps of margin compression: S&M as a % of sales was ~40% (mostly flat from the past few quarters). VALUATION AND MOVING AVERAGES Adobe trades at 35x forward PE vs. 31x for the long side of our portfolio. The 35x is well above what we might expect for a rather mature company even one experiencing a business model shift. In this case Adobe has a considerable moat around its business and qualifies as a technology "Castle" company which is not so common and merits a higher PE. But beyond that the multiple also reflects that the new business model is to be much more profitable than the old. THAT is where the action will most likely be centered going ahead It trades at 1.01x its 50 day moving average (vs. 1.02 portfolio average) and 1.11 its 200 day (vs. 1.03 portfolio average).

ANALYST DAY - FALL 2014 Adobe Analyst Day This past Monday, Adobe held an analyst day. The company reiterated its long term target model, which calls for 20% revenue growth from FY14-FY16. Also reiterated is the expectation that Digital media (Creative Cloud +Document Services) revenue will grow ~20%, Marketing Cloud revenue will grow ~25%, and marketing cloud bookings will grow ~30%. As the bulk of the SaaS transition is expected to be done by next year, Adobe thinks its operating margins will return to the 30% level, which translate to EPS of at least $2 in FY15 and $3 in FY16. Management reiterated its FY14 (November) goal of 3.3m creative cloud subscribers. None of this guidance is new, and might appear to assumed to be conservative as current consensus is a bit above those $2 and $3 targets by 5%-10%. There were a series of new announcements and takeaways that are best addressed through the lens of our predetermined gameplan, but the main point I took from the analyst day is Adobe’s focus on building ecosystems for its Creative Cloud and Marketing Cloud to compel further stickiness and cross selling (ARPU increases), which at its core is part of our thesis; we believe Adobe, because of its unique position as the dominant Creative software and potentially becoming a dominant Marketing software will be able to continue to drive upside over time…selling incremental modules at easy-to-digest SaaS pricing. Our Thesis: Adobe, the leading provider of software for digital media and marketing, is poised to profit from two key catalysts. In Creative (2/3 of its business), the company is enjoying the benefits of a forced migration of its installed base to a SaaS-based Creative Cloud having far higher long term margins as operating expenses for sales, marketing and development drop and potentially a larger TAM will be generated as well. On the marketing side (1/3 of its business), Adobe has assembled the most comprehensive digital marketing suite amongst a fragmented, uncohesive set of options. Adobe is in the early stages of an extended adoption period of tools by marketers.


Between these two changes, Adobe will see a catch up in revenue growth characterized by high incremental margins, translating to sizable earnings leverages and rising free cash flow generation. Slogan: SaaSy and Suite Burning questions (September 2014): #1: TRANSITION: How fast will Adobe transition its Creative Suite base to Creative Cloud, and how high are incremental margins? #3: ADDRESSABLE MARKET: Does Creative Cloud expand the addressable market for Adobe? Does Adobe’s recent segmenting of Cloud subscription to achieve this goal (e.g. a “premium” or “base” edition) Context: Currently 1.84m subs, FY14: 3m, FY15: 4m As of the end of last quarter, Adobe has 2.8 million subscribers on the Creative Cloud, and reiterated that it expects 3.3m by the end of the year. Management also reiterated that ~20% of the user base on CC is new to Adobe, which has been consistent for the past 1-2 years. What stood out at this analyst day was management’s strategy to expand the addressable market for Creative Cloud through developing its ecosystem and segmenting its user base for upsells. A few points: - On Mobile: Adobe released new Creative mobile apps for Photoshop and Illustrator so users can draw and edit

on tablets. In general, there is a focus on making content creation seamless across devices. Loads of new incremental products and integrations we need not list. One cool one was an integration with Microsoft called Project Animal, which allows creative people to make content that can be controlled through gestures.

- Back in June, when the company announced a slew of new features for Creative Cloud, they created “Adobe IDs” which is your login for the desktop applications, which is what you use to login on the mobile apps. This will allow Adobe to better segment its audience, increase retention, and theoretically allow more targeted upselling: Example…customer XYZ used Photoshop on the desktop and just downloaded the mobile app…lets pitch him a discounted Illustrator license.

- The company released a new SDK for the Creative Cloud. The intention is to get developers to build niche applications for Creative Cloud users that will make the platform more valuable to all users. This is smart platform strategy: increase the value of your service without expending more resources. Works for Salesforce and Apple….I was almost surprised Adobe hadn’t done this yet. Better late than never.

#2: MARKETING CLOUD: Does a true “marketing cloud” market actually develop or do marketers prefer using a collection of best of breed solutions? What signals (if any) that Adobe is becoming the standard? #5: CROSS SELL: Do Analytics (former Omniture) and/or Content Management (former Day Software) allow for a sticky foundation leading to greater cross-selling, higher ASPs, and increased penetration into the installed base? We’ve touched on this a good deal recently, about Adobe’s strong efforts to get its “Marketing Cloud” to become the standard in the industry. This was a pretty big focus on Adobe’s efforts to partner with ad agencies and integrators (e.g. Publicis, Wipro, SAP). Something that happened in the past few weeks we haven’t covered was that Omnicom formed an alliance with Salesforce.com to offer all of Salesforce.com’s marketing software to Omnicom agencies in a deal that seems similar to the Adobe-Publicis one. An important distinction is that this alliance is not exclusive like Adobe’s is with Publicis (I *think* based on my reading…but I’d like to confirm with some in our community)…I’d like to see if WPP makes a similar alliance in the coming months. A few weeks ago when Adobe reported, I mentioned that I would’ve preferred to see some more details about the progress of the Marketing Cloud. We got some the other day: - 66% of customers now use 3+ solutions, reflecting 74% growth in the number of customers with 3+ solutions

YoY…..a signal that Adobe’s cross sell efforts are beginning to take hold. - Adobe has seen 84% YoY growth in Marketing Cloud contracts of greater than $1m. - 30%+ YoY bookings growth overall. - The number of transactions taking place through Adobe-powered sites has grown from 6 trillion in FY11 to 25

trillion in FY14, with mobile growing 10x over that period to 1 trillion transactions.


One more interesting takeaway…Adobe launched Talent Search, which is a “LinkedIn-like” feature within its Behance module in the marketing cloud, where a creative director pays $1500/month to source creative talent to work on projects; seems like a vertical specific job board. Another example of “ecosystem” focus by Adobe…bringing creative and marketing professionals onto the platform to search for jobs. 3A: ENTERPRISE: How large is the incremental Enterprise Term License Agreement (ETLA) opportunity? We finally got some specifics on the size and impact of the ETLA opportunity. As a reminder, an ETLA is essentially a license that covers hundreds or thousands of users. It’s often used by big organizations or schools. It is not counted in the traditional Creative Cloud subs, who get billed monthly or annually – and don’t generate deferred revenues. This is why it’s a burning question for us…how BIG a part of Adobe’s business are these ETLAs? They have not been specific…until the other day. Management said unbilled backlog for both Media and Marketing was $1.5 billion last quarter. ETLAs are multi year agreements, but only the current year is counted in that backlog as deferred revenue. Management said if years 2 and 3 of current ETLAs were counted, the backlog would be $2.5 billion….so that’s a non-trivial $1 billion in backlog. Much like the rest of Adobe’s SaaS model, where revenues pile up over time – it would appear that the ETLA opportunity functions in similar fashion…however, while it wasn’t disclosed to investors until now, this is incorporated into guidance, so I wouldn’t judge this information as “good” or “bad”…but rather clarifying. #4: SALES AND MARKETING: Does Adobe’s existing user base in creative allow Adobe’s SaaS model to *actually* generate leverage at S&M over time? Some nice granularity on this question. Management talked about how 97% of Creative Cloud members are on an annual plan, with 87% of all revenues now recurring, and 76% of the subscribers transacting directly through Adobe.com. Why is that important? It relates to our thesis that over time, Adobe should recognize operating leverage at the sales and marketing line (perhaps moreso than most SaaS companies)….that 76% number of customers who sign up for Creative Cloud online means sales and marketing efficiency…it’s the type of thing that happens when you OWN a market like Adobe does with Creative professionals…”well, I know I have to get this product now, so I’ll just go sign up for it online”…there is no real need to have a salesperson call EVERY current user. Now management also said it would be reinvesting some of the “savings” on S&M from the Creative Business into helping drive further adoption of the Marketing Cloud – so perhaps these savings don’t translate into operating leverage quite yet….but at least are being put forward to a worthy goal: getting Adobe’s Marketing Cloud to be THE defacto standard. Likewise…on R&D, management expects R&D to generate operating leverage, but absolute spending will continue to rise as it is focused on continued innovation to differentiate itself from competitors.

EARNINGS – DECEMBER 2014 The “headline” of Adobe’s quarter was the acceleration in the number of subscribers in the core Creative Cloud business – an acceleration driven by the sale of a widening array of Point products (e.g. Creative Cloud Photography) and newly released mobile apps – all of which strikes us as indicative that Adobe *is* making inroads to expanding the addressable market for its software. Certainly nice for the long run health of the business to grow the user base – but revenues *this* quarter didn’t really pop out as a result – all those Point products carry lower ARPUs afterall. No, the key point that stuck for me was that operating leverage is now starting to show up. The investment case for Adobe for the last year or two has always involved a degree of complexity – at what point will the SaaS transition pass and the company have more straight forward revenue growth and operating leverage. That appears to be the case…the underlying “success” of the business should be easier to see going forward…management is now guiding to 17% revenue growth and 59% earnings growth for FY15.


We will maintain our long position. …Aaron ADOBE RESULTS & THESIS ASSESSMENT 12.12.2014 Aaron. We hold a long a position. CONCLUSION: Adobe reported 4Q14 results on December 11, 2014. Strongly supportive of the thesis. BULLET POINT #1: THESIS SUPPORTING: Creative Cloud’s sub adds grow 60% YoY; management expects 70% sub growth in FY15. BULLET POINT #2: THESIS SUPPORTING: Operating Leverage beginning to kick in; 59% earnings growth forecast for 2015. BULLET POINT #3: THESIS SUPPORTING: Marketing Suite Bookings grow 30%+, the number of clients taking 3 or more modules is growing 70%+ WHAT HAPPENED? Adobe reported revenues of ~$1.07 billion, up 3% YoY, and a touch above expectations. Gross margin was 87%, a 70bps decline YoY, while EBIT margins grew 90bps YoY to 22%. EPS came in at $0.36 (+13% YoY), ahead of consensus at $0.30. Free cash flow grew 30% to $363m. Adobe’s guidance for 1Q15 and FY15 was ahead of expectations, implying FY revenue growth of 17% to $4.85B at the midpoint and EPS growth of 59% (to $2.05). The big “upside” surprise in the guidance was Adobe estimating that Creative Cloud subscribers will reach 5.9m by the end of FY15; it had previously been targeting 4m. We’ll dig into this more below, but the rationale is better traction than expected plus a greater number of point products being sold subscription-style. With the SaaS transition essentially completed, management now expects Digital Media’s average recurring revenues to grow over 50% next year to $2.9B. WHAT IS THE NEXT THING THAT SIGNIFICANTLY MATTERS? As Adobe’s revenue growth accelerates and operating margins begin to expand going forward, does the pace of spending on operating expenses begin ticking upwards or does management allow margins to rise rapidly? THE BUSINESS THESIS: ** Thesis: Adobe, the leading provider of software for digital media and marketing, is poised to profit from two key catalysts. In Creative (2/3 of its business), the company is enjoying the benefits of a forced migration of its installed base to a SaaS-based Creative Cloud having far higher long term margins as operating expenses for sales, marketing and development drop and potentially a larger TAM will be generated as well. On the marketing side (1/3 of its business), Adobe has assembled the most comprehensive digital marketing suite amongst a fragmented, uncohesive set of options. Adobe is in the early stages of an extended adoption period of tools by marketers. Between these two changes, Adobe will see a catch up in revenue growth characterized by high incremental margins, translating to sizable earnings leverages and rising free cash flow generation. Slogan: SaaSy and Suite IS THERE A REQUIREMENT TO ALTER THE THESIS OR REPRIORITIZATION OF THE TOP BURNING QUESTIONS OR THESIS THREATS?


Yes – two modifications to work in: (1) The SaaS transition and how operating leverage may end up transpiring. Our initial thinking was that once

the promotional pricing for Creative Cloud rolled off, there would be a sharp jump in ARPUs that would be the driver, but as we’re learning over the past two quarters, the incremental subscriptions are coming 50/50 from the Suites and the Point products, which carry much lower ARPUs; the point is…ARPU will be rising, but from lower blended averages… So an alteration of a burning question might be what if these point products were to cannibalize Suite subscriptions, thereby reducing the trajectory of ARPU growth, thereby reducing the degree/pace of margin expansion?

(2) Our #6 burning question may rise in importance. #6: EXCESS SUCCESS: What does Adobe’s management team do with its rising margins and free cash generation? As we sketch below, Adobe is now through the difficult part of its model transition – it has held operating expense growth at 1-3% over the past two years, so that margins didn’t implode – but now that revenues are rising again, will Adobe loosen its purse strings?

