Time to Fade Out of Adobe?

By William Trent, CFA of Stock Market Beat

Adobe (ADBE) reported revenue and earnings ahead of consensus expectations and guided for slightly better than expected performance in the January quarter. This is rather impressive, as it is fairly well known that the company’s flagship Creative Suite (Photoshop and other graphic design programs) is due for a major overhaul. That there is not a dropoff in demand as customers hold out for the new version is impressive. On the conference call, management said:

Creative Solutions segment revenue was $359.9 million, compared to $328.1 million last quarter. This sequential increase was driven by our new hobbyist products and our Creative Suite products.

On the other hand, back in October we said:

The funny thing about this is that a bigger dip could be the most bullish scenario, as it would indicate a higher level of demand building up in anticipation of the CS3 launch. Of course, that wouldn’t be the first time Adobe’s stock reacted in unexpected ways to news.

So what to do now? First we will recap the history of our position for context.

On March 19, we said:

Adobe is one of our favorite long-term holdings. Its Acrobat, Photoshop and Illustrator are industry leading applications, InDesign is quickly becoming the standard, and Dreamweaver and Flash from the Macromedia acquisition round out a great product portfolio. Add zero debt and strong cash flow to the mix, plus a dash of being in the right place at the right time as the vast consumer photo market goes digital and you have a recipe for long-term outperformance.

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.

Sure enough, the stock dropped fairly sharply. By June we were ready to jump in, and took a long position on the January 30 call options. Our logic then:

So the company may lower guidance, but since investors already expect it the shares may not go down or could even rise. It lends way to several potential scenarios for next week’s earnings call (from worst case to best):

1. Adobe lowers guidance, and either the reduction or the size of the reduction is unexpected. Shares fall.
2. Adobe lowers guidance, and the reduction is in line with expectations even though those expectations are not reflected in consensus estimates. The shares do nothing.
3. Adobe lowers guidance, but the reduction is less than expected. The shares rise.
4. Adobe leaves guidance unchanged or even raises it. The shares rise by a lot.

We noted in past posts that before the bubble, and since it burst, ADBE’s trailing P/E multiple tends to vary between the low 20’s and high 30’s. Currently we are just above a 27x multiple.

If Adobe earns the $0.30 analysts expect, the trailing P/E would fall to 26.5x, quite close to the low end of the range we described. Further, given that three of the four potential scenarios next week would result in either a neutral or positive response we recently purchased call options on Adobe. We were a bit early, but we still like our odds.

Now the company has posted very solid earnings but with the new product cycle clearly in view, we expect Wall Street will decide it is time to move on. We’ll probably try to beat the rush.

Disclosure: Author is long Adobe call options at the time of writing but the position may is likely to change at any time.

The author may hold a position in the securities discussed. The author’s current holdings are as follows: Long: FedEx (FDX) put options; Intuit (INTU) put options; Nasdaq 100 (QQQQ) put options; Bookham (BKHM; Ballard Power (BLDP); Syntax Brillian (BRLC); CMGI (CMGI); Genentech (DNA); Ion Media Networks (ION); Lion’s Gate (LGF); Three Five Systems (TFS); Adobe Systems (ADBE) call options; IShares Japan (EWJ); StreetTracks Gold (GLD); Starbucks (SBUX); U.S. Oil Fund (USO); Plantronics (PLT) call options; Short: Ceradyne (CRDN) put options; Lion’s Gate (LGF) call options; Dell (DELL) put options; Plantronics (PLT) put options

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