Overview:
Adobe Systems, Inc. ("Adobe") designs a number of ubiquitous software products most people who use a computer interact with on a daily basis, including Flash animation technology and the Flash Media Player (web video and other web applications), Adobe Acrobat (digital document creation/viewing), as well as a book of market-leading design products used by both professionals and amateurs including Photoshop (photo editing), Dreamweaver (website design), Encore (DVD creation), Illustrator (graphic design), InDesign (page layout), Premier (video editing), among others. Many of these products have become industry standards with defensible market positions due to both their high quality and the switching costs that accompany their wide acceptance.
Adobe's business is currently divided into five segments: (i) Creative Solutions, which focuses on the Adobe Creative Suite family of products and accounts for roughly 58% of revenues, (ii) Knowledge Worker, which produces the Acrobat family of products and accounts for roughly 23% of revenues, (iii) Enterprise, which focuses on interaction with data stored in enterprise applications and currently accounts for roughly 7% of revenues, (iv) Platform, which focuses on improving the way Web and mobile device developers engage their customers and accounts for roughly 6% of revenues, and (v) Print and Publishing, which accounts for approximately 6% of revenues. Adobe's business is truly international. In 2008, 42% of sales were in the United States 4% in other Americas, 34% in Europe, Africa and the Middle East, 13% in Japan and 7% in Asia (excluding Japan).
In Dec. 2005, Adobe purchased Macromedia for $3.4b in Adobe stock (at Adobe's 2005 price of about $35 a share). In doing so it acquired the creator of Flash technology and its biggest competitor in the media-rich web application space. This acquisition has also allowed Adobe to enter into the growing market for mobile device applications software and has substantially enhanced earnings and cash flow since 2005. Macromedia also created Dreamweaver, a leading product for website design. The acquisition has resulted in a large amount of intangible goodwill on Adobe's balance sheet as an asset (more on this later).
Industry Insight: Over the last 20-30 years the stocks of pure-play software companies (ORCL, MSFT, ADSK, ADBE among others) have largely been thought of as "growth" stocks with their best earnings ahead of them. Historically, the market has priced them accordingly. But these same software companies are creating an enormous amount of value in the present. As an industry they produce astronomical returns on invested capital and equity and generate free cash flow much higher than their net income. In this bear market, valuations have swung to the other extreme and these stocks are priced as if they are no-growth or slow-growth businesses (which they certainly will be in 2009 and maybe 2010). We think that generally an investor should purchase companies at a reasonable multiple of present earnings and view future growth as a bonus for which a small premium, if any, is paid. We feel that the current market prices of the mature pure-play software companies now present that opportunity. Adobe is our favorite.
Our Favorite: While we certainly don't pretend to understand the technology involved in creating software or the variables that make certain software products financial successes, we find in Adobe: (i) a company (and a management team) with an excellent track record of growing revenue, EPS and free cash flow, (ii) the ability to create products with a loyal (and sometimes passionate - see Photoshop) following and (iii) a company that is on the right side of a number of worldwide growth industries including web video and other web applications, web site development, internet advertising, mobile device applications, the paperless office concept, secure digital documentation, and digital creative content (video, photography, sound, etc.).
The Business:
ROA: Adobe's return on assets has historically been very high - around 30% in the late 90s decreasing to around 15% now. This decline is largely due to: (i) the large cash balance Adobe carries on its balance sheet, and (ii) the large amount of goodwill and intangibles on its balance sheet due to the Macromedia purchase (the latter totaling about 37% of total assets in November 2008), and not due to a decline in the quality of the "business" or its earnings power. If one strips out the intangibles and excess cash on Adobe's balance sheet, ROA rockets to around 60%. This is a capital-light business that generates an enormous amount of profits on its investments, at least its organic investments. Note that while the Macromedia purchase price was probably unreasonable on a stand alone basis (over 40 x Macromedia's trailing earnings), the consideration paid was the inflated stock of Adobe.