** Burning Questions #1: TRANSITION: How fast will Adobe transition its Creative Suite base to Creative Cloud, and how high are incremental margins? Context: 4Q12-3Q14 Creative Cloud sub adds: 92K, 102K, 138K, 156K, 227K, 322K, 402K, 405K, 464K, 502K #3: ADDRESSABLE MARKET: Does Creative Cloud expand the addressable market for Adobe? Does Adobe’s recent segmenting of Cloud subscription to achieve this goal? Related Thesis Threat #2: ADOPTION: If the later stages of adoption of Creative Suite don’t materialize, making it difficult to forecast what steady state growth post-model transition looks like. UPDATED ASSESSMENT: CREATIVE SUITE ADDITIONS ACCELERATE: 644K NET ADS: 60% YOY AND 28% QOQ – MANAGEMENT SIGNIFICANTLY RAISES FY15 OUTLOOK, GROWTH COMING FROM POINT PRODUCTS…OPERATING LEVERAGE BEGINNING TO KICK IN. This quarter Adobe added 644K Creative Cloud customers (a 60% YoY increase and well ahead of consensus at 522K), finishing the quarter with 3.45m subs, also well ahead of its guidance from earlier in the year of 3.3m subs. The pace of sub adds has picked up over the course of 2014 (1Q14-4Q14 QoQ Growth: 1%, 15%, 8%, 28%). Adobe also raised its FY15 guidance to 5.9m subs – a 70% YoY increase; the figure had been left at 4m since 2013’s analyst day. That figure wasn’t really being used by most analysts at this point anyway, but the 5.9m figure was still well above expectations. What was the cause for the big growth this quarter and the upsizing of sub estimates? Adobe began selling many more point products (e.g. Creative Cloud Photography) and mobile apps towards the end of the summer, and has seen significant uptake. It also probably helped that channel sales kicked in for the cloud products over the summer too (they were previously still selling the traditional licenses). ARPU for point products is lower than the full suite, and management indicated that incremental sales for Creative Cloud right now seem to be split roughly 50/50 between point and suite. This trend has accelerated; a year ago 76% of subs were using the full Suite, the figure today is now 61%. So…while the number of subs has jumped significantly…its kind of important to recognize these are almost 2 separate products (or really 5 or 10) that are being counted as “Creative Suite” subscribers. So what? One way to look at this is that the shift to cloud based subscriptions for Adobe’s point products and mobile apps *does* appear to be expanding the addressable market at this point; management reiterated its comments about ~20% of the subscribers are new customers to Adobe. In our research work, we noted that management had sketched out an installed base of pro users of ~13m users, of which 2/3rds were on suites (maybe half of those were obvious upgrade candidates). If we believe Adobe’s


contention that the shift to subscription is bringing in ~20% more customers (e.g. pirated users or those who couldn’t afford the upfront costs of a full license), we can comfortably get to over 10m subs as the “addressable market”….to put that into context, at its peak pre-SaaS transition, Adobe never really sold much more than 3m CS units per year. We are at 3.45m now, guided to ~6m next year….a back of the envelope sketch might say Adobe may be halfway through the TAM by next year? Adobe’s argument right now is that it is rapidly increasing the functionality of the Creative Cloud platform which is continuing to expand the TAM; they specifically said they are only the 2nd inning. For the 2nd straight quarter, Adobe announced an acquisition meant to expand the Creative Cloud ecosystem. Last quarter, they acquired Aviary, a developer of mobile SDKs for the delivery of Creative apps, this quarter they acquired Fotolia ($800m cash deal), which is a stock content service for Creatives to buy and sell photos, graphics, and video. Layer on the rollout of its Creative Talent Search service (job listing service), and Adobe seems to be transitioning its Creative Suite from a desktop tool set to a cloud-based ecosystem. Fotolia also effectively expands the TAM a good bit – not in terms of users (almost all creative professionals and digital marketing customers already use Fotolia), but in terms of ARPU over time. Stock content is a multi-billion market, of which Fotolia was a main player. So what Part 2? OK…so Adobe seems to be showing signals of building out its suite into a possible ecosystem that is attracting users at an accelerating pace due to adoption of more point products (or at least providing a compelling core service that no one wants to leave). What does this mean for the business model…are we starting to see those high incremental margins kick in as the cloud user base grows? Despite the big jump in subs, Digital Media revenues this quarter were only slightly above estimates; annual recurring revenues were $1.95 billion, which struck me as a disconnect; much higher user growth, but only slightly higher revenues? The plug for this involves the lower ARPUs that come with point products. I view this an area to think about tweaking our burning questions; it’s a net positive…over time, growing the user base will add more absolute recurring revenues, even if the ARPU is a bit lower (assuming that these POINT products aren’t cannibalizing SUITE sales). The more pertinent point (for margins) is that ARPU grows for each product – which management insisted was the case. Tying this back to Fotolia – that acquisition should be ARPU enhancing for CC customers. #4: SALES AND MARKETING: Does Adobe’s existing user base in creative allow Adobe’s SaaS model to *actually* generate leverage at S&M over time? Context: Post transition, Adobe shouldn’t have to spend as much to capture customers or on discounts in the channel. #6: EXCESS SUCCESS: What does Adobe’s management team do with its rising margins and free cash generation? Related Thesis Threat: #1: MARGINS: If the expected operating margin expansion from the SaaS transition and Digital Marketing Suite never materializes. UPDATED ASSESSMENT: MARGIN EXPANSION FINALLY KICKS IN; EPS SET TO GROW 60% NEXT YEAR. Here we are finally seeing the green shoots of the SaaS transition translating to the long promised margin expansion. Overall operating margins rose 90bps, leading to 13% EPS growth and 30% FCF growth. Digital Media’s margins rose more than that (though unclear the figure), as Adobe’s Marketing Suite is passing through the latter stages of its own SaaS transition, which is a headwind for margins. Going forward, management expects margins to begin to rise as revenue growth kicks in. The midpoint of EPS guidance for 2015 implies ~60% growth. The general dynamics of the margin leverage are understood. - Gross margins for Creative Cloud should improve back to historical levels of 96%+ as physical software





KEY POINT…Adobe has done a fairly good job of restraining expense growth through the transition; this year operating expenses only grew 3%, last year (Fy13), they only grew 1%...AND that was with S&M ramping to drive the SaaS transition. Now that revenue growth is set to accelerate, the company should begin recapturing large chunks of EBIT margins as it regains the mid 30% level over time. So the key question is…how much might management loosen the reins on spending as margins tick upward – potentially restraining leverage to some degree? On the call, they did indicate that they intend on investing more in sales and marketing to build out an enterprise sales force, but that this spending was incorporated in the $2.05 FY15 and $3 FY16 EPS targets. Pip has a view that Adobe is a company with a long history of excellent financial management, so the risk that we typically think of with a SaaS company spending spending spending on sales and marketing indefinitely isn’t quite as in play here as can sometimes be the case when a SaaS company talks about “attacking a TAM”. #2: MARKETING CLOUD: Does a true “marketing cloud” market actually develop or do marketers prefer using a collection of best of breed solutions? What signals (if any) that Adobe is becoming the standard? Related Threat#4: POINT OVER SUITE: If Adobe is unable to drive 20%+ revenue growth in digital marketing because customers prefer best of breed solutions, rendering its suite strategy ineffective. UPDATED ASSESSMENT: FASTER TRANSITION FROM LICENSE TO TERM CONTINUES TO SKEW REVENUES, BUT 30%+ BOOKINGS GROWTH CONTINUES Digital Marketing Revenues grew 4% YoY to $374M; though bookings grew north of 30%. We think the bookings growth is what to pay attention to; the company’s *success* at transitioning its clients to the subscription model is what’s compressing revenue growth in the short term. More importantly, Adobe’s Marketing Suite is showing signals of becoming ingrained in the infrastructure of the ad world – as evidenced by its recent deals with Nielsen and WPP. Importantly, it is getting traction in selling multiple modules to customers: management noted that the number of customers with three plus modules continues to see upwards of 70% growth. The key issue on the call this quarter was the same as last quarter; Marketing Cloud is shifting more rapidly from perpetual to term than originally expected, specifically its two foundational components: Adobe Experience Manager (AEM) and Campaign Manager (ACM). In FY13, 45% of marketing cloud bookings were SaaS, and management had previously guided this figure to 60% by the end of this year. It now sees that figure as closer to 75% (and ultimately perhaps at 80% - some customers will always want on-premise). We have flagged in our work that the Marketing Cloud’s own SaaS transition is often underappreciated as folks tend to focus on the Creative Cloud transition. As we referenced above; this is also a headwind for margins for the first few quarters until Marketing Cloud – like Creative Cloud is through its SaaS transition. The net impact may be accelerating margin expansion over the course of FY15. VALUATION AND MOVING AVERAGES Adobe trades at 34x forward PE vs. 30x for the long side of our portfolio. The 34x is well above what we might expect for a rather mature company even one experiencing a business model shift. In this case Adobe has a considerable moat around its business and qualifies as a technology "Castle" company which is not so common and we think merits a higher PE. But beyond that the multiple also reflects that the new business model is to be much more profitable than the old. THAT is where the action will most likely be centered going ahead It trades at 1.04x its 50 day moving average (vs. 1.02 portfolio average) and 1.05 its 200 day (vs. 1.10 portfolio average).


EARNINGS – MARCH 2015 We are long and we saw this as a strong quarter in relation to the business thesis we are using: that operating margin expansion will be dramatic across the next two years as Adobe is a rare company that truly demonstrates that a "SaaS" model CAN in the right circumstances be a far better model. Adobe has the advantage of forcing its users to migrate to the new model as it is the only game in town in its particular expertise/service. Most won't be so lucky. In addition Adobe has a culture toward making money and not just "chasing revenues" as many many many saas "start ups" are hampered by. So we saw more operating margin expansion: 610bps this quarter, the vast majority (~560bps) coming from Sales and Marketing expense. At what level will the new margins stabilize? That is THE key question and we are still in process. …pip ADOBE RESULTS & THESIS ASSESSMENT 3.18.2015 Aaron. We hold a long a position. CONCLUSION: Adobe reported 1Q15 results on March 17, 2015. Mostly supportive of the thesis. BULLET POINT #1: THESIS SUPPORTING: Operating Leverage acceleration now beginning: +610bps YoY…last quarter was +90bp; ~60% earnings growth is still forecast for 2015. BULLET POINT #2: THESIS NEUTRAL: Creative Cloud’s sub adds grow 28% YoY TO 517K Subs, a steeper than expected dropoff from Q4, explanation seems viable as management reiterated 70% sub growth for FY15. BULLET POINT #3: THESIS SUPPORTING: Marketing Suite SaaS transition nearing completion, revenue acceleration expected to grow significantly as the year progresses. WHAT HAPPENED? Adobe reported revenues of ~$1.11 billion, up 11% YoY, more or less inline with expectations. Gross margin was 85%, a 20bps decline YoY, while EBIT margins grew 610bps YoY to 26%. EPS came in at $0.44 (+47% YoY), ahead of consensus at $0.39. Free cash flow declined 34% YoY to $147m. Adobe’s guidance for 2Q15 was a bit below expectations: revenue of $1.125B-$1.175B and EPS of $0.41-$0.47, below a consensus of $1.18B and $0.48…it would appear that targeted earnings growth for the year is more back end loaded as the multiple SaaS transitions’ operating leverage will accelerate. WHAT IS THE NEXT THING THAT SIGNIFICANTLY MATTERS?


Two points: (1) Lets see if Creative Cloud sub growth snaps back next quarter once this onetime “marketing experiment” to

drive Document Services ends. (2) As Adobe’s revenue growth accelerates and operating margins begin to expand going forward, does the

pace of spending on operating expenses begin ticking upwards or does management allow margins to rise rapidly?

THE BUSINESS THESIS: ** Thesis: Adobe, the leading provider of software for digital media and marketing, is poised to profit from two key catalysts. In Creative (2/3 of its business), the company is enjoying the benefits of a forced migration of its installed base to a SaaS-based Creative Cloud having far higher long term margins as operating expenses for sales, marketing and development drop and potentially a larger TAM will be generated as well. On the marketing side (1/3 of its business), Adobe has assembled the most comprehensive digital marketing suite amongst a fragmented, uncohesive set of options. Adobe is in the early stages of an extended adoption period of tools by marketers. Between these two changes, Adobe will see a catch up in revenue growth characterized by high incremental margins, translating to sizable earnings leverages and rising free cash flow generation. Slogan: SaaSy and Suite IS THERE A REQUIREMENT TO ALTER THE THESIS OR REPRIORITIZATION OF THE TOP BURNING QUESTIONS OR THESIS THREATS? The SaaS transition and how operating leverage may end up transpiring. Our initial thinking was that once the promotional pricing for Creative Cloud rolled off, there would be a sharp jump in ARPUs that would be the driver, but as we’re learning over the past few quarters, the incremental subscriptions are coming 50/50 from the Suites and the Point products, which carry much lower ARPUs; the point is…ARPU will be rising, but from lower blended averages… So an alteration of a burning question might be what if these point products were to cannibalize Suite subscriptions, thereby reducing the trajectory of ARPU growth, thereby reducing the degree/pace of margin expansion?

