Adobe Acting Like We Wrote the Script

Adobe shares traded up about 8% after-hours last night after posting $0.29 in earnings per share when the street was expecting $0.26. The news was so good for our portfolio (we are long call options) that we will spend only the briefest moment to poke a hole in the report: the $0.29 they earned was exactly what analysts expected them to earn until the company guided downward three months ago.

But hey, if the market wants to give ‘em a mulligan for setting the bar lower when they don’t need to, who are we to complain? ‘Cause other than that, Adobe has been acting almost exactly according to our plan. So first we will update you on the history of our position, then tell you where we think it will go next.
On March 19 we wrote:

Near-term, however, expect the smart money on Wall Street to fret over how they are late in the product cycle, with no major upgrades yet announced. If this causes a drop in the stock price, it is worth taking the time to figure out if you want to hold a position.

We followed up on March 25 with:

Now, according to our theory, the shares should be rallying ahead of the release of Creative Suite 3. So why do we blame Wednesday’s slump on the product cycle? We chalk it up to conflicts between rumors. Will the CS3 launch occur in late 2006 or  early 2007? The six-month date discrepancy calls for a short term pause before the shares rally again.

On May 2 we started running the numbers:

So now we do some simple math. At 35x the then-trailing P/E of perhaps $1.25 the stock would fetch $43.75. At 32x forward EPS of $1.50 it could get as high as $48. Against this we have a downside potential of perhaps 20x the $1.25 estimate, or $25. Furthermore, this year options are being expensed for the first time. Although the consensus estimates currently exclude option expense, our view is that over the next year the market will stop ignoring them, which may result in a reset to historic multiple ranges.

Long story short, although we are fans of ADBE over the long term, the short term valuation picture shows as much room for downside as upside.

Piper Jaffray called the bottom on May 15, and UBS followed suit on May 23. We said long-term folks may want to nibble, and we bought our call options ($30 strike price) on June 1. (We also sold put options on two occasions, and the second of these looks to expire worthless today.) With one brief exception since then, the script has been played out to perfection. So what’s next?

The next version of the PDF reader, Adobe Acrobat, is due out in November. The third edition of its Creative Suite, which packages Photoshop, Illustrator and other programs (and will be the first to run native on the new Intel-based Macs), is expected to ship in the first half of 2007. According to our thesis, the stock should continue rallying until about then. The estimates have come down a smidgeon since May (we expect them to go back up now, but what the heck - we’ll be conservative) so the new target range is $42-$45. Until either the release of Creative Suite 3 or a price above $45 we are comfortable holding (though our options expire in mid-January.)

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