I was able to pick up a great company at a pretty good price when Adobe Systems (ADBE) fell 20% upon weak 2010 guidance. 3rd quarter results were great but Wall Street didn’t want to hear about a slowing 4th quarter.
It’s the short term nature of Wall Street that creates entry points and if Mr Market feels like holding a ADBE sale, I’ll take it.
At just under $27, I see ADBE to be a good deal with an ample margin of safety for such a high quality business.
Brief Company Info
Adobe specializes in graphics and desktop publishing software. You’ve most likely heard of Photoshop, Acrobat and Flash. If you are unfamiliar with any of those names, just think of the Photoshop as Windows Paint on steroids. I’m sure you know what PDF and Flash is.
Adobe is by far the leader for many of its software products in the industry.
Since Photoshop and other creative software division makes up more than 50% of the company’s revenue, a comment on a slow education sector and Japanese market is enough to send shivers down Mr Market’s spine.
Intrinsic Value Calculation
Discounted Cash Flow Calculation
It really doesn’t matter whether the next quarter will be slow because ADBE should be able to generate more than $200m in free cash flow. This should get the company to the $900m range for fiscal 2010.
Cash related numbers have increased consistently for the past 10 years and competitive pressures from Apple (AAPL), plus the recession, definitely hurt Adobe's margins.
Adobe’s net income margin was around 25% so if the market improves, the company should be able to get back to the 20% range again.
With conservative assumptions of 13% growth and a 12% discount rate, the intrinsic value comes out to around $33.
If I then include 20% of intangibles to the equation, as the name Adobe is what generates a significant amount of sales, then the fair value definitely comes out to the $30 range.
Here’s a sensitivity matrix of what different assumptions would lead to.
Earnings Power Value Calculation
Normalized operating income of $900m with a 12% cost of capital yields an EPV of $19.
Keep in mind that EPV is calculated with 0% growth assumptions.
I have to admit that Adobe cannot be classified as screaming value. More like borderline GARP but the 25% margin of safety I have will allow me to profit-- even if I did make a mistake.
1. Multimedia Explosion
What I do see, however, is the continuous evolution of the web and explosion in multimedia services. Websites and web applications are growing in number exponentially.
There is also a young programming language called Ruby on Rails that makes web app development (which is the rage, in case you haven’t noticed) much easier.
Flash isn’t just limited to your computer. It’s now integrated in mobile phones. The new wave of tablet PCs feature flash and with over 3m iPads sold, there is a huge market for developers.
Dell (DELL), Blackberry (RIMM), Samsung (OTC:SSNLF) and HP (HPQ) have released or will be releasing their own versions of the tablet. This means more creative content than ever before, wherever you go.
Another win for Adobe is the announcement by Apple that it will be easing up on app requirements, allowing developers to use competing technology.
2. Recession is Over
Supposedly the recession is over. Either way, will Adobe sales remain stagnant? No.
The balance sheet has always been strong, with huge amounts of cash with no long term debt until the recent acquisition of Omniture in 2009. The market has rallied substantially and with a little patience ADBE should easily catch up.
Disclosure: Long ADBE