As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Adobe Systems' (ADBE) case, we think the firm is fairly valued at $36 per share, slightly higher than where it is currently trading. Our report on Adobe Systems and hundreds of other companies can be found here.
For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation on our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best.
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Adobe Systems posts a VBI score of 7 on our scale, reflecting our 'fairly valued' DCF assessment of the company, its attractive relative valuation versus peers, and bullish technicals. Though imperfect, we use Salesforce.com (CRM), F5 Networks (FFIV), Microsoft (MSFT), and Oracle (ORCL).
Our Report on Adobe Systems
Adobe Systems earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 189% from 183.4% during the next two years.
The firm is trading at attractive valuation multiples relative to peers, but our DCF process indicates a less compelling opportunity. We'd wait for a clearer signal on valuation before jumping into the firm's shares.
Adobe Systems has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 26.7% in coming years. Total debt-to-EBITDA was 1 last year, while debt-to-book capitalization stood at 20.8%.
Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company. We expect the firm to trade within our fair value estimate range for the time being. However, if the firm's share price fell below $27, we'd take a closer look at adding it to the market-beating portfolio of our Best Ideas Newsletter. In the spirit of transparency, we disclose the performance of the portfolio in our newsletter below:
The firm experienced a net income CAGR of about -1.5% during the past 3 years. However, we expect its net income growth to be better than its peer median during the next five years.
Most Recent Quarterly Results
Adobe reported poor fiscal first-quarter 2012 results that disappointed most investors. Though we plan to update our valuation model on the firm, we don't expect to make a material change to Adobe's fair value at this time.
The company's revenue advanced a modest 1.7% in its fiscal first quarter as subscription and services-and-support sales expansion offset weakness in its products segment, which fell over 4% from the same period a year ago. Adobe's gross margin, however, improved to 89.6% from 89.5% in last year's quarter. Operating income fell 4.4% from the year-ago quarter, as sales and marketing expenses surged. There was nothing concerning in the firm's below-the-line items, though the company did suffer from a higher tax rate in the quarter (31.5% versus 18% in last year's period). Diluted net income per share fell to $0.37 from $0.46 in the same period a year ago, capping off what we'd describe to be a disappointing quarter overall, in our opinion. On a non-GAAP basis net earnings per share came in at $0.57 (matching consensus estimates), cash flow from operations was $314.4 million in the quarter, and free cash flow was a solid $263.3 million, or 1.42 times net income (representing excellent cash-flow conversion). Free cash flow as a percentage of sales was a whopping 25%+ in the quarter, among the best free-cash-flow margin we've seen from any company.
Looking ahead, the Photoshop and Acrobat developer is targeting revenue in the range of $1.09 billion to $1.14 billion for the second quarter of its fiscal 2012. On a GAAP basis, the company is looking for first-quarter net earnings to come in the range of $0.37 to $0.43 and the range of $0.57 to $0.61 on a non-GAAP basis (the midpoint slightly below consensus, which was at $0.60 per share). On a full-year basis, Adobe is targeting revenue growth of 6% to 8% (up from 4% to 6% previously) and adjusted diluted earnings per share to come in the range of $1.63 to $1.73 on a GAAP basis and $2.38 to $2.48 per share on a non-GAAP basis. We are optimistic that the company's upcoming release of its Creative Suite and Creative Cloud offerings will drive top-line expansion and are very impressed with Adobe's continued free-cash-flow generating prowess. However, we remain on the sidelines based on valuation.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Adobe Systems' 3-year historical return on invested capital (without goodwill) is 155%, which is above the estimate of its cost of capital of 10.3%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Adobe Systems' free cash flow margin has averaged about 30.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. We are the only firm that makes available fully-populated discounted cash flow models available to our financial-advisor clients here. At Adobe Systems, cash flow from operations increased about 38% from levels registered two years ago, while capital expenditures expanded about 76% over the same time period.
Our discounted cash flow model indicates that Adobe Systems' shares are worth between $27 and $45 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $36 per share represents a price-to-earnings (P/E) ratio of about 21.8 times last year's earnings and an implied EV/EBITDA multiple of about 11.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 5.6%. Our model reflects a 5-year projected average operating margin of 35.7%, which is above Adobe Systems' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For Adobe Systems, we use a 10.3% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $36 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Adobe Systems. We think the firm is attractive below $27 per share (the green line), but quite expensive above $45 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Adobe Systems' fair value at this point in time to be about $36 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Adobe Systems' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $49 per share in Year 3 represents our existing fair value per share of $36 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements