Adobe Systems (ADBE) is the high quality leader in a strong growth area.
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Our top VCA Stocks theme right now is Software Tools for Websites. 15 private companies have attracted $121 million in total venture capital funding over the last 3 months, more than any other theme we track. The venture capital community has clearly identified this area as one of long term growth, and as investors it behooves us to pay attention.
Some of these companies enable online payments, some help practitioners augment their websites with social networking or blogs, and some provide new software technologies for Rich Internet Applications or AJAX development. All of these companies are enabling Internet practitioners to build better, more powerful and more effective websites.
MySql’s Success Story
One recent success story is MySql AB, the Swedish open-source database company. MySql was sold to Sun MicroSystems (JAVA) in January of this year for $1 billion. Less than two years previously, in February of 2006, MySql received an $18 million VC financing. The valuation on the financing has not been publicly disclosed, but this was surely a 10+ bagger for the VC firms involved.
Sun’s $1 billion purchase affirmed MySql’s business model, one I would characterize as a hybrid. Free open source software (like the MySql database this website is run on) is monetized by selling expensive business-to-business higher end software and services contracts. Most companies will not need the additional support and engineering provided by MySql. Those that do need the extra support pay professional level fees. A support contract for MySql, for example, started at $5,000 last year when I looked into it.
The Acrobat and Flash product lines at Adobe Systems Inc. (ADBE) have a similar hybrid business model. Free user software is monetized by selling expensive professional software to power users.
Adobe Systems Inc.
Adobe Systems is the dominant graphics software company in the world. As the Internet continues to expand, both in the number of people online and their usage rates, and as the level of sophistication found in online websites and applications increases, Adobe’s target market of web developers and graphic designers should expand. The heavy investment of venture capitalists into our “Software Tools for Websites” theme gives me confidence that this expansion will continue over a period of years.
Adobe is in the middle of rolling out Creative Suite 3 — a new version of their bundled software, including Photoshop, Illustrator and Acrobat Professional, for their Creative Solutions division. The US version was launched last year, and the foreign language versions are in the process of being launched abroad (more than 55% of Adobe’s sales are international). Adobe’s launch of Creative Suite 3 has been timed to piggyback on the huge (and slow moving) Microsoft Vista upgrade. Accordingly, CS3 may see a longer upgrade cycle than the Company has guided investors to expect. It seems likely that consensus estimates based on Adobe’s conservative guidance are “in the bag” for the rest of 2008.
The February quarter report lends confidence to this assessment, as Adobe came through with revenues and earnings well above consensus estimates. Revenues in the February quarter showed a 37% year-over-year growth rate, the majority of which was driven by CS3’s new product cycle. Longer term, Adobe’s revenue growth is expected to slow to the 10-11% range. I have built my long term valuation analysis shown below on consensus assumptions, but Adobe may very well surprise to the upside. I do believe that their target markets will continue to grow for the next five years.
Valuation
View the spreadsheet used for this valuation analysis.
The most useful valuation methodology, in my experience, is to develop a long term target value for a company given a 4-5 year outlook. Basically, you work through a five year income statement to arrive at a five year estimate for earnings and sales. Then, you place a reasonable valuation on those long term earnings and sales estimates to arrive at a target value. You can then discount that long term value back and figure out how much you would pay for the Company now.
You can click the spreadsheet link above to see the detail, but basically I have developed a November, 2012 target price for Adobe Systems of $58 per share. Discounting that $58 back to today at a 10% annualized rate of return gives me a current fair value for Adobe of $37. Adobe is a Buy up to $37 per share. The stock is trading at $35.72 right now.
I’ve made a bunch of assumptions in developing this terminal value of $58.
- I am assuming Adobe comes through at the consensus revenue growth of 11-13% per year over the next five years. Adobe has few recurring revenue stream products, so this growth consensus expectation implicitly assumes a series of strong products out of Adobe as they entice their client base to upgrade.
- I have assumed that Adobe continues to shrink their share base by 3-4% per year.
- I have assumed very little net margin deterioration. Specifically, I have net margins coming through at 27% in 2012 while comparable net margins (adjusted for goodwill) should be 30% this year.
- I placed a 5 multiple on 2012 estimated sales and a 20 multiple on 2012 estimated earnings. These multiples are well below Adobe’s historical norms, but they are still premium, growth multiples.
Also, I discounted the $58 value back at a 10% internal rate of return to arrive at my current fair value of $37. This 10% assumption is completely spurious. Accordingly, I have included a table in the spreadsheet above that allows the reader to look up their own current fair value given a series of annualized internal rates of return.
Competition and Other Operational Risks
Adobe has an in-depth analysis of the competition for each of their products and divisions in their 2007 Annual Report (search for keyword Competition).
The strongest paid software competitor for Adobe’s Creative Suite is Microsoft’s Expression product line. Adobe seems relatively confident in their ability to compete in the Creative Solutions target market (Photoshop, etc), with Micrososft and a host of others.
The Company is less sanguine about their Acrobat product line:
- “With our Adobe Acrobat business, we continue to see an increase in competition from Microsoft. Microsoft has released its new operating system called Windows Vista which includes a proprietary digital rights management technology and a new document format, called XML Paper Specification (”XPS”), which competes with Adobe PDF. In addition, Microsoft’s new version of its widely used Office product offers a feature to save Microsoft Office documents as PDF files through a freely distributed plug-in. This new PDF feature in Office competes with Adobe Acrobat. Given Microsoft’s market dominance, XPS, the PDF feature in Office and any other competitive Microsoft product or technology that is bundled as part of its Office product or operating system or made freely available, could harm our overall Adobe Acrobat market opportunity.”
This seems like a risky outlook for the Acrobat product category.
There are two other very serious threats that all software development companies must deal with — open source initiatives and software piracy.
The only real protection from open source initiatives is making sure your product is demonstrably better than the free alternative. Adobe thus far has successfully accomplished this.
I don’t know how well Adobe has fared in combatting software piracy. However, their strong growth over the last few years, both in the US and abroad, indicates that Adobe has done what is necessary to limit the damage.
Capital Structure
I generally think of capital structure as a risk metric. An extraordinary level of debt relative to market capitalization, an outstanding convertible bond issue (that can be used to arbitrage down the share price), or an outstanding warrant position (which can conceal a predatory insider) are all red flags. In Adobe’s case, there is no issue. The Company has $450 million in long term debt and $1,710 million ($3 per share) in cash.
An extraordinary level of employee options can also be a red flag. Adobe has 47 milion options outstanding (8.1% of shares) as of November 30, 2007, down from 76 million options outstanding three years previously. That is a very reasonable level of options.
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