This article was originally published at RealMoney on September 18, 2007.
As impressive as were yesterday’s earnings and stock rally for Adobe (ADBE), perhaps even more impressive is the fact that the stock appears cheaper after going up than it did before. At yesterday’s close, it was trading at 28.5x 2007 earnings estimates. After the nickel beat and three cent guidance increase, based on after hours trading at $44.76 it is only at 28.1x.
That said, 2007 is so this year – most investors are already looking ahead to 2008 and beyond. With no major product upgrades expected until late 2008 at the earliest, there is more than a small possibility that this year’s upside comes out of sales that would otherwise have been made next year. Already growth was expected to slow from 17.5% this year to 12.5% in 2008. If the estimates for next year aren’t raised the growth from the new guidance will be single digit.
I’m quite confident the estimates for 2008 will be raised. But that’s not to say that everything about the earnings report was fine and dandy. License sales are growing slower than total revenue, with the remainder being service and support. Since licenses have to be sold before support can be provided, the slower license sales point to a slowdown in support growth later on. For another thing, deferred revenue is growing at a slower rate (if only slightly) than booked revenue. This indicates that the license revenue will probably continue to slow as well. Furthermore, the growth is in current deferred revenue – long-term deferrals are down 18% since December 2006.
But enough with the forensic accounting. Cash is king, and Adobe’s free cash flow over the last four quarters is about $1.25 billion, giving the company a free cash flow yield north of 5%. Even if the $100 million provided by a reduction in accounts receivable is excluded (as being non-recurring) the yield is still nearly 5%. That cash flow has grown at a double digit pace in each of the last four years and, while it may slow in 2008 due to the product cycle it seems likely to resume at a similar clip in the years following. With a cash flow yield already north of Treasuries, double-digit growth provides a healthy cash on cash return potential.
From what I have observed in the past, Adobe’s P/E multiple usually rises into the mid-30’s immediately ahead of a major new product release, then retreats to the mid-20’s afterward. In early August, with the stock below $40, I sprang into action (sort of.) Since, based on estimates at the time, I was looking for an ideal entry point of $37.50 I sold put options that would force me to buy at that price if the stock was lower when the options expire this Friday. While it looks like the $1.25 option premium I collected will be free money, I also clearly left more on the table. Not that I’m upset about that – the reason I sell the puts is because I know I will usually be wrong, but not the direction in which I will be wrong. The option premium reduces my regret regardless of how things turn out.
With the current news, though, it is time to update the earnings and the “ideal” entry point. Even after the rally, the new earnings estimates leave the P/E multiple in the mid-20’s range I thought it would retreat to – only instead of the stock price falling back a bit the earnings rose to meet it. What’s more, my $37.50 entry seems like little more than a pipe dream. The company bought back more than $700 million worth of stock so far this year, and has the ammo for much more (not to mention ongoing cash flow that would sustain that rate.) It just doesn’t look like management will let me get away with buying that cheaply. While I may continue to follow my regret-minimizing strategy by selling new puts, I’d be willing to do so at the current prices. And those investors who, being less skittish than I, decide to buy may end up with the least regret of all.
Disclosures: William Trent was short naked put options against Adobe at the time of publication.Like this article? Why not try out: