As an
And as a teacher of business strategy and entrepreneurship at Babson College -- selected by U.S. News and World Report as the top entrepreneurship school for the last 20 years in a row -- I have enjoyed watching how it successfully transformed itself from a maker of boxed software to a provider of software as a service.
After all, the way Adobe accomplished this transformation is in direct defiance of a core principle of how to manage so-called disruptive technologies as articulated by Harvard Business School Professor Clayton Christensen.
Indeed in the 26 months since I recommended investing in companies that defy the disruption guru's prescriptions, Adobe's stock has risen 61% -- while the S&P 500 increased about 12%.
Before getting into this -- let's look at Adobe's latest expectations-beating earnings report. On September 20, Adobe reported revenues for its fiscal third quarter of $1.46 billion and adjusted earnings per share of 75 cents -- exceeding expectations by $100 million and three cents, respectively, according to TheStreet.com.
In addition to beating investor expectations, Adobe raised its forecast for the current quarter to a range between 83 and 89 cents per share -- well above the 78 cents that Wall Street expects.
What does this have to do with the famed HBS professor? About 17 years ago, I wrote my first article suggesting that his idea of how to manage disruptive technologies -- set them up in a separate subsidiary charged with killing the parent -- was wrong.
In July 2014, Jill Lepore, a Harvard history professor who used to be the administrative assistant of my former boss, Harvard Business School professor Michael Porter, eviscerated Christensen in the New Yorker.
In a letter to the editor, I reiterated what I had said in January 2000 -- that the best way to manage a disruptive technology was for the CEO to push its adoption against all the internal naysayers who wanted to preserve the old product lines to ease their ascension to the top job.
And that's when I pointed out the investment advantages of taking Christensen's prescription and doing the opposite.
Adobe was a case in point. In 2011, its CEO decided to stop selling packaged software at $1,900 a box and move to $50 a month bundles of software available in the cloud. This was disruptive based on Christensen's definition because it represented a superior value proposition that brought in many new customers -- in June 2014, Adobe estimated that “roughly 20% of Creative Cloud’s 2.3 million subscriptions [were] new users,” according to Barron’s.
Adobe's CEO-managed self-disruption had a harsh effect on its revenues and profits in the short-term. But since Adobe communicated its strategy effectively to investors -- and they understood how the cloud-based model would boost long-term cash flows -- they bought its shares.
Indeed Adobe's success highlights that dangers of Christensen's prescription. If Adobe had hived off its cloud in a separate subsidiary, it would have lost the battle for internal resources needed to make the radical change required to manage this corporate transformation.
With Adobe popping 7% after the announcement to a record high, is it too late to buy its shares? The shares are pretty expensive -- trading at a P/E of almost 61. But considering that its GAAP net income grew 55% in the quarter and the company raised its guidance for the current quarter, Adobe's PEG ratio -- P/E of 61 divided by earnings growth of 55 -- is a reasonable 1.1 (I think 1.0 is fairly valued).
Infamous stock hawker Jim Cramer is an Adobe bull. According to TheStreet.com, "Cramer said that Adobe's 'brilliant' conference call really highlighted how spectacular the cloud is. People who do creative work on the Internet are more than likely using Adobe. Given that Adobe offers a cloud-based subscription plan, it's clear to see why growth has been so strong. The company's creative cloud unit posted exceptional growth of 39%, he added. Adobe is 'great and that's why this stock is not done going up,' Cramer concluded."
I wish I had Cramer's certainty about Adobe's future. My concern is that if Adobe keeps beating expectations, investors will raise their hopes so high that Adobe may fall short.
However, Adobe might be able to keep investors happy if its CEO continues to invest in new growth opportunities.
