I Bought Adobe Systems (ADBE)

Adobe (ADBE) Stock Dashboard

Adobe ADBE Stock Dashboard 20100928

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 to them to the $900m range for fiscal 2010.

Cash related numbers have increased consistently for the past 10 years and competitive pressures from Apple plus the recession definitely hurt Adobe 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.

You can try it yourself with the premium intrinsic value calculator.

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 profit even if I did make a mistake.

Expected Catalyst

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 it much so easy for web app development which is the rage in case you haven’t noticed.

Flash isn’t just limited to your computer. It’s now integrated in mobile phones. The new wave of tablet PC’s feature flash and with over 3m iPad’s sold, there is a huge market for developers.

Dell, Blackberry, Samsung and HP 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 they will be easing up on their 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 recently with the acquisition of Omniture in 2009. The market has rallied substantially and with a little patience ADBE should easily catch up.



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15 responses to “I Bought Adobe Systems (ADBE)”

  1. Chris says:

    None of those 3 million iPads sold feature Flash capability. Apple’s stunning success is a true thread to Adobe – as long as Apple continues to grow without supporting Flash, developers will stop developing for Flash. I’m not saying this wont turn around, but at the moment there are a number of emerging technologies (eg HTML 5) that are challenging Flash.

  2. Hello Jae,

    Aren’t you worried that the FCF for Adobe has basically been in free fall for the last 4 years? (including TTM of $833M). I see in your review that FCF has been growing nicely over the 5 and 10 years period, however I’d be worried by looking into what happened since 2007.

    Also, in terms of revenue growth, ADBE has grown at 12 and 11% p.a. on a 5 and 10 year basis respectively. Isn’t 13% growth a bit high in your model, or is it FCF growth, not revenue?


  3. Zehua Zhou says:

    The margin of safety does not seem to be high on this one.
    Not sure why you want to buy a stock with a P/E of 29.

  4. Jae Jun says:

    @ Chris,
    iPads don’t display flash but trying to show the potential of the tablet market.

    @ Ben,
    I don’t think free fall is the right word. Yes it has decreased but next year should fix that. A bad year with $900m FCF is very good in my opinion.

    As for revenue growth, I get 20% for a 5 year period and 15% for a 10 year period. So 13% on a revenue and FCF basis is very realistic.

    @ Zehua,
    If you look at PE it will be expensive, but I have gone after the name and the value based on FCF.

  5. The Android operating system uses flash extensively and is currently outselling the iPhone. I’m guessing Adobe will have no problem staying a leader in their industry. A very important point that some of you may have missed and is really the secret sauce to Adobe is their PageMaker software. I’ve worked in the television, radio, and newspaper industries. There’s not a newspaper in the country that I can think of that doesn’t use Adobe PageMaker to create their newspapers. It’s a very expensive program and must be updated on a regular basis. I haven’t done a valuation on Adobe but it’s a pretty safe bet from my perspective that Adobe definitely has a rather large moat. I’m sure Jae doesn’t need any advice on the valuation of the business. After all, a large majority of the contributors here use the DCF spreadsheet that JAE created so it’s a bit ironic to here someone rant that he’s got the valuation all wrong especially because if it weren’t for Jae’s spreadsheets, I’m guessing 75% of you wouldn’t know how to compute a DCF on the back of an envelope the way some of us old schoolers do every day.

  6. Jae Jun says:

    It is true that Android is already far outselling iPhone and the difference keeps growing.

    One point I wanted to make with competing technologies such as HTML5 is that it will take a very long time before it goes mainstream.

    I bet that the majority of the population that use the internet do not even know what HTML5 is. These people will also be less inclined to update their browsers. I keep up to date with web design and graphical design but I still use IE7 which does not support HTML5.

    35% of the browsers in India is still IE6.
    Unless you actively update your browsers, it won’t work. It took a long time for flash to be compatible on every browser but as of now, it is the standard in creative content.

    I refuse to install quicktime because I find it useless. Barely any sites except Apple use it. The population on MAC’s is very small so analysts could talk about competitive pressures all they want, but the market Apple serves cannot outgrow Adobe.

    Same argument goes for how Windows became no.1 despite Apple coming to market first with the GUI.

    Apple serves a hard core niche. Adobe has everything else.

  7. Zehua Zhou says:

    Even based on DCF, it is just around 20% of MOS, which does not seem good.

  8. Jae Jun says:

    For quality large caps, 25% margin of safety is perfectly adequate for me. A discount rate or 12% is also much higher than any bond yield + risk premium.

  9. Parker Bohn says:

    This one is outside of my circle of competence.

    If you are right about the moat and the 12%+ growth, you should do very well.

    One question…
    What event, news, or quarterly result could make you change your mind about your investment thesis on ADBE?

    I enjoy watching you think. Thanks.

  10. Oh, Adobe. Good times.

    Adobe was the first individual stock I ever bought. Admittedly I didn’t invest in it for particularly skilled reasons, but it was a great learning experience for a new investor.

    I now consider Adobe to be out of my circle of competence, because I’m not going to try to predict how they’ll hold up to a rapidly changing tech environment. But good luck with your investment; it certainly is a great company at the current time.

  11. Ziv says:

    Hey Jae,
    What do you think about html 5 and the threat it can have on flash?
    html 5 is open code, which fits into the recent surge in [open code] demand.
    those are just my 2 cents, what do you think?

  12. Jae Jun says:

    @ Ziv,

    I wrote about HTML5 in my previous comment.
    To sum it up, it holds no threat to Adobe for many years.

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