But hey, if the market wants to give ‘em a mulligan for setting the bar lower when they don’t need to, who are we to complain? ‘Cause other than that, Adobe has been acting almost exactly according to our plan. So first we will update you on the history of our position, then tell you where we think it will go next.
On March 19 we wrote:
Near-term, however, expect the smart money on Wall Street to fret over how they are late in the product cycle, with no major upgrades yet announced. If this causes a drop in the stock price, it is worth taking the time to figure out if you want to hold a position.
We followed up on March 25 with:
Now, according to our theory, the shares should be rallying ahead of the release of Creative Suite 3. So why do we blame Wednesday’s slump on the product cycle? We chalk it up to conflicts between rumors. Will the CS3 launch occur in late 2006 or early 2007? The six-month date discrepancy calls for a short term pause before the shares rally again.
On May 2 we started running the numbers:
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.
Long story short, although we are fans of ADBE over the long term, the short term valuation picture shows as much room for downside as upside.
Piper Jaffray called the bottom on May 15, and UBS followed suit on May 23. We said long-term folks may want to nibble, and we bought our call options ($30 strike price) on June 1. (We also sold put options on two occasions, and the second of these looks to expire worthless today.) With one brief exception since then, the script has been played out to perfection.
So what’s next?
The next version of the PDF reader, Adobe Acrobat, is due out in November. The third edition of its Creative Suite, which packages Photoshop, Illustrator and other programs (and will be the first to run native on the new Intel-based Macs), is expected to ship in the first half of 2007. According to our thesis, the stock should continue rallying until about then. The estimates have come down a smidgeon since May (we expect them to go back up now, but what the heck - we’ll be conservative) so the new target range is $42-$45. Until either the release of Creative Suite 3 or a price above $45 we are comfortable holding (though our options expire in mid-January.)
But don't just take our word for it. Here are what some others have said in the wake of the strong earnings report.
Eric Savitz provided a nice run-down of commentary from the major brokerage firms covering Adobe. Short summary: they liked the earnings report.
Other followers, however, sounded some sour notes. Motley Fool wrote that Adobe is Snoozing Toward Excellence, posting such good results each quarter that it has become boring.
The only real problem at Adobe is its valuation. At a rich P/E of 35, and an enterprise value-to-free cash flow ratio of 37, it’s just too expensive for my value-investor blood. Perhaps Mr. Market will give us a blue-light special one day soon.
We have found the rally from recent lows far from boring, and believe Mr. Ellis missed his blue-light special earlier this summer with the stock closer to 25x earnings. Better luck next time.
And George Gutowski weighed in with concerns about their restructuring liability:
You have to wonder about the new liability category entitled accrued restructuring. Appearing in both short and long term liabilities the obligation now amounts to just under $37 million. Not insignificant when you realize this amount exceeds 10% of the first nine months of net income. Restructuring costs are notoriously notorious. Is this the Trojan horse? Will this one bite Adobe and burn shareholder values?
The quick answer is “no.” For one thing, Gutowski is double-counting the impact of the restructuring charge. A restructuring charge is accrued when it is recognized in net income. So the $322 million in 9-month net income that the restructuring laibility exceeds 10% of already reflects the restructuring charge. (Pro-forma numbers that exclude the restructuring charge are another story.)
The main reason to be concerned about restructuring charges is if the company is repeatedly incurring them (recurring non-recurring charges) and asking investors to ignore them. In Adobe’s case, the restructuring is a rare occurrence related to a large acquisition they made, and as long as there aren’t a string of future charges this one seems legit.
Accounting rules dictate that the estimated costs of any restructuring be charged to income when the decision to restructure is made. Since the costs typically occur in a later accounting period, the reduction in net income is matched by a liability. Amounts that are expected to be paid within one year are “current” liabilities and those expected to be paid later are “long-term” liabilities. It is not that different from an account payable, which arises when the company buys something but has not yet paid the supplier. In this case, the supplier is primarily labor. When the actual severance payments are paid, rather than being reflected in net income at that time (since they have already been deducted from income in the period the decision was made) the liability is reduced.
If you want, you can use the information to adjust the financial statements to reflect the expense in the period(s) they actually occur. To do so, you would add back the restructuring charge to net income in the most recent period, and would reduce net income in future periods by the change in the restructuring liability.
In Adobe’s case, the $12 million of current liabilities are about 3% of this year’s pre-restructuring operating income. The long-term liability may represent 5% of next year’s operating income. So when Yahoo! reports that Adobe is trading at 25.69x 2007 earnings, the investor may want to adjust that to reflect the restructuring charges as they are incurred, which would result in an adjusted price/2007E of 28.02x. Not enough to scare us away (though Motley Fool’s Ellis is probably another story.)
ADBE 1-yr chart:
Disclosure: Author is long Adobe call options.