** Burning Questions #1: MARGINS: If the expected operating margin expansion from the SaaS transition and Digital Marketing Suite never materializes. #4: SALES AND MARKETING: Does Adobe’s existing user base in creative allow Adobe’s SaaS model to *actually* generate leverage at S&M over time? Context: Post transition, Adobe shouldn’t have to spend as much to capture customers or on discounts in the channel. #6: EXCESS SUCCESS: What does Adobe’s management team do with its rising margins and free cash generation? UPDATED ASSESSMENT: MARGIN EXPANSION KICKING IN…+610BPS THIS QUARTER; EPS GROWS 45% If last quarter’s 90bps worth of margin expansion were the green shoots of the SaaS transition, this quarter’s 610bps showed the promise of a bigger ramping of operating margins as Adobe has come through its multi-year SaaS transition period where revenues and margins decline at the outset as you stop recognizing full licenses upfront, then as ratable licenses build, a model will hit a trough and begin building, ultimately generating significant revenue and margin expansion….at least that’s how we understand it. Corporate EBIT margins expanded 610bps. That’s the highest quarterly operating margin since 2012 (pre-transition). Two quarters ago was the trough, when Adobe was at 19% margins. The main sources of margin expansion was Sales and Marketing expense (560bps of leverage).


How many SaaS companies have we looked at that claim S&M expenses will decline as the model scales…but don’t…cause they are “attacking a TAM”? I’m not sure, but I’ll go with “most” or “almost all”….so it’s almost refreshing to see a company convert to SaaS and do what they say they’ll do…allow the operating leverage to kick in, rather than continuing to invest for growth. Now Adobe is a bit of a unique situation – this is more of a mature business that will be experiencing sales growth and margin expansion now mostly BECAUSE of the SaaS transition (its merely snapping back to former levels). A KEY POINT to reiterate…Adobe has done a fairly good job of restraining expense growth through the transition; In FY14, the company grew opex just 3%, in FY13 it was just 1%. AND that was with S&M ramping to drive the SaaS transition. This quarter, it was actually down a few million dollars…Now that revenue growth is beginning to accelerate, Adobe should begin recapturing large chunks of EBIT margins as it regains the mid 30% level over time. The key question we need to consider NOW is….whats the target? Is it the former ~35% level? Or does this transition (which we think helps expand the addressable market) end up closer to 40% margins? Or low 30s? How fast will Adobe regain its former peak? This is an area to wrestle with in the coming weeks. #1A: TRANSITION: How fast will Adobe transition its Creative Suite base to Creative Cloud, and how high are incremental margins? Context: 4Q13-4Q14 Creative Cloud sub adds:408K, 405K, 464K, 502K, 644K #3: ADDRESSABLE MARKET: Does Creative Cloud expand the addressable market for Adobe? Does Adobe’s recent segmenting of Cloud subscription to achieve this goal? Related Thesis Threat #2: ADOPTION: If the later stages of adoption of Creative Suite don’t materialize, making it difficult to forecast what steady state growth post-model transition looks like. UPDATED ASSESSMENT: CREATIVE SUITE ADDITIONS DECELERATE: 517K NET ADS: 28% YOY AND -20% QOQ…OPERATING LEVERAGE BEGINNING TO ACCELERATE. This quarter Adobe added 517K Creative Cloud customers (+28% YoY), finishing the quarter with 3.97m subs. Management reiterated its guidance issued last quarter for FY15 of 5.9m subs (a 70% increase)….coicidentally, 1Q15 finished at ~4m subs, which was the previous guidance for FY15. However, this is a sharp deceleration from the past year’s growth rates: YoY 1Q14-1Q15: 160% 104% 56% 60% 28% QoQ 1Q14-1Q15: 1% 15% 8% 28% -20% Whats going on? That -20% seems more than usual seasonality one might expect from Q4 to Q1. Here is management’s explanation, which I find reasonable. Yesterday, Adobe announced it was launching a 3rd “Cloud”…its Adobe Document Cloud…its built on the new version of Adobe Acrobat, which has new touch enabled interfaces and new features for mobile. But Acrobat is also something that is included in Creative Cloud’s suite. This quarter, in ramping up for the launch of Document Cloud, Adobe was using Acrobat to push customers towards the new Document Services products. The net of this? It’s basically accounting semantics…Adobe had to credit Acrobat sales to Document Services rather than Creative Cloud…the impact to the number of subscribers was “significant”…but also one time in nature, which is why management reiterated it will hit the 5.9m figure exiting FY15; management incorporated this quarter’s marketing and its impact on subs when it issued guidance last quarter…so we *should* expect to see a good jump up in QoQ growth next quarter as they are discontinuing the practice. Because of all these moving parts within Adobe’s Digital Media business, its best to keep our eyes on Annual Recurring Revenues…where how one accounts for Acrobat in Document Services vs. Creative Cloud doesn’t impact the overall number. Adobe’s Digital Media’s Annual Recurring Revenue was $2.09 B (+81% YoY) a touch


better than consensus (Creative Cloud’s contribution was 1% lighter than expected, and Document’s was 11% better). As for the questions regarding does Cloud expand Adobe’s TAM? As we’ve observed over the past few quarters, Adobe’s selling of more point products (e.g. Creative Cloud Photography) and mobile apps has meant Creative Cloud subs growing faster than revenues, in part because ARPU for point products is lower than the full suite, and management indicated that incremental sales for Creative Cloud right now seem to be split roughly 50/50 between point and suite. This trend has accelerated; a year ago 70% of subs were using the full Suite, the figure today is now 59%. So…while the number of subs has jumped significantly…its kind of important to recognize these are almost 2 separate products (or really 5 or 10) that are being counted as “Creative Suite” subscribers. Our thinking is these point products and the layering on of new features through acquisitions (like this quarter’s acquisition of Fotolia or the Aviary deal from last Fall) do help expand the TAM. #2: MARKETING CLOUD: Does a true “marketing cloud” market actually develop or do marketers prefer using a collection of best of breed solutions? What signals (if any) that Adobe is becoming the standard? Related Threat#4: POINT OVER SUITE: If Adobe is unable to drive 20%+ revenue growth in digital marketing because customers prefer best of breed solutions, rendering its suite strategy ineffective. UPDATED ASSESSMENT: MARKETING CLOUD’S SAAS TRANSITION IS ALMOST THROUGH, REVENUES EXPECTED TO ACCELERATE MEANINGFULLY AS THE YEAR GOES ON. The more pressing part of the question is….”Is Adobe Marketing Cloud becoming THE standard” Last week, Adobe held its annual Digital Marketing Summit where it announced two new partnerships (IBM & Accenture) and introduced two new Marketing Suite modules: Adobe Primetime, and Audience Manager. Primetime is Adobe’s audience measurement tool that measures video viewing audiences by IP address, while Audience Manager is the related data management platform….this is the service that Nielsen will be partnering with to offer cross platform measurement. Through Primetime, Adobe can track viewers habits by IP address (including Netflix, Amazon Prime, Hulu, and all those the standalone streaming services being launched daily it seems)…this type of service – if successful – is the type of differentiator vs. say Oracle or Salesforce’s marketing clouds that might translate into Adobe becoming the defacto “winner” in the evolving marketing suite wars. As for this quarter? Digital Marketing Revenues grew 17% YoY to $357M; inline with consensus. As a reminder, for the past few quarters, Marketing Cloud’s two foundational components: Adobe Experience Manager (AEM) and Campaign Manager (ACM) were undergoing their own SaaS transition, which had depressed revenue growth a bit: 1Q14-1Q15 YoY Growth: 24%, 23%, 14%, 4%, 17% Management reiterated it expects full year growth to be 25%...which would imply a pretty sizable acceleration over the next few quarters. We have flagged in our work that the Marketing Cloud’s own SaaS transition is often underappreciated as folks tend to focus on the Creative Cloud transition. Much like Creative Cloud, as Marketing Cloud comes out of its transition, we should see it contribute to accelerating margin expansion over the course of FY15. VALUATION AND MOVING AVERAGES Adobe trades at 24x forward PE vs. 29x for the long side of our portfolio. The 34x is above what we might expect for a rather mature company even one experiencing a business model shift. In this case Adobe has a considerable moat around its business and qualifies as a technology "Castle" company which is not so common and we think merits a higher PE. But beyond that the multiple also reflects that the new business model is to be much more profitable than the old. THAT is where the action will most likely be centered going ahead