ROE: Adobe's return on equity could be stronger - dropping as low as 14.42% in 2007, and at 19.8% in 2008. This again is due to Adobe's large cash position and large amount of goodwill left over from the Macromedia purchase. We feel that Adobe holds too much cash and equivalents given the enormous amount of cash the business generates on an ongoing basis. The productive use of this current cash balance by management, as well as future cash flows, will be a key variable to the success of an investment in Adobe.
Margins: Adobe's gross margin has stayed consistently around the 90% range (as high as 94% in 2005). This high number is due to the nature of the business - customers purchase a license to easily-replicated digital information. Note that pure-play software companies MSFT and ORCL operate with lower gross margins - each in the low 80s. Adobe's operating margin is around 29%, down from as high as 37% in 2005. MSFT and ORCL both have operating margins in the mid 30’s. Operating margins have declined largely due to non-cash amortization/depreciation expenses, but we consider it one point to monitor going forward. We would hope that Adobe can maintain a non-GAAP operating margin above 30% indefinitely. Note that R&D as percentage of sales has stayed constant around 18-20%, a manageable number but slightly higher than MSFT and ORCL. We will assume that this difference reflects the comparative complexity of Adobe's design software, but we will examine this further.
Cash Flow: In each of last ten years free cash flow (operating cash flow - cap ex) has been substantially greater than net income. This is because large intangible amortization and depreciation expenses taken against earnings don't accurately reflect the reality of the "business" - the corresponding decline in the earnings power of these assets. We believe that this strong free cash flow generation demonstrates management's ability to invest in projects and acquisitions which add great value to Adobe's franchise over time. A separate point about FCF - software companies have relatively limited cap ex expenses (about 2-4% of sales for ADBE - similar to MSFT, ORCL). Investments instead take the form of R&D expenses, or acquisitions. The abundance of free cash flow puts management in an enviable position - determining how to spend it. Historically, management has chosen to repurchase an enormous amount of Adobe's shares and then given a number of these shares back to their employees. Adobe's large stock option grants are one item of concern and a point to monitor going forward.
Growth: Adobe's revenue, operating income and diluted EPS growth rates are as follows:
Revenue Growth: 10yr - 14.9%, 5yr - 22.6%, 3yr - 22.1%
Operating Income Growth: 10yr - 23.4%, 5yr - 22.1%, 3yr - 12.2%
EPS Growth: 10yr - 23.4%, 5yr - 23.7%, 3yr - 10.1%
The 3yr EPS of 10.1% appears to be an anomaly - in 2006 Adobe took non-cash charges against earnings in connection with the Macromedia acquisition. 2007 and 2008 saw EPS growth rates of 46% and 31%.
10yr EPS Growth Comparisons:
MSFT - 16.2%
ORCL - 23%
A 10yr EPS growth rate of 23.4% compares favorably to a 10yr revenue growth rate of 14.9%. However, we believe this difference could be drastically higher if fewer dilutive stock options were granted (we do however appreciate management's desire to hire and retain top talent). Nevertheless, the above growth rates exemplify management's ability to consistently grow sales over a substantial period of time with an eye towards the bottom line.
Balance Sheet: We generally prefer to invest in companies that operate with a small amount of debt relative to their assets. Adobe certainly falls into this category. In fact, as noted above Adobe probably carries too much cash and short term investments - about $2b (35% of assets) vs. long term debt of $350M.
Valuation:
As a capital-light business we view Adobe's balance sheet assets as largely irrelevant to the intrinsic value of the "business". Adobe's value is determined by the number of software licenses it can sell which in turn is determined by the quality of its employees and its intellectual property - not the equipment used to produce this software (computers, furniture, etc.) Thus, price/book ratios tell us very little. Instead, Adobe's intrinsic value is closer to the present value of its future cash flows (see below for an analysis of the present value of future cash flows).
EV/EBITDA: At the time we entered into our position Adobe's EV/2008 EBITDA was around 5.8, and EV/3yr Avg. EBITDA of roughly 6.26 - numbers appropriate for a business with very little growth if any. Stripping out Adobe's excess cash and short term investments, the market is assigning “the business” a PE ratio of around 8.
