Tuesday, April 26, 2005

Bring it on Microsoft, You Don’t Stand a Chance

Bill Gates is shaking in his boots. Last Monday, Adobe’s $3.4 billion acquisition of Macromedia sparked a flurry of speculation that Adobe is positioning itself for a showdown with the billionaire himself. Okay, so maybe the future of Microsoft is not at stake, but the deal still makes for an interesting marriage. Many questions surround the transaction; the most prominent uncertainty is can Adobe successfully integrate Macromedia to enhance its competitive advantage in the software market? This is a particularly salient topic in light of investor disillusionment over technology mergers, such as the Hewlett-Packard/Compaq deal in 2001 and Symantec’s acquisition of Veritas in 2004. This latest acquisition brings us to the classic argument of whether a company is pursuing an acquisition for the right reasons, that is, increasing economies of scope. However, Chief Executive Bruce Chizen commented, “This is not a consolidation play. This is all about growth.” Rather than providing us with the expected comfort level for the acquisition, this statement made us cringe since growth arguments typically enhance the control objective of the managers, not necessarily shareholder value.

However, unlike Microsoft’s reaction, reactions on the Street were mainly positive, with an overwhelming majority of analysts and media reporters providing praise for a transaction “that finally makes sense.” The Deal.com reported that the acquisition would help Adobe expand its current Web and print product offerings to include audio and video applications. Analysts’ view the Adobe-Macromedia transaction as positive because combining Macromedia’s software for putting graphics and animation on Web sites with Adobe’s programs in graphic design and Internet publishing could extend their combined positions in the market for software by creative professionals.

A few dissenting voices in the media conjectured that paranoia about a possible foray by Microsoft in the online content development market may have initiated the acquisition. It was speculated on Market Watch that since Macromedia is regarded as the home of the preferred web development platform, Macromedia’s acquisition was a move to pre-empt Microsoft. On another front, Business Week pondered whether Adobe overpaid for Macromedia given the 25% premium to Macromedia’s closing price the day before the transaction was announced.

Criticism and praise aside, we believe that the necessary ingredients are present for a successful merger. First, both Adobe and Macromedia service the same end user (photographers and graphics designers) through their software products. Therefore, in theory, the combination of Adobe’s Internet publishing software expertise and Macromedia’s graphics and animation software capability will give Adobe the ability to bundle a “must-have” software package for creative professionals. In other words, this transaction could allow Adobe to service its target customer better and provide higher benefits, at a (hopefully) lower cost. We view this scenario as an opportunity to maximize economies of scope because Adobe could have the opportunity to combine the production and distribution process for creative publishing software.

Secondly, both businesses are aligned along the same objective to grow beyond their successful niches, to sell publishing software to bigger clientele and to expand their competitive advantage in the market for “smart phones” and other wireless devices. However, contrary to Chizen’s statement that both companies have similar cultures, we wonder whether this is really the case given the ill will that was generated in a patent-infringement lawsuit in 2000.

While the window of opportunity is present to maximize economies of scope, the question remains whether Adobe has the organizational capabilities to pull off the integration. Although, the company has engaged in some smaller acquisitions, Adobe does not have any prior experience with integrating such a large transaction.

We are also somewhat worried about the paranoia that was touched upon earlier in this article. Chizen has been reported to say: “When I think about competitors, there’s only one I really worry about. Microsoft is the competitor, and it’s the one that keeps me up at night.” If part of the acquisition rationale was to better compete against Microsoft by enhancing Adobe’s competitive advantage, we are not bothered by this paranoia. However, if as Market Watch suggests, the acquisition was a pre-emptive move to forestall Microsoft’s entry into the online content development market, then this may suggest that Adobe is not up to the challenge of successfully capitalizing on the economies of scale.

Did Adobe overpay? This is up for debate because Macromedia brings with it Micromedia Flash, which is just a few deals away from being the dominant program for smart phones and other handsets. Although Adobe has also pursued this market, Micromedia’s Flash is expected to make more money delivering games, video, and animation. This is why some analysts argue that Macromedia may have in fact left money on the table, despite the 25% premium. If Adobe is able to capitalize on this technology and more importantly, if Adobe can create synergies between the two businesses, Adobe can extract some of the rents from the purchase.

Are Photoshop and Flash a potent combo? We believe that all the right ingredients are in play for Adobe to increase its economies of scope. However, this will be highly dependent on its ability to craft a successful integration and utilization of Micromedia’s capabilities.

By: Jasmin Fung

Steve Lyons


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