My latest column is up at RealMoney. You can read the full article there, but here is a summary:

Adobe has also generated nearly $1.5 billion in free cash flow over the last 12 months, which gives it a free-cash-flow-to-enterprise-value-yield of more than 9%. That is nearly a 400% premium to the five-year Treasury yield.

Of course, the last six months have shown that attractive valuations can get you nowhere (or even put you in the hole). That is why the catalyst provided by the likely release of Creative Suite 4 becomes so important.

If Creative Suite 4 pans out like any of the last three product cycles, investors should start getting excited about it sometime between now and July. With consensus 2009 earnings estimates already at $2.07, a P/E expansion to 30 times gives a potential target of $62, up from a current $35.

If the thesis continues to play out, I’ll be able to stop kicking myself for jumping the gun.

Disclosure: William Trent owns shares of Adobe (ADBE)

This article is a reprint of my December 19, 2007 RealMoney column.

An Update of My September 2007 Stock Picks

• My picks in September had winners and losers, but fortunately more of the former
• Closing out my bearish stance on Office Depot (ODP)

I wrote six articles in September that included a bullish or bearish stock opinion, and with three months behind them I thought it was a good time to see how they performed and whether any changes were warranted. On the whole, the picks are playing out more or less as planned.

Motorola

On September 10, I wrote that if Motorola (MOT - Annual Report) could get to 2004 free cash flow levels and grow the cash flow a measly 2% per year from there Motorola shares would be worth nearly $23.

Instead, the cash flow position has continued to deteriorate, contributing to former CEO Ed Zander’s recent ouster. The stock is down 7.2% since the article was written, compared to just a 0.5% decline in the S&P 500.

Still, I think the issues at Motorola can be fixed by bringing the costs - particularly research, development and overhead - in line with the current revenue generation. Alternatively, activist shareholder Carl Icahn could push to break the company up into smaller pieces that might be acquired for a higher total than the current company is currently able to garner. Either way, I’m sticking to my guns on Motorola.

Yahoo

On September 11 I made a bearish call on Yahoo! (YHOO), saying I didn’t believe in the consensus growth estimates and that Yahoo isn’t generating enough cash flow today to make waiting for the recovery worthwhile — at least not for me.

Things haven’t gotten any better since then, and the stock has lost 1.1% - although that is a slightly better performance than the 1.7% loss in the S&P over the same period. I remain bearish on Yahoo.

Office Depot

On September 12, I made a bearish call on Office Depot (ODP), saying “things are likely to get worse before they get better.” Things got worse, and after the company missed earnings and delayed filing its required 10Q the stock has lost 23.3%, compared to a 1.7% decline in the S&P 500.

But I also said “it looks like a stock that will pay off in the end,” and I think the current downturn may have taken the worst out of the stock. I have written put options against the shares (a bet that has lost money) and I think there are more reasons to be positive than negative.

Think the worst of the housing downturn is over? Office Depot’s solid cash flow should make it a safer play than homebuilders or financials. Think small-business tech spending will rise? Office Depot’s P/E is a fraction of Dell’s (DELL).

Office Depot could still have some downside, and I don’t expect a quick recovery. But at current valuations I can no longer justify a bearish position, so I’m closing out that call.

Delta Airlines

On September 17 I made another bearish call, this time against Delta Airlines (DAL). Although the stock looked cheap, after I made some adjustments for earnings quality it looked more like a company recently emerged from bankruptcy (which it is.) The stock has lost 17.7% since that call, compared to a 2.1% decline in the S&P.

Short term, anything can happen as airlines have tons of leverage that can lead to wild swings in profitability in pricing. But long-term I don’t think the major airlines have any better prospects than they did before the previous 10 or so bankruptcies, and I remain bearish.

Apple

I weighed in favor of the bulls for Apple (AAPL) on September 17, and was rewarded with a 32.5% increase in the shares, compared to the 2.1% loss for the S&P 500. The share gains cut Apple’s 3.9% free cash flow yield down to 2.9%, so it isn’t the value it was then.