It trades at 1.07x its 50 day moving average (vs. 1.05 portfolio average) and 1.12 its 200 day (vs. 1.11 portfolio average).

EARNINGS – JUNE 2015 We are long and we saw this as a strong quarter in relation to the business thesis we are using: that operating margin expansion will be dramatic across the next two years as Adobe is a rare company that truly demonstrates that a "SaaS" model CAN in the right circumstances be a far better model. Adobe has the advantage of forcing its users to migrate to the new model as it is the only game in town in its particular expertise/service. Most won't be so lucky. In addition Adobe has a culture toward making money and not just "chasing revenues" as many many many saas "start ups" are hampered by. So we saw more operating margin expansion: 400bps this quarter, the vast majority (~330bps) coming from Sales and Marketing expense. At what level will the new margins stabilize? That is THE key question and we are still in process. Aaron ADOBE RESULTS & THESIS ASSESSMENT 6.17.2015 Aaron. We hold a long a position. CONCLUSION: Adobe reported 2Q15 results on June 16, 2015. Nicely supportive of the thesis. BULLET POINT #1: THESIS SUPPORTING: Operating Leverage acceleration continues: +400bps YoY…last quarter was +610bp; ~60% earnings growth is still forecast for 2015. BULLET POINT #2: THESIS NEUTRAL: Creative Cloud’s sub adds grow 38% YoY TO 639K Subs, a nice snapback from last quarter’s deceleration. BULLET POINT #3: THESIS SUPPORTING: Marketing Suite SaaS transition nearing completion, revenue acceleration expected to grow significantly as the year progresses. WHAT HAPPENED? Adobe reported revenues of ~$1.16 billion, up 9% YoY, more or less inline with expectations. Gross margin was 84%, a 140bps decline YoY, while EBIT margins grew 400bps YoY to 27%. EPS came in at $0.48 (+24% YoY), ahead of consensus at $0.45. Free cash flow grew 28% YoY to $435m. Adobe’s guidance for 2Q15 and FY15 was adjusted a touch downward due to FX headwinds, though growth targets set last quarter for the respective businesses were reiterated. Earnings growth for the year is more back end loaded as the multiple SaaS transitions’ operating leverage will accelerate. WHAT IS THE NEXT THING THAT SIGNIFICANTLY MATTERS?


The #1 area I want to focus on in the coming weeks is how big is the Marketing opportunity? What do steady state margins look like there IF Adobe were to be the *winner* in the space….this would involve a modeling/scenario analysis exercise. THE BUSINESS THESIS: ** Thesis: Adobe, the leading provider of software for digital media and marketing, is poised to profit from two key catalysts. In Creative (2/3 of its business), the company is enjoying the benefits of a forced migration of its installed base to a SaaS-based Creative Cloud having far higher long term margins as operating expenses for sales, marketing and development drop and potentially a larger TAM will be generated as well. On the marketing side (1/3 of its business), Adobe has assembled the most comprehensive digital marketing suite amongst a fragmented, uncohesive set of options. Adobe is in the early stages of an extended adoption period of tools by marketers. Between these two changes, Adobe will see a catch up in revenue growth characterized by high incremental margins, translating to sizable earnings leverages and rising free cash flow generation. Slogan: SaaSy and Suite IS THERE A REQUIREMENT TO ALTER THE THESIS OR REPRIORITIZATION OF THE TOP BURNING QUESTIONS OR THESIS THREATS? We might want to consider adding a question around the new Adobe Stock – this entrance into the $4B stock photography market seems a bit more significant than an average “bolt-on” TAM expansion. What are the economics of the new product…is it enough to prolong/increase the trajectory of Digital Media’s Average Recurring Revenue growth? ** Burning Questions #1: MARGINS: If the expected operating margin expansion from the SaaS transition and Digital Marketing Suite never materializes. #4: SALES AND MARKETING: Does Adobe’s existing user base in creative allow Adobe’s SaaS model to *actually* generate leverage at S&M over time? Context: Post transition, Adobe shouldn’t have to spend as much to capture customers or on discounts in the channel. #6: EXCESS SUCCESS: What does Adobe’s management team do with its rising margins and free cash generation? UPDATED ASSESSMENT: MARGIN EXPANSION CONTINUES TO BUILD: +400BPS THIS QUARTER; EPS GROWS 24% This quarter’s 400bps of margin expansion showed the continuation of last quarters’ (+610bps) ramping of operating margins as Adobe has gone past the midpoint of its multi-year SaaS transition period. As a reminder, revenues and margins decline at the outset as you stop recognizing full licenses upfront, then as ratable licenses build, a model will hit a trough and begin building, ultimately generating significant revenue and margin expansion….at least that’s how we understand it. The main sources of margin expansion was Sales and Marketing expense (330bps of leverage) and R&D (130bps) How many SaaS companies have we looked at that claim S&M expenses will decline as the model scales…but don’t…cause they are “attacking a TAM”? I’m not sure, but I’ll go with “most” or “almost all”….so it’s almost refreshing to see a company convert to SaaS and do what they say they’ll do…allow the operating leverage to kick in, rather than continuing to invest for growth. Now Adobe is a bit of a unique situation – this is more of a mature business that will be experiencing sales growth and margin expansion now mostly BECAUSE of the SaaS transition (its merely snapping back to former levels).


