Adobe: Earnings Preview

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About: Adobe Inc. (ADBE)
by: HF Analyst
Summary

Adobe reports next earnings on Thursday, March 14.

Creative Cloud adoption has pushed up overall revenue and potential catalyst for stock.

Based on the scenario analysis of earnings for Q1-2019, Adobe expected to report GAAP EPS of $1.24 and Non-GAAP EPS of $1.70.

Based on DCF analysis, implied share price is $287, which is a 9% premium to the current price of $263. The most likely implied value is between $203 and $374.

The scope of this article will be to look at the earnings preview through scenario analysis of earnings/quantitative approach. We will analyze whether the company can beat the street based on expectations of management, analysts, and investors. If yes, then we will certainly see upside in share price and, if not, then either hold or sell. We will also validate the scenario analysis of earnings with a relative valuation technique, DCF analysis, and street analyst's recommendations.

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Adobe (ADBE) beat the street in every quarter in the last 4 quarters. What do you expect when Adobe reports next earnings on Thursday, March 14?

Source: Seeking Alpha

Analysts expect revenue of $2.547 billion and EPS of $1.61. The revenue estimate implies 3.3% growth sequentially.

Management Guidance for First Quarter

  • Revenue of $2.54 billion
  • Digital Media segment revenue up 20% year over year
  • Digital Experience revenue up 31% year over year
  • Share count to be approximately 495 million shares
  • Net non-operating expense to be approximately $39 million
  • Tax rate of 3% on a GAAP basis and 11% on a non-GAAP basis
  • GAAP EPS of $1.14 and non-GAAP EPS of $1.60

Sources of Revenue - Creative Cloud Adoption has Pushed Up Higher Overall Sales and a Potential Catalyst for Adobe

Source: Company Fillings

Digital Media revenue increased to $6.33 billion in FY-2018 from $5.01 billion in FY-2017 (26% YoY growth). In FY-2018, Digital Media segment contributed 70% of total revenue. This segment was followed by Digital Experience segment, which contributed 27% and Publishing segment contributed 3% of total revenue. In FY-2018, Adobe moved enterprise offerings into the Publishing segment from Digital Experience segment.

Digital Media Segment: Creative Cloud segment is a key growth driver

Digital Media segment generates revenue from Creative Cloud and Document Cloud services. Creative Cloud is a subscription-based service which encompasses Adobe's creative products. This is Adobe's flagship offering with revenue contribution of $5.34 billion in FY-2018 (representing 28% YoY growth due to strong growth in Creative Cloud subscriptions). Microsoft (MSFT) and Apple (AAPL) are competitors in this segment.

Management expects 20% year-over-year revenue growth for the Digital Media segment in FY-2019. This indicates that increasing adoption of Creative Cloud is expected to be a key growth driver for the Digital Media segment.

Key Performance Metric

Annualized Recurring Revenue (ARR) is the performance metric that shows the money that comes in every year for the life of a subscription. ARR is a good measurement to assess the health and trajectory of the overall Digital Media segment. Adobe calculates ARR as follow:

Source: Company Fillings

In FY-2018, Digital Media ARR grew to $6.83 billion (Creative ARR $6.03 billion and Document Cloud ARR $801 million), up from $5.39 billion in FY-2017 (27% YoY growth). Management expects $1.45 billion of net new ARR in FY-2019.

Conclusion

Increasing adoption of Creative Cloud, as is evident by the increase in subscriptions, has pushed up overall revenues. Therefore, Creative Cloud is likely to be the next big catalyst for Adobe.

Margin Acceleration and Strong Cash Flow from Operation

Source: Company Fillings

Adobe's operating income growth and net income growth continued to exceed its revenue growth. Although its revenue grew 24% to $9.03 billion in FY-2018, its operating income grew 31%, and net income grew 53%. Higher net income also contributed to cash flow from operations. In FY-2018, cash flow from operations was $4.02 billion increased by 38% compared to FY-2017.

Historical Analysis of Guidance vs. Actual (Variation Analysis)

Adobe provided quarterly guidance for revenue, net operating expenses, tax rate, and EPS. To get a better understanding, I have done historical analysis of average vs. actual guidance and calculated delta/variation. I will forecast Adobe's full income statement simply by understanding how to interpret the company's guidance (a Top-Down approach to Adobe's guidance).

Please note that Q1-2019 numbers shown in green on various tables are management guidance vs. my financial projection.

1. Revenue Guidance vs. Actual

Source: Company Fillings

Increasing adoption of Creative Cloud, as is evident by the increase in subscriptions, has pushed up overall revenues. In the table above, I calculated delta by comparing guidance vs. actual result. Based on this analysis, we can conclude that Adobe has a tendency to beat its revenue guidance. Management expects revenue of $2.54 billion for Q1-2019. I believe that Adobe will hit the higher ranges of its revenue guidance and report revenue of $2.59 billion for Q1-2019 due to the robust performance of Adobe's operating segments and inorganic growth fuel by recent acquisitions.