Still, the cash flow rose 250% from the prior year, and Apple’s market share remains small for most of its product lines. The company continues to make desirable products, and if I have to take a chance on a tech name surviving an economic downturn it might as well be Apple.

Adobe

My last September stock pick was a bullish call on Adobe (ADBE) on the 18^th. The stock always seems to sell off after a major product introduction such as the Creative Suite launch in May of this year. Investors tend to sell on that news after buying up the shares in anticipation of it.

Although the sell-off wasn’t very pronounced this year, the shares did get stuck in neutral. My own call may have been a bit early, as the shares are down 6.3% since the article and the S&P is only down 4.9%.

On their earnings call, the company reiterated their guidance for next year. As the next product cycle moves closer, I think my bullishness will pay off.

Disclosure: William Trent owns shares of Adobe (ADBE) and has written naked put options against the shares of Office Depot (ODP).

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William Trent currently has a short position in put options related to Office Depot (ODP).

This article was originally published at RealMoney on November 6, 2007.

Parametric Technology (PMTC) develops software used for Product Lifecycle Management (PLM) and Enterprise Content Management (ECM). At a P/E of approximately 15x and a 5.3% free cash flow yield, Parametric appears cheap relative to other technical software developers. However, its earnings quality has historically been low and it faces more severe competition than some of its peers. With earnings quality improving and the valuation favorable, PMTC certainly bears watching. But for now I think Dassault Systemes (DASTY) and Ansys (ANSS) have sufficiently better prospects to justify their higher valuations.

Compared to companies like Ansys, which develops highly technical products and has relatively few competitors, Parametric has significant competition in each of its business segments.

PLM competitors include Dassault Systemes SA, Siemens (SI) subsidiary UGS, Autodesk (ADSK) and Agile Software (AGIL). They also compete with larger enterprise-solution companies such as SAP (SAP - Annual Report) that have entered the PLM market and offer solutions integrated with their other enterprise software applications.

ECM competitors include EMC (EMC - Annual Report) Documentum, IBM’s (IBM - Annual Report) FileNet, OpenText, Adobe (ADBE) Framemaker, and the Microsoft (MSFT - Annual Report) Office suite.

Parametric suffered mightily during the tech downturn, but since 2004 the company has been engineering a turnaround based on improved profitability and a return to growth. Current consensus growth estimates for the next five years are just 7%, or half the rate expected for the industry. The lower growth estimates are part of the reason for the cheaper valuation. However, they also make for a lower bar to clear, and the recent reversals of its deferred tax valuation allowance are a signal that the company is now “more likely than not” to earn sufficient income in future years to utilize tax losses from prior periods.

There are a few other issues that cause me to think Parametric’s low valuation is justified. For example, 58% of revenues are derived in North America, which faces an uncertain near-term economic outlook.

Another issue is earnings quality. Gross margins have been declining due to a higher percentage of revenue being derived from consulting and training rather than license and maintenance revenue. A bad debt charge-off in 2006 and increased customer financing activity are other signals that earnings quality may be low.

To get a feel for overall earnings quality, I calculated the accrual ratio, or the change in net operating assets divided by average net operating assets. This ratio describes the percentage of earnings contributed by discretionary accounting items rather than actual cash flows. An ideal accrual ratio would fluctuate around zero. Parametric’s has been all over the map, though it has been improving for several quarters.

Sources: Zacks Research Wizard, William A. Trent

If Parametric continues to improve its earnings quality, or if it gives back some of the stock gains it enjoyed post-earnings (or preferably both!) it could become an attractive buy candidate.  In the meantime, interested investors may find an option play worthwhile.

The January 17.50 puts were trading recently at $0.50/$0.75. If you could write the option for $0.60 it would offer a 3.1% 2.5-month return on the money at risk, which annualizes to nearly 15%. You’d be forced to pay $17.50 for the shares if they drop between now and then, but the option premium would give you an effective price of just $16.90. At that price, the 6.0% free cash flow yield would probably be enticing enough to justify a buy anyway.