A KEY POINT to reiterate…Adobe has done a fairly good job of restraining expense growth through the transition; In FY14, the company grew opex just 3%, in FY13 it was just 1%. AND that was with S&M ramping to drive the SaaS transition. This quarter, sales and marketing absolute spend was exactly flat YoY. recapturing large chunks of EBIT margins as it regains the mid 30% level over time. The key question we continue to mull over…how high do margins go once Adobe is through the transition? We are working from the assumption that Adobe should expect to go above the previous ~35% level – one doesn’t pursue a multi-year transition to achieve a *lower* level of profitability. Does this transition (which we think helps expand the addressable market) end up closer to 40% margins? Thus far, management has continually said it is bringing in ~20% more customers than previously due to the subscription model. We think those should come with very high incremental margins and push the steady state level above 35%. Related…. #1A: TRANSITION: How fast will Adobe transition its Creative Suite base to Creative Cloud, and how high are incremental margins? Context: 4Q13-4Q14 Creative Cloud sub adds:408K, 405K, 464K, 502K, 644K #3: ADDRESSABLE MARKET: Does Creative Cloud expand the addressable market for Adobe? Does Adobe’s recent segmenting of Cloud subscription to achieve this goal? Related Thesis Threat #2: ADOPTION: If the later stages of adoption of Creative Suite don’t materialize, making it difficult to forecast what steady state growth post-model transition looks like. UPDATED ASSESSMENT: CREATIVE SUITE ADDITIONS REACCELERATE: 639K NET ADS: 38% YOY This quarter Adobe added 639K Creative Cloud customers (+38% YoY), finishing the quarter with 4.6m subs. That was broken down into 239K adds (-7% YoY) for the full Creative Suite and 400K adds (+92% YoY) for the standalone products. Overall a nice reacceleration….a reminder that last quarter’s slowdown was due to a marketing test decision to account for Acrobat additions in Document Services rather than Creative Cloud (this quarter things reverted): YoY 2Q14-2Q15: 104%, 56%, 60%, 28%, +38% QoQ 2Q14-2Q15: 15%, 8%, 28%, -20%, +24% Management reiterated its guidance from last year that it expects at least 5.9m subs by the end of FY15 (a +70% YoY figure) but also said it would no longer be offering guidance for subs going forward as it prefers the investment community to focus on ARR (average recurring revenue), which is more of a “same store sales” type figure that accounts for the various permutations/SKUs of cloud customers (e.g. Full suite vs. point products like Photoshop). This makes sense if we consider the growing ecosystem that Adobe is building. When I stop to think about it…lets say, I’m a Creative Cloud subscriber. I’ve been for a year. But I’ve now decided to pay for the new Adobe Stock product. The subscriber figure doesn’t increase, but the ARPU does…so it *does* kind of makes sense to look at the ARR figure as the metric of choice. This quarter, ARR for the Digital Media business came in at $2.35B (+70% YoY). Creative Cloud accounting for $2B (+69% YoY) and Document Services (+80%) Cloud accounting for the remainder….reminder…Document Services is Acrobat and different eSign type products. As for the questions regarding does Cloud expand Adobe’s TAM? As we’ve observed over the past few quarters, Adobe’s selling of more point products (e.g. Creative Cloud Photography) and mobile apps has meant Creative Cloud subs growing faster than revenues, in part because ARPU for point products is lower than the full suite, and management reiterated that incremental sales for Creative Cloud right now seem to be split roughly 50/50 between point and suite. This trend has accelerated; a year ago 67% of subs were using the full Suite, the figure today is now 56%.


Our thinking is these point products and the layering on of new features through acquisitions do help expand the TAM. The big announcement this quarter was the launch of Adobe Stock (which comes from the Fotolia acquisition last quarter). ….Adobe Stock puts Adobe into the stock photography business (like Getty Images or Shutterstock). The company describes this as an incremental $4 billion TAM it now competes in…leveraging the power of its bundle to expand into an adjacency where there is a large overlap between creative professionals. Management said that over 85-90% (!) of stock content buyers and sellers use Adobe tools. Seems like smart strategy. And maybe not good for Shutterstock and Getty? Wonder if those could be “platform crush” fallout victims. #2: MARKETING CLOUD: Does a true “marketing cloud” market actually develop or do marketers prefer using a collection of best of breed solutions? What signals (if any) that Adobe is becoming the standard? Related Threat#4: POINT OVER SUITE: If Adobe is unable to drive 20%+ revenue growth in digital marketing because customers prefer best of breed solutions, rendering its suite strategy ineffective. UPDATED ASSESSMENT: MARKETING CLOUD’S SAAS TRANSITION IS ALMOST THROUGH, REVENUES EXPECTED TO ACCELERATE MEANINGFULLY AS THE YEAR GOES ON. The more pressing part of the question we continue to ask ourselves is….”Is Adobe Marketing Cloud becoming THE standard” One way to look at this is how many of the modules customers are taking and how fast are billings growing (billings lead revenue growth). This quarter, Adobe Marketing Cloud added two more modules (its now 8 altogether), and noted that 2/3rds of its customers were licensing multiple modules. Adobe is seeing larger and larger deals as a result…deals over $1m in size grew 56% YoY. The two new Marketing Suite modules are Adobe Primetime and Audience Manager. Primetime is Adobe’s audience measurement tool that measures video viewing audiences by IP address, while Audience Manager is the related data management platform….this is the service that Nielsen will be partnering with to offer cross platform measurement. Through Primetime, Adobe can track viewers habits by IP address (including Netflix, Amazon Prime, Hulu, and all those the standalone streaming services being launched daily it seems)…this type of service – if successful – is the type of differentiator vs. say Oracle or Salesforce’s marketing clouds that might translate into Adobe becoming the defacto “winner” in the evolving marketing suite wars. As for this quarter? Digital Marketing Revenues grew 15% YoY to $327M. As a reminder, for the past few quarters, Marketing Cloud’s two foundational components: Adobe Experience Manager (AEM) and Campaign Manager (ACM) were undergoing their own SaaS transition, which had depressed revenue growth a bit: 2Q14-2Q15 YoY Growth: 23%, 14%, 4%, 17%, 15% Management reiterated it expects full year growth to be 24%...which would imply a pretty sizable acceleration over the next few quarters. Billings growth is expected to be 30%+ this year (even with FX headwinds)…the point? Marketing Cloud should see its revenue growth accelerate significantly in coming quarters. We have flagged in our work that the Marketing Cloud’s own SaaS transition is often underappreciated as folks tend to focus on the Creative Cloud transition. Much like Creative Cloud, as Marketing Cloud comes out of its transition, we should see it contribute to accelerating margin expansion over the course of FY15. VALUATION AND MOVING AVERAGES


Adobe trades at 25x forward PE vs. 29x for the long side of our portfolio. The 25x is above what we might expect for a rather mature company even one experiencing a business model shift. In this case Adobe has a considerable moat around its business and qualifies as a technology "Castle" company which is not so common and we think merits a higher PE. But beyond that the multiple also reflects that the new business model is to be much more profitable than the old. THAT is where the action will most likely be centered going ahead It trades at 1.03x its 50 day moving average (vs. 1.03 portfolio average) and 1.09 its 200 day (vs. 1.12 portfolio average).

