Adobe Warns (ADBE)

| About: Adobe Systems (ADBE)

Adobe (NASDAQ:ADBE) sees second quarter profits, which it will report June 15, at the low end of the range it forecast on March 22. The shares are down about 6% in after-hours trading, to $36. We have written before how Adobe tends to trade around its product cycles. Specifically, it tends to reach its peak valuation levels sometime around the release of new products, and to decline to trough valuations in between new products. The chart below, from (click to enlarge), shows those peaks and troughs over the last decade in the lower portion.

Before the bubble, and since it burst, ADBE’s trailing P/E multiple tends to vary between the low 20’s and high 30’s. The forward P/E tends to have a narrower range from the high 20’s to lower 30’s.

Over the last four quarters, Adobe earned a total of $1.12, giving it a current trailing multiple (at $36) of 32x. It is expected to earn about $1.30 in the fiscal year ending November 2006, and about $1.50 in the November 2007 fiscal year. Given the reduced guidance in the current quarter, the FY06 number is probably light. However, Adobe is expected to launch the next Acrobat upgrade late this year (probably with most of the benefit accruing in FY07) and the Creative Suite (Photoshop, InDesign, etc.) in early 2007. So not only do the 2007 numbers seem achievable, but given past patterns, the stock should hit its peak P/E sometime late this year or early next.

So now we do some simple math. At 35x the then-trailing P/E of perhaps $1.25 the stock would fetch $43.75. At 32x forward EPS of $1.50 it could get as high as $48. Against this we have a downside potential of perhaps 20x the $1.25 estimate, or $25. Furthermore, this year options are being expensed for the first time. Although the consensus estimates currently exclude option expense, our view is that over the next year the market will stop ignoring them, which may result in a reset to historic multiple ranges.