2. Net non-operating expenses Guidance vs. Actual

Source: Company Fillings

This includes interest expense and other income/expenses. This is a bit tricky to project because of the fluctuating pattern of other income/expenses. Net non-operating expenses are expected to be $39 million for Q1-2019. I believe that Adobe will report $49 million for Q1-2019 due to increase in debt for recent acquisitions.

3. GAAP tax rate Guidance vs. Actual

Source: Company Fillings

The tax rate is expected to be 3% for Q1-2019. I believe that Adobe will hit the tax-rate guidance and report 8% for Q1-2019.

3. GAAP EPS Guidance vs. Actual

Source: Company Fillings

GAAP EPS are expected to be $1.14. Based on scenario analysis of earnings, Adobe will report GAAP EPS of $1.24 (variation 8.8%) in Q1-2019.

4. Non-GAAP EPS Guidance vs. Actual

Source: Company Fillings

Adobe has a tendency to beat guidance. Non-GAAP EPS are expected to be $1.60 in Q1-2019. Based on scenario analysis of earnings, Adobe will report Non-GAAP EPS of $1.70 (variation 6.3%) in Q1-2019.

5. Outstanding shares Guidance vs. Actual

Source: Company Fillings

Outstanding shares will be in line with guidance based on historical trend.

Conclusion - Based on Historical Analysis of Guidance vs. Actual (Variation Analysis), we can conclude that Adobe will report the following financials in Q1-2019:

Scenario Analysis of Earnings (Q1-2019) - A look at earnings from the view of management, analyst & investors

Through scenario analysis of earnings, we will analyze whether the company can beat the street based on expectations of management, analysts, and investors. If yes, then we will certainly see upside in share price and, if not, then either hold or sell. We will also validate the scenario analysis of earnings with a relative valuation technique, DCF analysis, and street analyst's recommendations.

Income Statement - a top-down approach to Adobe's guidance

Source: Company Fillings

In the above analysis, I have tweaked the revenue ($2.59 billion, 5.4% growth sequentially) and operating income ($718 million, margin 27.7%) in line with Street estimates, management guidance and variation analysis. Tax-rate and outstanding shares projected based on variation analysis 8% and 495 million, respectively.

Conclusion (Hold/Buy Opportunity): Based on the scenario analysis of earnings for Q1-2019, we can conclude that Adobe will beat Non-GAAP EPS guidance by a margin of 6.6%. Hence, we can hold/buy till the next earnings.

Now, we will validate the scenario analysis conclusion by applying the valuation methodologies.

Valuation Methodologies

Investors should look at valuation methodologies when deciding whether to enter or exit a stock. Valuation is driven by perceived growth, risks and investors' willingness to pay. There are various methods available to assess the valuation of a stock.

We used the DCF analysis over a five-year period, with the following assumptions:

  1. Revenue was projected to be in line with the Street's expectations. Currently, analysts expect Adobe to generate revenue in the range of $11.08 billion to $11.33 billion in FY-2019 and between $12.71 billion to $13.43 billion in FY-2020. Thereafter, I moderated the growth rate to 17% by FY 2024
  2. I expect operating profits to be 33% in line with management expectation
  3. The company's fiscal 2019 tax rate was in line with historical levels
  4. D&A & capital expenditures are expected to continue in line with past trends. Working capital is projected at 7% of revenue.
  5. We used a baseline rate of 8% for WACC and a baseline terminal FCF growth rate of 3.0%.

Here's the DCF analysis down to the unlevered FCF:

The company's implied share price is $287, which is a 9% premium to the current price of $263. The most likely implied value is between $203 and $374 per share, based on this analysis.

Based on our analysis, the recommendation for Adobe is Buy/hold. Now, we will validate the scenario analysis conclusion and DCF analysis by understanding the overall market view for Adobe.

Market View - Positive

Analysts have a target price of $291.21, which is a 12% premium to the current price of $254. Of all the analysts covering Adobe, 17 recommended it as a strong buy, 3 recommended it as a buy, and 12 recommended it as a hold.

My Recommendation: Buy Rating

1. Creative Cloud is likely to be the next big catalyst for Adobe

2. Based on the scenario analysis of earnings for Q1-2019, we can conclude that Adobe will beat Non-GAAP EPS guidance by a margin of 6.6%. Hence, we can hold/buy until the next earnings report

3. Based on DCF analysis, the implied share price is $287, which is a 9% premium to the current price of $263. The most likely implied value is between $203 and $374 per share

4. Market view is positive and validates our analysis

Conclusion

Adobe has outperformed both its own management guidance and street expectations in every quarter of the previous four quarters. Based on our analysis, Adobe keeps up its winning streak when releases its next earnings on Thursday, March 14.

Disclosure: I/we 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.