EV/FCF: At the time we entered our position, Adobe was trading at EV/2008 FCF of 6.7, and EV/3yr FCF of 7, very small numbers given Adobe's consistent cash generation. CAPM suggests an equity cost of capital around 12%-15%, EV/FCF ratio of around 6.6x for a zero growth company of Adobe’s size (10x for a company in Adobe's space with around 5% perpetual earnings growth, and 20x for a company in Adobe's space with around 10% perpetual earnings growth). As we have noted before, we believe attempting to assign an intrinsic value to be an educated guess at best - our guess would put intrinsic value at least 40-50% higher than current market price. We believe Adobe's current valuation combined with the stability of its business, and the "bonus" growth prospects provides a substantial margin of safety.
Valuation Comparisons (at the time we entered our position):
MSFT: ORCL:
EV/2008 EBITDA - 5.1 EV/2008 EBITDA - 8.3
EV/3yr EBITDA - 7.42 EV/3yr EBITDA - 11.2
EV/2008 FCF - 8.47 EV/2008 FCF - 11.75
EV/3yr FCF - 8.38 EV/3yr FCF - 15.13
Risks:
The current economic downturn will be tough on software companies, and Adobe in particular. A number of analysts have recently revised their estimates of Adobe's quarterly earnings and 2009 earnings downward. Design professionals and businesses will likely delay upgrading their software until the recession appears to be nearing its end (and then will likely all upgrade in mass). Amateurs will likely do the same. While these are disturbing trends for Adobe's short term prospects (1-2 years), we think that they are certainly priced into Adobe's current price and will soon enough (perhaps 5 years) be a distant memory. We believe Adobe's competitors present a more serious risk to its future than the economy. Microsoft has developed an alternative to Flash technology called Silverlight, and to the .pdf format called XML Paper Specification (XPS), and will undoubtedly be pushing these on Windows users. Tech powerhouses Apple and Google are also players in a number of Adobe's specialties (notably photo and video editing), especially with respect to the amateur market. We will closely watch the developments of Adobe's competitors.
Beyond competition, we think the second greatest risk to an investment in Adobe is the potential of management to misuse Adobe's strong cash flows (engaging in poor acquisitions, performing stock buybacks when the stock is inflated).
Finally, note that copyright infringement and piracy eats at Adobe's sales and is an ongoing risk to its business, especially in the less policed emerging markets.
The Models:
We've devised the following models which demonstrate the impact we believe Adobe's abundant free cash flow will have on the investor's rate of return.
In all scenarios we have assumed a required rate of return of 12.5%, this rate inherently captures the riskiness of the cash flow stream. If it were truly a risk free cash flow stream, we would discount the future cash flows at the current risk free rate (approx. 3.8%), providing a much higher present value of the future cash flows. The 12.5% also far outpaces the historical equity rate of about 9%.
In the conservative scenario we assumed absolutely zero perpetual growth of FCF from the base of $800 million. $800 million is very conservatively 66% of 2008 FCF of $1.2B as we are trying to capture the effect of the recessionary economy in the short term. This scenario produces a value per share of approximately $15. We see this as an extremely attractive valuation, (purchasing a proven cash flow stream, with an inherent 12.5% annual ROR) which ties into our put selling at $15 in the event of a near term dip to this level.
In the moderate scenario we assumed perpetual FCF growth of 5% from a base of $900 million. We see 5% growth as attainable by Adobe as historic growth has been closer to 20% (see above).
In the aggressive scenario we assumed a perpetual FCF growth of 7.5% from a base of $1 billion.
In the current scenario, we have reverse engineered the model from the current stock price, keeping the investors required return (12.5%) and beginning FCF the same, producing an implied perpetual growth of 2.1%, which we believe severely discounts Adobe's prospects (note that as discussed above this model begins with depressed 2009 FCF).
In addition to the above we have provided another table outlining what we view as the appropriate valuations of FCF into perpetuity, using different perpetual growth assumptions and require rates of return. In the below table we hold the base years FCF constant at $800 million.
Please see our February 25th post for information regarding our initial purchase of Adobe stock, and sale of Adobe put options.
