Adobe - Valuation Remains A Problem For A Business Model In Transition

| About: Adobe Systems (ADBE)

On Thursday, after the markets' close, Adobe (ADBE) announced its intention to acquire Neolane in an attempt to boost its online marketing-tailored service offerings.

While the deal is strategically sensible I remain on the sidelines. The valuation multiples for the company are way too high and price in a perfect transition of a business model geared towards online cloud subscription services.

The Deal

Adobe announced that it has entered into a definitive merger agreement under which it will acquire privately held Neolane. Adobe will pay $600 million in cash for the French-based leader in cross-technology campaign management technology.

Neolane integrates marketing data both online and offline and performs audience segmentation and marketing messages across channels. Its services enable companies to boost customer experiences and personalize campaigns which ultimately increase return on investment on their marketing budgets.

Senior Vice President of the Digital Marketing unit Brad Rencher commented on the rationale behind the deal:

"The acquisition of Neolane brings critical cross-channel campaign management capabilities to the Adobe® Marketing Cloud. Adobe has long been the trusted partner to creative professionals and we are now extending our lead in the digital marketing space with the addition of Neolane."

Neolane will become the sixth solution within Adobe's marketing cloud offerings, operating next to Analytics, Target, Social, Experience Manager and Media Optimizer offerings. Adobe has invested heavily in its digital marketing offerings already in recent years. Over the past few years, it acquired Omniture, Day Software, Demdex, Auditude and Efficient Frontier, among others.

The deal is expected to close as early as July and is subject to normal closing conditions. The transaction is not expected to materially impact the full year revenue and earnings forecast for the fiscal year of 2013.


Adobe ended the second quarter of its fiscal year of 2013 with $3.86 billion in cash, equivalents and short term investments, giving it plenty of financial flexibility to finance the deal. The company operates with $1.53 billion in debt and capital lease obligations, for a net cash position of roughly $2.3 billion.

Revenues for the first six months of the fiscal year fell 7.0% to $2.02 billion. Net income fell by 65% to $141.7 million, or $0.28 per share. Based on Adobe's full year outlook, revenues could come in around $4.1 billion. Non-GAAP earnings could come in around $1.45 per share while net earnings could approach $300 million.

Trading around $46 per share, the market values Adobe at $23 billion, or its operating assets around $20.7 billion. All this values Adobe at 5.0 times annual revenues and almost 70 times annual GAAP earnings.

Despite the solid financial position, Adobe does not pay a dividend at the moment.

Some Historical Perspective

Over the past decade, shares of Adobe have risen from $20 back in 2003 to highs in their mid-forties by 2007. Shares fell back towards the $20 mark during the financial crisis of 2009 but have steadily recovered to the mid-forties at the moment, with shares trading close to all time highs.

Between 2009 and 2012, Adobe has increased its annual revenues by 50% to $4.40 billion. Net earnings more than doubled to $833 million in the meantime. Full year results for 2013 will come in markedly below these levels as a result of the transformation in Adobe's business model.

Investment Thesis

Investors continue to applaud Adobe's efforts to change its business model. While the strategy to focus on recurring license stream via the cloud results in short term pressure on revenues and earnings, Adobe is confident that it will smoothen out future growth in revenues and earnings. This should ultimately create more value for shareholders.

This will result in a modest decline in revenues for 2013, while earnings will take a much larger plunge. Adobe's Create Cloud software plays a key role in this transition process, now having 700,000 users after adding 221,000 users over the past quarter who use popular products like Photoshop and Dreamweaver.

On top of that, Adobe sees greater customer satisfaction as creative users can now access their entire product portfolio online and have no hassles of product upgrades, but simply pay an affordable monthly fee while subscribing for automatic updates. At this rate, Adobe is on track to have 1.25 million subscribers by November of this year, marking a successful transition in its business model.

Yet the transition is putting short term pressure on the financial performance. Average revenues per user are under pressure, mainly attributable to promotion efforts to increase adoption of cloud-based solutions. ARPU from Creative Cloud users came in at just $37 per month, which compared to full list prices of $50 per month.

While the user base seems keen to adopt the online version of Adobe's products, it does have a short-term financial impact. Adobe and the market seem to conclude that this is still worth it, in an effort to reduce future revenue volatility related to major product releases and upgrades. The lack of large up-front investments should also widen Adobe's potential market base, thereby growing the community of users.

Consequently, product revenues for the second quarter fell by 26% to $645 million. Subscription revenues based on the online model rose by 60% to $255 million while service and support revenues rose by 18% to $111 million. The combination of a total 10.1% decline in revenues, combined with an 11.1% increase in operating expenses was deadly for earnings, with second quarter GAAP earnings coming in at just $0.15 per share.

Overall I am not convinced as the company is valued too high on both GAAP and non-GAAP earnings metrics. Even if I account for accelerating revenue and earnings growth in the coming years, based on the sensible cloud-based subscription business model, I think the current valuation is too high.

I remain on the sidelines, with a slight bearish stance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.