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Microsoft, Adobe Now Fly In The Cloud; Is Artificial Intelligence Next?

For desktop software companies, the rise of cloud computing has meant change or die.

The internet cloud brought the notion of selling computing resources as a service, a step out of the past in which customers bought packaged software and installed it in their computers, networks and data centers.

With cloud computing, customers pay for information technology as though it were a utility, like gas or electricity, delivered into their home through the internet.

But change is difficult when you're a company the size of Microsoft (MSFT), with market capitalization nearing $650 billion, or even Adobe Systems (ADBE) with an $88 billion market cap. Both companies took hits to their sales and earnings during their transition to cloud-based software providers, but are now reaping the benefits.

After years of pushing cloud computing, both Microsoft and Adobe are being applauded for their deft handling of the transition. But challenges remain for those giants and others making the shift to the cloud.

To date, their transitions have mostly involved urging customers of licensed legacy software products to convert those products over to cloud-based subscriptions. The next step is to see if they can upsell them additional services to increase their average revenue per user.

Powerful Growth Drivers

UBS analyst Jennifer Swanson Lowe projects that the software sector will see most of its future revenue growth from the creation of new services rather than replacement of legacy systems, she said in a Nov. 8 report.

"We see ongoing secular tailwinds as shifts in the computing landscape favor increasing software adoption," Lowe said. Cloud computing and Big Data "remain powerful growth drivers."

The cloud transition puts desktop software players in a position to be more valuable partners for their customers, Piper Jaffray analyst Alex Zukin told Investor's Business Daily.

"That transition allows you to go from being a company that sells lots of (individual products) once upon a time to their customers to a company that is continuously involved in delivering value," Zukin said.

The market is underpricing U.S. software stocks on two fronts: total addressable market expansion and profit margin expansion, Lowe said. Microsoft, Salesforce.com (CRM) and ServiceNow (NOW) are among her top picks in the sector.

Improving profitability is now a major driver for stock valuations in the sector, she said.

"We think the market broadly underappreciates the margin expansion potential of high growth stories that also deliver high cost efficiency on new business acquisitions," Lowe said.

For instance, Adobe's efficient cost structure has enabled 59 cents of every new revenue dollar to drop through to profit, she noted.

IBD's Computer Software-Desktop industry group includes seven companies, led by Microsoft and Adobe. Others in the group include Monotype Imaging (TYPE), Nuance Communications (NUAN) and Red Hat (RHT).

Collectively, those seven stocks have gained 57% since the start of 2017, lifting the group to a No. 25 ranking on Thursday among the 197 groups tracked by IBD.


IBD'S TAKE: The IBD 50 list of top-performing growth stocks includes two companies from the desktop software industry group: Adobe Systems and Red Hat.


MoffettNathanson hosted senior executives from Adobe, Microsoft, Red Hat and others at a software forum in mid-November. MoffettNathanson analyst Adam Holt said the meetings made him upbeat about the sector.

"We left feeling constructive about the current demand environment and favorable structural shifts in software," Holt said in a Nov. 20 report. "We continue to be bullish on (the) sector."

Analysts read the fact that Microsoft is now running complex SAP (SAP) workloads on its Azure platform as a coming-of-age signal for the company's cloud business. The knock on Microsoft's cloud operation previously was that it handled only low-end workloads for corporate customers, Holt said.

"There just aren't really more complex workloads than ERP (enterprise resource planning) and that kind of use case/referenceable customer opens up a huge (total addressable market) for Microsoft," he said.

The transition to the cloud is redrawing the traditional industry group lines. Unlike its desktop software peers, Microsoft plays not only in cloud applications but cloud infrastructure. Its Azure platform provides the infrastructure on which internet-based software applications run. That means, in the cloud infrastructure space, Microsoft competes mostly with Amazon.com (AMZN) Web Services and to a less extent Alphabet's (GOOGL) Google. Google also competes with Microsoft in productivity software apps. Its Google Docs are an alternative to Microsoft's Office 365 apps, which include Word, Excel and PowerPoint.

Market research firm IDC predicts that 2018 will see much activity around partnerships in cloud computing. It sees platform providers Amazon, Microsoft and Google looking to sign more application software makers to preferred provider arrangements. For example, Microsoft has forged cloud partnerships with Adobe and SAP.

Adobe has a clean cloud transition story compared with Microsoft, which is diversified across other businesses, including its Windows PC operating system, Xbox video game consoles, Surface computers and other devices.

Microsoft's cloud-computing businesses include Office 365 productivity software, Azure cloud infrastructure services, Dynamics business software and LinkedIn services.

Other traditional desktop software companies that have been moving to the cloud include design software firm Autodesk (ADSK) and accounting and tax software firm Intuit (INTU).

A key metric for software companies making the transition to the cloud is annualized recurring revenue. Rather than lumpy bursts of revenue that once came from large-scale sales, recurring revenue shows subscription-type revenue streams associated with software-as-a service models. These streams tend to be repetitive, and provide more visibility to upcoming results.

Adobe, a maker of digital media and marketing software, ended its fiscal third quarter with $4.87 billion in annualized recurring revenue in its digital media business alone. Its digital media business includes software subscriptions for the Creative Cloud, Photoshop and other tools.

In the September quarter, Microsoft exceeded $20 billion in commercial cloud ARR, outpacing a goal it set just over two years ago.

Adobe Prepares To Go Shopping

Another big technology trend is the infusion of artificial intelligence into software applications.

Artificial intelligence could be an "underappreciated lever" for Adobe in 2018 and beyond, KeyBanc Capital Markets analyst Brent Bracelin said in Nov. 21 note. Adobe's Sensei technology is already powering advanced features in its creative software, such as enhanced photo search and editing.

"We see a clear AI and (machine learning) monetization opportunity for Adobe through potential price increases and potential share gain shifts that could be justified based on higher levels of automation and material time savings for designers," Bracelin said.

Adobe is likely to be active in mergers and acquisitions in the year ahead, Zukin said. Adobe needs to broaden the portfolio of its Marketing Cloud business, he said.

"They need to buy in multiple parts of the marketing stack," Zukin said. "They could use an asset in e-commerce … They could use functionality that gets them more into the CRM (customer relationship management) space of marketing — something like a Zendesk (ZEN) would make sense for Adobe."

But don't expect Microsoft to do any big deals in the next 12 to 18 months. It's still trying to make its acquisition of online professional network LinkedIn work, he said.

The name of the game for Microsoft, Adobe and other desktop software players next year will be staying the course.

"Challenges in the new year will be execution focused and managing the sales force, the customer service organization, the partner ecosystem and the partner community," Zukin said.

They've planted the seeds for their cloud computing businesses, now they have to help them grow, he said.

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