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The second quarter (2Q06) reported by Adobe Systems (ADBE) did not change my long-term enthusiasm for the stock. In the near term, we stare down a rich P/E multiple of about 39x against guided, full year diluted EPS of $0.73 (+/- $0.03).

So logic for short-term plays eludes me, as it always does. Quality of earnings is high: the difference between GAAP EPS and non-GAAP is mostly either stock-based compensation or merger-related charges. I think they will eventually get “partial credit” toward non-GAAP EPS of $1.22 (+/- $0.02, full fiscal year 2006).

The merger continues to, in a lagging effect, contribute to higher quality of reported earnings because there is hidden strength is some deferred segment revenues and they are expensing some items that might normally be capitalized. Also, foreign exchange losses apparently lopped $15 million of revenues for the quarter.

Adobe’s strategic position in software is strong. The company has moat, diversification and a few embedded options. Two of the three bundles may have under-whelmed for the quarter, but I count several products growing at double digits, in unit terms. And Adobe has enviable pricing; they don’t suffer intense price deflation like some software companies.

I think they are well-placed to maintain, or in some cases, improve their position into higher priced segments (e.g., Acrobat Pro, vertical applications in imaging, high end video production). I doubt that Acrobat is seriously threatened by either Apple or the proliferation of PDF-generation tools (even if embedded into Office products). Erosion at the commoditized end of this business is more than outweighed by higher-end, value-added applications (e.g., the 3D version for engineers) as Adobe adds functionality.

I’d argue Acrobat’s future has never looked better as it turns the corner from being widely perceived as merely a means to secure documents and toward an interactive, print-based workflow platform. It’s the upside-down logic of software and open standards (.pdf) where opportunities seem like threats, but Adobe can actually embrace all sorts of “nipping at its heels” as the standard proliferates while exposing the base to open, free alternatives… as long as Adobe leverages its know-how to climb up the value stack where it can sell stuff for a price. The ability to climb the value stack ought to be at the heart of the matter for any software company, and this is precisely where Adobe has a track record.

My favorite embedded options (small today but maybe big tomorrow) are: the engagement platform, Flex, mobile Flash and Breeze. When they said on the conference call they are going to send more of their salespeople into enterprises, that sounded to me like the engagement platform.

The Verizon deal is a harbinger of things to come for mobile Flash. Mobile flash has pole position in the race to serve mobile content. Breeze is the web conferencing platform that leads its category from a technical standpoint; a market that is nascent today but could become epic as it includes e-learning and more broadly, all things collaboration.

With regards to diversification, try to find a software company with a deeper bench. The latest round of production tools raised the bar. If guided by able hands, AfterEffects 7 will take your breath away. Adobe bought the whole company Macromedia for Flash, which fits into the Flex platform. Eventually, maybe Flash morphs into Flex. Flex has been tagged at times as an antithesis to Ajax (a set of tools built on top of the existing HTML infrastructure) but it is now becoming clear they are likely to co-exist and complement; e.g., Google and Yahoo both deploy Ajax/Flash combinations.

And here look at the difference between Microsoft and Adobe: can you imagine Microsoft bending over backwards to embrace Ajax like Adobe is doing with Ajax? I think Adobe’s clever reaction to (embrace of) Ajax reveals their wise approach to the web. It was a decision too early to be forced on them. Microsoft thinks they can control the environment, like they controlled the desktop. But that’s not working on the web, so you are much better to do like Adobe did with Ajax: make the other product look better when combined with your own. Be one of the partners on the winning team, since the winner won’t be one company. To summarize good web strategy, it is predestined that you cannot beat them, so may you be good enough to join them.

When they bought Macromedia, Adobe also acquired ColdFusion which is quietly staging a comeback after a bit of uncertainty. I love ColdFusion – you can develop dynamic pages almost out of the box, so much easier than PHP or ASP (apparently, it’s slower than PHP and doesn’t do advanced apps as well). ColdFusion is also an interesting case study in open source. The server version of ColdFusion retails for over $1,000 while developers can instead use the open-source PHP for free (or ASP). PHP is an unqualified open source success but that has not killed off ColdFusion. Either/or dichotomies distract from the fact that markets are segmented. Individual pros can cobble together open source tools, but enterprises will always pay big bucks for deep, robust solutions.

That’s the idea that is larger than the creative suite: both Microsoft and Adobe appear to believe that “expressive” rich media applications will supplant windows as the web’s de facto operating system. If you agree with that, there are a limited number of rich media platform candidates (i.e., Microsoft Expression, Flex, Ajax, Ajax on Rails). Who knows what the future will bring, but if you narrow the question to rich media platforms for companies (enterprise-wide solutions), it looks like a short list that Adobe is on.

And Adobe owns the creative professional space. Look at InDesign romping all over Quark. You saw that coming. Creative professional is where Adobe started, but what’s interesting is how this formerly tiny market segment just keeps growing and adding expanding its definition. In the future, where will the creative professional segment stop and end?

I think Adobe also has the inside track on video. On our site, we tested virtually all of the video formats. We did not expect to use flash player for video [FLV] given the strong legacy of the competing formats, but it trumped them in terms of speed/quality. Given the technical strength of FLV, I think the Disney announcement is just the start of many high-profile flash video adoptions.

To be sure, we are between product cycles (Acrobat 8 comes in Q4 and Creative Suite 3 in Q2 of 2007), but the long-term case depends on Adobe’s leading position in the mobile, creative, self-helping rich media web. I do agree that the wildcard is Microsoft’s Expression suite, but as Microsoft’s forte is complexity not usability, it’s not clear how they will beat Adobe to the rich media web.

Full disclosure: The author is long ADBE

Source: Adobe: Climbing Up the Value Stack (ADBE)