rent vs. buy: why rent a product instead of selling it?

Adobe (ADBE) used to sell physical copies of a given edition of its Creative Suite of products to individuals or small businesses for $2600 apiece.  Now it rents the same thing as Creative Cloud for $50 a month.  In 2012, selling physical copies (let’s ignore the other cloud-based tools ADBE sells–the big change is in its media tools), ADBE made $1.66 a share in profit and had $2.24 in cash flow.  This year, having gone totally digital the company says it will have earnings of around $.30 a share and will generate, I think, $1 or so in cash flow.

How can this be a good deal?  It takes over four years of rental income to generate the same revenue that a sale would do all at once.  In addition, in a world where interest rates were back to normal, present value considerations make the rental stream worth less than cash in hand today.

So why switch?

I can think of four reasons:

pricing umbrella   $2600 for Creative Suite, or $700 for Photoshop alone, leaves the door wide open for a competitor to enter the market with a lower-priced product–even a shareware entry–that does more or less the same thing as an ADBE product.

piracy  I’ve seen bootleg copies of Creative Suite on Craigslist for $100.  Yes, they’re illegal and, yes, maybe they won’t all work forever, but still the price difference is enormous!  Back when I was following Microsoft carefully–which is over a decade ago–that company thought that almost half of the copies of its Office suite being used by small- or mid-sized companies were stolen.  Because the rental model matches the cost of the software more closely with the potential buyer’s cash flow, stealing the software becomes much harder to justify.  If it’s all on the cloud, it’s impossible for most people to do.

upgrades (or lack thereof)  Before I signed up for the cloud version of Photoshop, I was using a version (CS5) that was several years old.  I’m sure there are individuals and businesses using much older versions.  Same general argument as for piracy–using outdated tools become much less worthwhile.

selling direct  Delivering Creative Cloud products through downloads eliminates the commissions paid to distributors of physical copies.  It also eliminates the expense of making the physical copies, but I think that’s a minor expense (the box and shrink-wrap are probably the largest cost elements).

 

ADBE thinks it will make $2 a share in 2015 and $3 a share in 2016 because of switching to the cloud for its media tools.  I’m not sure these number make the stock cheap at today’s price (I have a small position and would be a buyer at lower levels), assuming they come in as ADBE anticipates.  But I’m convinced that the piracy thing is real and that the incremental cost of selling an extra copy is as close to zero as you can get.  Also, once you start using the better tools it’s highly unlikely you’re going to go back.  You’ve probably thrown out the disks anyway.

Therefore, there’s at least a shot that number s are better than that.

But in this post, my main point is that the rental model is an extremely powerful one.

Examples tomorrow–Anixter, Olympus and EA.

buying Microsoft (MSFT) !?!

Yes, that’s what I’m beginning to do.  I’ve bought a small amount and intend to add to it on weakness.

For me, this is an unusual step, since MSFT isn’t exactly what you’d call a growth stock.  Quite the opposite.  It’s a value idea.  I’ve been building to it for some time, though.  I few months ago I wrote that in a year like 2014, where I imagined (and still do) that a stock that’s up by 10% will be an outperformer, the bar is set pretty low.  And after thirteen years of decline vs. stocks in general, the news that the company had dysfunctional management and had gone ex growth had been pretty thoroughly worked into the stock price.  My son-in-law told me it’s the nicest thing he’s ever heard me say about MSFT.  (It was a big part of my portfolios all through the 1990s, however.)

I also privately scoffed at prominent value managers who loaded up on MSFT several years ago purely on the notion that the stock was cheap, ignoring the issue that change of control was well-nigh impossible.

What’s changed?   …or, better, what’s changed my mind?

As I mentioned above, the market situation is one thing.

The stock’s metrics haven’t moved much:  steady cash flow of $3+ a share, earnings of $2.75, a dividend yield of just under 3%.

There’s a chance earnings may improve over the next few years:

–the board of directors has put new top management in place.  A cadre of looks-good-in-a-suit-but-doesn’t-do-much lieutenants are disappearing, as well.  There’s no guarantee that the new guys are any better than the old.  On the other hand, it’s hard to imagine they’ll be worse.

–Apple’s failure to produce an adequate alternative to the Office suite has limited the inroads it can make into MSFT’s corporate market.

–Windows 8 (I just got a new touch-screen laptop) is pretty good–very iPad-ish.

–a new generation of Intel chips + the emergence of Samsung, Asus (my brand), Acer and Lenovo making high-quality products may well reenergize the US consumer market.  Much lighter weight, high-resolution screens, instant-on and touchscreens may counter some tablet momentum.

–with its consumer/small business products, MSFT has had a continuing (large) piracy problem.  The shift to the cloud will help police that.

–new management may do good things.  Even if not, the idea that the company is turning a new page will likely support the stock until we can make a better judgment.