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Recent Developments/Catalyst

Adobe (ADBE) reported quarterly earnings on Wednesday, July 19. We wanted to take some time to update our model with the given changes in earnings. Going into the report, we had a $33 price target with Sell rating. Today, we want to breakdown those earnings and update our price model. After the report and update to our models, we maintain a Sell rating with $32 target now.

The company reported $1.01B of revenue along with 0.36 EPS. The company was expecting to see $975M-$1.02B in revenue for the quarter. The company reported $247M in operating income. These statistics compared to $1.12B in revenue in 2012, $305M in operating income, and 0.45 in EPS. These levels showed a lack of growth year/year, but we did some positive results in the company's Creative Cloud subscriptions. The company saw 221K added subscriptions from Q1 of FY13, and the Creative Cloud is a big growth market for the company. Growth in the Marketing Cloud grew by 25%.

The issue for ADBE has been how can they invigorate a growth model that is non-cyclical and non-stagnant. They are the obvious leader in content creation and publishing, but the company has seen mixed growth year/year that was mostly based on model cycles. In Q3, the company expects EPS of 0.29-0.35 along with revenue around the same level. The company expects FY13 revenue to get to $4.1B and EPS to 1.45. 2012 EPS was 1.66. The switch to Creative Cloud is still ongoing, but these original results are encouraging.

What can investors expect in the long-term for ADBE?

The future for the company is in the cloud. The company can push updates more quickly, provide service more easily, and have fewer overheads. For users, the experience is better as well as they can use their subscription from multiple places and can be customized to users. The Cloud is where ADBE is moving. They announced at their MAX conference in May that all new innovation would go through Creative Cloud.

What's great for ADBE is that a subscription model is much better for the company than a one-time payment. The subscription keeps payments coming every month, allows the company better understanding of client trends, and keeps margins up.

Coming next is Enterprise Creative Cloud offering that will allow ADBE to get its enterprise partners in with the new offering, which is another big win for Adobe as these early results are just individual subscribers. The monthly payments for enterprise will also provide consistent revenue and earnings that will also produce strong margins and better returns. The decision completely streamlines the application development process. Once you buy in, you get most options, but you need to buy in to get the offerings.

Adobe has done great to continue to move to digital with Document Services and Digital Marketing. With the company's EchoSign project, the company is at the cutting-edge of e-signatures, which will continue to be a growing business.

All this seems pretty great, and we agree that the future looks strong for Adobe, but when we start to look at the company in a model to price, the upside potential looks limited and the valuations show that. Right now, ADBE holds a PE at 31.5 and future PE at 25.5. Price/sales are over 5, and even the PEG ratio is at 3. PEG is usually a great way to value growth names since it looks at future earnings growth. Even on that model, ADBE appears overvalued. An overvalued decent growth name with no dividend and high valuations is not attractive to us.

In our model, we priced in 20% operating income growth next year along with 15% and over 7% for the following tow ears. ADBE is a cyclical name, and we should see two solid years of growth before things trail off again as comps become higher. There is potential for some higher growth in 2016 and 2017, but it's hard to imagine more than 8-10%. Even with those rates, this stock looks like it has priced in all growth potential and then some. We have capital expenditures coming own in 2015 - 2017 as we expect the cycle will lead to lower expenses for the company.

Even with such solid growth priced in, we can only get to a fair valuation of $32 for ADBE. Therefore, we believe that ADBE may be ready for a correction on any disappointments. The stock is pricing in best case, so if there are any issues, there will be a major correction. What is the catalyst as well for more upside?

(click to enlarge)

Price Target Analysis

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

 

 

 

2013 Projections

2014 Projections

2015 Projections

2016 Projections

2017 Projections

Operating Income

900

1080

1240

1335

1435

Taxes

234

281

322

347

373

Depreciation

310

320

330

340

350

Capital Expendit.

-280

-300

-240

-260

-275

Working Capital

230

230

230

230

230

Available Cash Flow

466

589

778

838

907

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012). WACC for ADBE: 9.4%

 

2013

2014

2015

2016

2017

PV Factor of WACC

0.9141

0.8355

0.7637

0.6981

*

PV of Available Cash Flow

426

492

594

585

*

Step 3.

For the fifth year, we calculate a residual calculation. Taking the fifth year available cash flow and dividing by the cap rate, which is calculated by WACC subtracting out residual growth rate, calculate this number. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. Cap Rate for ADBE: 4.4%

 

2017

Available Cash Flow

907

Divided by Cap Rate

4.4%

Residual Value

20611

Multiply by 20167PV Factor

0.6981

PV of Residual Value

14389

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

  

Sum of Available Cash Flows

2097

PV of Residual Value

14389

Cash/Cash Equivalents

1246

Interest Bearing Debt

1525

Equity Value

16207

Step 5.

Divide equity value by shares outstanding:

  

Equity Value

16207

Shares Outstanding

510.94

Price Target

$32

Source: Sell Adobe: Potential 25% Downside