Why We're Long Adobe Systems Ahead of Earnings (ADBE)

| About: Adobe Systems (ADBE)

In a recent post about Starbucks (NASDAQ:SBUX), we said Wall Street can be a tricky place to navigate at times. Sometimes you can get things exactly right, but the stock will react the opposite to what you thought because everyone else had also figured it out and baked it into the share price. That is one reason we try to keep track not only of what we expect, but also whether what others expect is getting out of hand.

In an example of a case where the gaming of the system is going several layers deep, we have this story on Adobe (NASDAQ:ADBE) from Marketwatch:

Adobe Systems Inc. is expected to post next Thursday a higher quarterly profit as revenue surges 30%, though some analysts said the design-software powerhouse may temper expectations for its results for the remainder of the year.

The average estimate on Wall Street puts Adobe’s fiscal second-quarter profit at 30 cents a share, before items and employee stock-option expenses, up from 28 cents a share in the year-earlier period, according to a Thomson First Call survey…

Adobe, the company behind the Acrobat program used to share digital documents and installed on most of the world’s personal computers, disappointed investors in May by saying results for the quarter would come in at the low end of its forecast.The company cited weaker-than-expected demand in North America and Europe during recent spring holidays as the reason behind its updated view of the quarter.

What’s more, several analysts said they expect the company to reset expectations for the current fiscal year when it hands over its financial scorecard next week.

So far, we have a case where the expectations for the second half may be too high because the early estimates were overly optimistic about the contribution from Macromedia. Although the company recently reduced its guidance for the quarter, they didn’t change their annual guidance and some analysts now fear they will reduce that as well. But then the plot twists further.

The company’s forecast, originally issued in March, call for a net profit of 18 cents to 21 cents a share, or 30 cents to 32 cents after stripping out one-time items. Its projection called for revenue of between $640 million and $670 million.

Citigroup analyst Brent Thill is among those expecting Adobe to lower its forecast for the year as a whole, though he said such a move would be unlikely to take investors by surprise. “It appears many investors expect this move,” he said, pointing out that the stock has fallen sharply since the company’s forecast update in May. “We believe such a reset could provide relief and pave the way for a constructive move upward ahead of the upcoming product cycles,” Thill added.

So the company may lower guidance, but since investors already expect it, the shares may not go down or could even rise. It lends way to several potential scenarios for next week’s earnings call (from worst case to best):

1. Adobe lowers guidance, and either the reduction or the size of the reduction is unexpected. Shares fall.

2. Adobe lowers guidance, and the reduction is in line with expectations even though those expectations are not reflected in consensus estimates. The shares do nothing.

3. Adobe lowers guidance, but the reduction is less than expected. The shares rise.

4. Adobe leaves guidance unchanged or even raises it. The shares rise by a lot.

We noted in past posts that 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. Currently we are just above a 27x multiple.

ADBE 1-yr chart with P/E multiples:

ADBE 1-yr

If Adobe earns the $0.30 analysts expect, the trailing P/E would fall to 26.5x, quite close to the low end of the range we described. Further, given that three of the four potential scenarios next week would result in either a neutral or positive response we recently purchased call options on Adobe. We were a bit early, but we still like our odds.

Full Disclosure: The author is long Adobe call options with a $30 strike price and a January, 2007 expiration date.

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