As investors, we are at a critical juncture. One path will lead us down the road of investing in mature firms that the efficient market has already fully appreciated. Another path takes us down the road of investing in smaller underfollowed companies that will potentially receive the Street's attention. With the Fed printing money like there is no tomorrow, the government spending beyond its means, and the lack of a gold standard, it's time for us to recognize that we are living in a Platonic world. Our economy has functioned through a currency that has deluded investors into the housing bubble and the internet bubble.
Perhaps the best way to act now is to invest in companies within the social media sector. There is plenty of room to penetrate and significantly greater upside than downside. Again, smaller companies are likely to generate the highest returns. BroadVision (BVSN) and Omtool (OMTL) are two meaningfully undervalued companies that are well positioned to outperform broader indexes. Since I first pitched Google (GOOG) here and Microsoft (MSFT) here, the stocks have taken off like a rocket, gaining 18.4% and 27.7%, respectively. At this point, however, these larger companies have closed their discounts, hence my optimism about BroadVision and Omtool from a fundamental standpoint.
Towards proving my point of how social media and software businesses exploring "the cloud" have become less discounted than their smaller peers, I will run you through my DCF analysis on Adobe (ADBE) and will then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Google and Microsoft. I find that the company is actually overvalued.
First, let's begin with an assumption about revenues. Adobe finished FY2011 with $4.2B in revenue, which represented a 11% gain off of the preceding year - deceleration. Analysts model a 9.3% per annum growth rate over the next half decade, and I find that this is reasonable in light of it being in-line with what is expected for the S&P 500.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I expect cost of goods sold to eat 10.5% of revenue versus 43% for SG&A, 18.5% for R&D, and 4.5% for capex.
We then need to subtract out net increases in working capital. I estimate that this will hover around 3% of revenue. Taxes are estimated to trend around 20% - 25% of adjusted EBIT (accounting for non-cash depreciation charges).
Taking a perpetual growth rate of 2.5% and discounting backwards by a, frankly, generous WACC of 9.5% yields a fair value figure of $29.70, implying 12.2% downside.
All of this falls within the context of weak performance on the cloud:
Q1 revenue was within our targeted range for the quarter. We also achieved solid Q1 non-GAAP earnings per share as well as strong cash flow and growth in deferred revenue. At the outset of this year, we outlined our strategy to double down in 2 fast-growing markets, Digital Media and Digital Marketing.
In our Digital Media business, our strategy is to help customers create, publish and monetize their content on any device. Demand is building for our upcoming Creative Suite and Creative Cloud launches. And as a result, Creative Suite revenue was lower than expected in Q1.
From a multiples perspective, Adobe trades at a respective 20.5x and 12.7x past and forward earnings versus 11.6x and 10.6x for Microsoft and 21.6x and 13x for Google. It should be noted that Adobe gained 26.1% since I first promoted it here. While I like the management, I don't think there is that much upside left.
Microsoft and Google are both more attractive. Google is attractive due to the combination of its undervalued Google+ offering and meaningful penetration in the mobile landscape. Being that the company manages the largest search engine, it has significant synergistic value. But, again, the nature of it being heavily covered on the Street has since, relatively, closed much of the value gap compared to underfollowed companies. Assuming a multiple of 15x for Google and a conservative 2013 EPS of $46.50, the rough intrinsic value of the stock is $697.50.
Microsoft's attraction stems from its Windows 8 catalyst, leading brand, and strong position in cloud services. Windows 8 offers an innovative user interface that provides an appropriate answer to taking away share from Apple's (AAPL) "artsy" market. Assuming a multiple of 13x and a conservative 2013 EPS of $2.90, the rough intrinsic value of the stock is $37.70.
Disclaimer: We seek IR business from all of the firms in our coverage, but research covered in this note is independent. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.