Disclosure: Short naked put options on Ansys (ANSS)

William Trent currently has a short position in put options related to Office Depot (ODP).

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.

Featured at the Festival of Stocks.

I have followed Adobe Systems for several years, and up until now it has been one of the names I have been more successful at timing. Much of last year I owned call options in anticipation of the Creative Suite upgrade. Since December I have been on the sidelines expecting a 20% pullback that frequently occurs over the months following such a release.

Then in June I said “The high current expectations may be the catalyst I need for my prediction to come true, which in turn would hopefully create an opportunity for me to buy the stock again. My ideal entry point would be $37.50, but anything below $40 might be interesting given the current earnings estimates.”

The stock is now trading at approximately $39, a multiple of 26x expected FY (November) 2007 earnings and 23x 2008 estimates, which is getting toward the low end of the long-term trading range. And while it is still only in the “might be interesting” price range I did find it interesting enough to make a small bet this morning.

I sold September $37.50 put options for $1.25 each, which will require me to buy the stock for $37.50 in September if the stock is below that price. I won’t mind, since I considered $37.50 an ideal entry point anyway, and the option premium would make my effective price just $36.25 - giving me a cushion against any further downward pressure (though if the stock falls to $20 for whatever reason I will still be down a bunch). On the other hand, if the stock never reaches my entry point I will get to keep the premium - a 3% return on my money at risk for a holding period of about 6 weeks - which isn’t a bad alternative.

Adobe Systems Incorporated (ADBE) reported financial results for its second quarter of fiscal 2007 ended June 1, 2007. Revenue of $745.6 million was better than the guidance of $700 to $740 million and consensus of $729 million. Non-GAAP diluted earnings per share for the second quarter of fiscal 2007 were $0.37, compared to the company’s target range of $0.34 to $0.36 and the $0.35 consensus.
For the third quarter of fiscal 2007, Adobe announced it is targeting revenue of $760 million to $800 million, right in line with the $781 million consensus. They also forecast a GAAP earnings per share target range of approximately $0.28 to $0.31 and a non-GAAP earnings per share of approximately $0.39 to $0.41, compared to a $0.40 consensus target.

So why did the shares fall after the report? As I suspected, the expectations got ahead of reality.  Regardless of what the published estimates said, investors were expecting them to beat them. Such a situation frequently leads to (possibly unwarranted) disappointment when the numbers are released.

As I said in the preview article, I’d rather buy the shares below $40. The shares traded lower on a positive market day and were weaker after hours on an apparently strong number, so there is definitely some weakness there. Not enough weakness, however, for me to jump in.

At least not yet.

This post was featured at the Festival of Stocks.

Here we go again. Almost exactly one year ago I fretted over comments regarding Adobe’s expected earnings. At the time, analysts were betting the company would lower guidance. At the time I said “the company may lower guidance, but since investors already expect it the shares may not go down or could even rise.” I backed up my words by buying call options, a trade that worked very well for me.
Analysts Expect Strong 2Q for Adobe: Financial News - Yahoo! Finance

BY THE NUMBERS: In March, Adobe projected second-quarter sales of $700 million to $740 million, earnings of 23 cents to 26 cents per share, adjusted income of 34 cents to 36 cents per share, and an operating margin of about 23 percent to 25 percent.Analysts polled by Thomson Financial think Adobe will earn 35 cents per share on sales of $728.8 million.

ANALYST TAKE: In a note to clients last week, Wachovia Securities analyst Philip Rueppel wrote that after talking with resellers and looking at data, he thinks sales of Adobe’s Creative Suite 3 and Acrobat 8 software will push the company’s second-quarter results above his estimates of 37 cents per share in earnings and $735.9 million in revenue.

Rueppel rates the stock “Outperform.”