COMPARE / CONTRAST: ADOBE vs AUTODESK SAAS Transitions: Adobe vs. Autodesk We have held a Long position in Adobe since early in 2014. Central to the thesis we are using is that the transition of the customer base for Creative Suite (~2/3rds of Adobe’s revenues) to a SaaS-based Creative Cloud would translate to an expanded customer base with higher lifetime values without an appreciably higher operating expense base (subscription customers require lower S&M maintenance spending over time)…eventually generating operating leverage on a larger revenue base. Adobe was amongst the first large software companies to fully transition its model – a move many traditional license/maintenance giants are making to some degree: Microsoft and SAP most prominently, but plenty of others, such as Intuit and Autodesk. The investment case on Autodesk is often described in comparison to Adobe – a comparison that Autodesk’s management team actively talks to (albeit pointing out key differences). The mechanics of a multi-year transition from a License/Maintenance to SaaS pricing model involves a decline in revenues and margins at the outset as a company stops recognizing full licenses upfront, then as ratable licenses pile up, a model will hit a trough and begin building, ultimately generating significant revenue and margin expansion. A long case on Autodesk is built on seeing through this transition to the promise of a larger, more profitable business in 2019 and beyond. Not all SaaS transitions are equal and we see multiple differences between Adobe and Autodesk: 1. Competitive Position Matters: The key point of a SaaS transition is forcing your customers to pay more for your product over a multi-year period – and do so while keeping churn low. Adobe’s Creative is a defacto monopoly, with over 50% market share within creative software – and it is the standard taught in schools and used universally by professionals. If you work in this industry, you HAVE to use Creative Cloud. Autodesk? Definitely a market leader – but there are CAD rivals in Dassault, PTC, Siemens, Bentley. Viable alternatives might hinder Autodesk’s ability to push through LT pricing increases. 2. Culture of Making Money Adobe may have been a “R&D playground” back in the 1990s – but for the past 15 years, this is a company that consistently kept an eye on operating expenses. Its traditional model’s operating margins were 35%+ before its SaaS transition – a level we would expect it to return to (and potentially surpass depending on the trajectory of the Marketing Cloud).Why? During its transition, Adobe has held the line on expenses: In 2013, opex rose 1%. In 2014, it rose 3%. Sales and Marketing spend the past few quarters has essentially been flat. Adobe EBIT margins FY11-FY19 37%, 38%, 36%, 23%, 21%, 28%, 36%E, 36%E, 33%E, 33%E


Autodesk has historically not operated as profitable a business as Adobe. Pip has watched Autodesk since 1994 - after the company had really experienced its great growth years under Carol Bartz. In some specific ways Autodesk is a perfect SaaS candidate in that historically Autodesk would release alternating "hot" and "cold" releases to sell for license revenue and SaaS would smooth that completely. One version would have a bunch of intriguing features and so clients would BUY that version but the next release was too soon for a fresh upgrade for clients and wasn't as loaded with new intriguing features. A hard business to run for certain. The margins in all this have NEVER been impressive especially given the company's major market share. We did hold a long position in the 2010-2012 time period when we saw some room for margin improvement but sadly the culture and model couldn't keep closing the gap in margins versus other major software companies beyond a certain point. Since then, its margins have floundered and we have often remarked internally…what would Autodesk’s margins be if Larry Ellison was running the show? We think the projections for steady state margins to be significantly higher than the previous peak may be wishful thinking. Autodesk EBIT margins FY11-FY19: 21%, 24%, 25%, 22%, 15%, 9%, 2%E, 12%E, 25%E, 32%E 3. Who is doing the Selling? Adobe relied on channel partners far less than Autodesk. Ingram Micro accounted for 11% of sales back in 2012. Pre-SaaS, Adobe relied on a direct sales force mostly – and because of the consumer nature of its product, much of its software was purchased in stores or through its website. By comparison, Autodesk has traditionally relied more heavily on its channel partners for sales (~80% through resellers). This may provide a more difficult headwind in a business model transition – altering the incentives of resellers who make more money selling perpetual licenses…after all, if Autodesk goes subscription, there really isn’t as much a need for resellers – Autodesk would sell directly. In the recently reported 2Q16, Autodesk noted that 60% of its desktop subscriptions were sold via the channel, up from 40% in 1Q16 – both figures remain below the overall ~80% level. 4. Platform Extensions The investment case for Adobe isn’t ENTIRELY based on a business model transition. We think its incredible competitive position in Creative software allows it to readily extend its bundle to grow its average recurring revenue. The recent acquisition of Fotolia to layer on Adobe Stock is a perfect example. The other leg of the thesis involves Adobe’s Marketing Cloud – a collection of acquisitions Adobe made over the past half decade to piece together a suite in a yet-to-be settled competitive environment. It competes with Salesforce.com, Oracle, and IBM in the marketing software arena – none has established themselves as the default choice for corporations YET – and we like Adobe’s tact of leading with Adobe Experience Manager (essentially what an ecommerce business runs its website on) vs. competitors who lead with email marketing (Salesforce.com’s Exact Target) or social (Oracle’s Virtu). Autodesk by comparison is seeking to use cloud-based delivery + subscription pricing as a competitive wedge to grow its business in Product Lifecycle Management (PLM) and Simulation software. In both cases, Autodesk is seeking to expand against competitors who are more entrenched and/or are considered the defacto standard (e.g. Ansys). This is a more difficult strategy than competing in a blue ocean. 5. Legacy Positions and Size of Customer Base The starting point for the transitions are significantly different: Autodesk already had half its customers on recurring revenues (maintenance), while Adobe did not….making the lift for Adobe greater (and making Autodesk’s sharper margin contraction more puzzling). Autodesk essentially rebuilt its entire tech platform to be delivered through the cloud FIRST – now it is in the process of transitioning its customer base (and the business model)…Adobe did it in reverse – changed the pricing model first (to subscription) and rebuilt the technology as it went.


Adobe’s customer base is also 2-3x larger than Autodesk (a few years ago it estimated 13m users while Autodesk is closer to 5m). Conclusion: As one might tell by now – these are not apples to apples comparisons. Each business should be judged on its own merits; its difficult to make direct comparisons of SaaS transitions – but we think the greatest business model “lift” tends to come from software businesses that have massive installed bases where the vendor is a standard/monopoly that customers are compelled to stick with despite increased pricing over time because there isn’t an easy substitute. Adobe fits this bill. Autodesk has similar elements, but its path to profitability is less certain.

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