Deutsche Bank analyst Tom Ernst Jr. raised his estimates for Adobe’s second quarter and fiscal 2007 in a June 3 note, writing he thinks Creative Suite 3 is “off to a fast start.”

Comments like those tend to worry me, because the better investors think things are the easier it will be to disappoint them. I have been neutral since December, feeling that the Creative Suite product cycle could lead to a “what next” attitude among investors, who will exit until they see the next product cycle on the horizon. While the stock has not fallen much yet, it also has not performed any better than the average stock during the last six months.

The high current expectations may be the catalyst I need for my prediction to come true, which in turn would hopefully create an opportunity for me to buy the stock again. My ideal entry point would be $37.50, but anything below $40 might be interesting given the current earnings estimates.

Design software maker Adobe Systems (ADBE) is rightly proud of its headquarters building, which it lauded last December in a press release:

Adobe Systems Incorporated today announced the U.S. Green Building Council (USGBC) has awarded Leadership in Energy and Environmental Design-Existing Building (LEED®) Platinum certifications for Adobe’s East and Almaden headquarters towers in downtown San Jose, distinguishing Adobe as the world’s first commercial enterprise to achieve a total of three Platinum certifications under the LEED program.

However, the pride in its building is more muted when it comes to showing the property and its associated debt on the balance sheet, as disclosed in a recent SEC filing:

On March 26, 2007, Adobe Systems Incorporated (the “Company”) renewed its lease arrangement for one of three buildings the Company occupies as part of its corporate headquarters, known as the Almaden Tower, located in San Jose, California (the “Property”).

Pursuant to a lease agreement (the “Lease”), dated March 26, 2007, between the Company as Lessee and SELCO Service Corporation as Lessor, the Company has leased the Property for a new five year term that extends to March 26, 2012, with an option to extend for an additional five years at the Company’s sole discretion. Rent payments under the Lease are a function of LIBOR; payments for the initial term are currently estimated to be $29.7 million. The Company has the option to purchase the Property at any time during the term of the Lease for approximately $103.6 million. The maximum recourse amount (or residual value guarantee) under this obligation is approximately $89.5 million. The Lease will continue to qualify for operating lease treatment under Statement of Financial Accounting Standards No. 13, “Accounting for Leases,” and as such, the Property and related obligations will not be included on the Company’s consolidated balance sheet.

With a value of $104 million and annual lease payments of approximately $6 million, the payments do not appear all that different from those the company would pay in a mortgage. It’s not like Adobe needs creative financing arrangements, either. With $2.2 billion in cash and short-term investments as of December, they could buy 20 such buildings without taking out a mortgage against any of them. We’re actually more concerned that management is spending time drafting arrangements like this than we are about the arrangement itself. But that’s not the least of it:

As part of the financing of the Lease, the Company purchased a portion of the Lessor’s receivable under the Lease for approximately $80.4 million, which will be recorded as an investment in lease receivable on the Company’s consolidated balance sheet for the quarter ended June 1, 2007. This purchase may be credited against the purchase price if the Company purchases the Property, or may be repaid from the sale proceeds if the Property is sold to a third party.

So rather than carrying the property on the balance sheet and taking a charge for depreciation and interest expense, the company keeps it off the balance sheet and pays rent. With the investment in the lease receivable, it makes us wonder why they even bothered.

Back in December we said:

We recently took profits on our Adobe (ADBE) position because we have noticed the stock tends to trade down following the release of a major new upgrade on the theory that there will be no more good news for a while. Of course, this is not the typical upgrade and things could be different this time. For one thing, the switch to Intel-based Mac support should be a significant demand driver for the company’s creative professional customer base. For another, it isn’t just a Photoshop upgrade, as some users are reporting.

The company’s guidance certainly buouyed investor enthusiasm after the latest conference call, and early indications suggest the enthusiasm may be warranted.

The Test Bed: Adobe’s online store buckles under the pressure of CS3 rush - computer product reviews and news

It would appear Adobe underestimated the excitement the launch of Photoshop CS3 would cause.Although the homepage works fine, try to access the online Store and it all goes horribly wrong.

As you’ll see in our screenshot, the IE title bar states “Scheduled maintenance” as the reason for the site being down. We can help thinking it odd that Adobe should schedule maintenance on its site on the same day it launches its biggest money-spinner.

The product, which so far is available only for download, has been widely anticipated (and when we tried the store opened fine.)  The dangerous game investors play, however, is to try and figure out whether it was more widely anticipated than anticipated.

Over the weekend we made our forecast for the Adobe Systems (ADBE) earnings results, saying “We think they are likely to beat but that investors will still be too worried about the product cycle for the stock to benefit.” Today the company Reported First Quarter Results:

Adobe Systems Incorporated (Nasdaq:ADBE - News) today reported financial results for its first quarter ended March 2, 2007.

In the first quarter of fiscal 2007, Adobe achieved revenue of $649.4 million, compared to $655.5 million reported for the first quarter of fiscal 2006 and $682.2 million reported in the fourth quarter of fiscal 2006. Adobe’s first quarter revenue target range was $640 to $670 million.Adobe’s GAAP diluted earnings per share for the first quarter of fiscal 2007 were $0.24, based on 604.2 million weighted average shares. This compares with GAAP diluted earnings per share of $0.17 reported in the first quarter of fiscal 2006, based on 621.8 million weighted average shares, and GAAP diluted earnings per share of $0.30 reported in the fourth quarter of fiscal 2006, based on 602.2 million weighted average shares.

Non-GAAP diluted earnings per share for the first quarter of fiscal 2007 were $0.30. This compares with non-GAAP diluted earnings per share of $0.32 reported in the first quarter of fiscal 2006, and non-GAAP diluted earnings per share of $0.33 reported in the fourth quarter of fiscal 2006. Adobe’s first quarter non-GAAP earnings per share target range was $0.28 to $0.30.

The consensus estimates were for $655 million in revenue and $0.29 in earnings per share, which means that for the quarter Adobe missed on the top line but more than made it up by controlling expenses. Importantly, its major product upgrade is ahead of it, and that can often result in lower sales as customers wait for the new version. Adobe management alluded to this in the earnings release:

“Q1 was a solid quarter for Adobe, as we came in at the high end of our earnings target range and were within our targeted range for revenue,” said Bruce Chizen, chief executive officer of Adobe. “As Adobe prepares for the biggest product launch in our history, we are excited about our opportunities and bullish about our prospects for another year of strong performance.”

According to a Forbes article, that product launch is targeted for May, which puts it at the end of the current quarter. It shows in the revenue guidance:

For the second quarter of fiscal 2007, Adobe announced it is targeting revenue of $700 million to $740 million. The Company also is targeting a GAAP operating margin of approximately 23 to 25 percent in the second quarter. On a non-GAAP basis, the Company is targeting a second quarter operating margin of approximately 36 to 37 percent.

In addition, Adobe is targeting its share count to be between 605 million and 607 million shares in the second quarter of fiscal 2007. The Company also is targeting other income in its second quarter to be approximately $23 million to $24 million, with a GAAP tax rate of approximately 24 to 26 percent and a non-GAAP tax rate of approximately 25 to 27 percent.

These targets lead to a second quarter GAAP earnings per share target range of approximately $0.23 to $0.26. On a non-GAAP basis, the Company is targeting earnings per share of approximately $0.34 to $0.36.

Analysts were expecting $717 million in sales and $0.35 non-GAAP EPS. Better still, the company expects further gains in the third quarter, according to a Reuters article:

“We also expect Q3, which is normally a tough quarter for Adobe due to seasonality and the way our quarter breaks out, to be sequentially up,” said Chizen in a telephone interview with Reuters.

With all of the good news, the stock is trading up considerably in the after-hours, making our weekend punditry look a little too conservative.