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Owning a Slice of Adobe's Toll Bridge

February 02, 2008 | About:
Joe Ponzio

Joe Ponzio

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On Wall Street, growth and value are anything but joined at the hip. Stocks are typically split into two groups: growth and value. When a growth stock gets hammered down, it becomes a "real bargain" growth stock; when a value stock drops in price, it is a "better value" at the lower price.

So, is Adobe a real bargain, a better value, or a pass?

With 80% market share and a new word in our vocabulary ("googled"), it is safe to say that Google is the internet. I can't remember the last time I met someone who didn't know what Google was.

Such is the case with Adobe. Even if you don't know the company's name or product line, you have seen and/or used their stuff. You probably have Adobe® Reader® to view and interact with PDF documents. If you've ever visited YouTube (e.g., to watch Rick Santelli yelling at Jim Cramer), you've seen Adobe® Flash® because you, like 99% of all internet users, have the Flash plugin in your browser.

Adobe equals Design

Photoshop and Illustrator are the standards for photo editing, and hence web image design (pictures don't get doctored, they are "photoshopped"); Dreamweaver is the standard for drag-and-drop web design; After Effects is the movie-editing tool of choice for web developers and is used in Hollywood for both traditional and animated movies (watch the credits for "After Effects editor"); Acrobat is the tool of choice for creating portable business documents. The list goes on and on.

Suffice it to say, Adobe has a very durable and competitive moat. One of the truly amazing things about this moat is that developers have crossed the moat, and yet their products never truly compete because every non-Adobe design/animation software is seen as a poor man's fix. (This doesn't include super high-end, specific software used in video games or movies. Adobe owns the personal and casual market and have decent market share in the super-niche market as well.)

It's practically an ATM

Adobe generates cash. It's tough to figure out how much cash it will generate simply because the gigantic Macromedia acquisition from a few years back is still working its way through the financials. Still, Adobe generated about $980 million in owner earnings last year, up from $580 and $540 million in 2006 and 2005, respectively.

When a new Adobe product comes out, people want it - and they pony up the cash. After all, you aren't going to get an FWA award without After Effects video work or some stunning Photoshop design thrown into Flash.

It is financially sound (some other ratios to look at)

For every dollar of tangible long-term assets, Adobe has just $0.36 of long-term liabilities(1) . The company has no long-term debt (could be good or bad, but "none" is better than "too much") (2) and generated 21% owner earnings on its equity last year(3).

What does all this mean?

  1. Management is doing a great job of managing the balance sheet and helping secure our claim in the company;
  2. If management doesn't believe that additional debt will fuel growth, it shouldn't assume any. In Adobe's case, this "growth" company seems to realize that rapid growth doesn't have to be highly leveraged.
  3. The company is utilizing assets well and seems to be well positioned (and durable) should it experience some difficulties.

Price versus Value; Growth versus Value

Though Adobe is typically considered a growth stock, its financial position, dominance, and ability to generate dependable (and perhaps predictable) excess cash makes it look more like a value stock. Of course, why buy "value" stocks if you don't expect them to grow, and why buy "growth" stocks if their businesses have no value? Buffett said it best:

Growth and value investing are joined at the hip.

Right now, some kids are banging away at computer code, trying to become the next Google. In 10 years, Google went from nobody to leader. Who will be the leader in another 10? But Adobe? This is one of those rare technology companies that have such a durable and broad moat that any competition is going to have to be extremely well funded and large, and will have to survive many years of losses during the software development stages, all while trying to keep up with Adobe's products, innovations, and possible buy-out attempts.

You can run through the price on your own (see How to Value a Business), but I come up with a value around $44 a share. I was extremely conservative (in my mind, at least) by using a 14% growth rate for 3 years, followed by 12% for 3, followed by 10% for the next 4. And so, throughout 2007, Adobe traded right around its intrinsic value. As the markets tumbled, so did Adobe, and now it appears to be about 25% underpriced.

Is it a steal? Personally, I know the company well and I think my assumptions are on the conservative side. As Buffett said,

It is far better to buy a wonderful business at a fair price than a fair business at a wonderful price.

I'd be happy to buy Adobe today and hang on to it for the long term. Any mistake I made in my valuation will likely work itself out in my margin of safety and through the company's aggressive stock buyback program. (If I made a valuation mistake and the company was constantly increasing its outstanding shares, I'd be up a certain creek without a paddle.)

Sound business. Largely insulated. Fair price. What are your thoughs?

About the author:

Joe Ponzio
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.1/5 (14 votes)

Comments

kfh227
Kfh227 premium member - 6 years ago
The PDF format has no moat, especially if things go the way of ODF or some other open document format.

Their photo editing s the best. It truely is amazingly good stuff.

Flash can be replaced any time over the next 5 years. I'd go as far as to say that it will be replaced.

What I'm getting at is that it is obvious that 2 of the 3 areas mentioned have no moat. And the photoshop moat is even questionable.

While the numbers are good, I always have to think of moat and ADobe doesn't have it. When it comes to technology, it is always easy to punch holes in products when moat is brought up as a topic. The fact is that hte only thing with a barrier is the photo editing software.
fk
Fk - 6 years ago
I enjoyed Ponzio's article and Kfh227's comment. I rated KFh's comment 5 stars, since I believe his points are well made and compelling. Whoever rated his comment so low please speak up and offer your ideas on why you believe Adobe has the moats. I'm not so convinced they do, or at least not a very deep and wide moat.

Anyone know how the toll bridge for Adobe works? How do they get license fees for PDF documents and flash videos?

Although tech and software can change extremely rapidly, for legacy and other reasons they often are not adopted rapidly.

Examples:

Microsoft Dos was a buggy p.o.s. that was supported for about 20 years longer than it should have to maintain backwards compatability with software and infrastrcture that corporations had already invested tremendous amounts. That was a very nice toll bridge for MS.

Microsoft office when I checked a few years ago was a huge percentage of microsoft revenue. Open office can be downloaded for free, is extremely well written, and has > 90% of the microsoft office functionality. I've been using it myself for about a year, and stopped using MS office 2003. But I bet MS office revenue hasn't taken as big of a hit as you'd think. Anyone know how we can look up that data online?

I don't believe Adobe PDF and flash video has moats anywhere close to something like MS.

Regarding Photoshop, where's the toll bridge for that? Something like John Madden Football I'd have to buy every year to get the current years player stats. What is it about this year's photoshop that I absolutely need compared to buying a 2 year old version on ebay?




kfh227
Kfh227 premium member - 6 years ago
I'm not sure what kind of licensing Adobe Photshop has. I think it is a pay once product though.

As for the star ratings it seems like people hate me these days. I don't get it.
valuemodel
Valuemodel - 6 years ago
I am not sure either way about the existence of moats. As a recent user of open document software (when I had to buy a new laptop this year, I didn't want to pay up for MSFT's Windows Suite), I don't understand why the world still is so Windows-focused. My conclusion is that it is all about the (marketing of the) brand, and that this is probably Adobe's moat, as well. Just look at college curricula, and at least here in CA, they're all learning Photoshop. If there are equal to superior products to Adobe's at better prices, one would think that consumers would be more rational, but the reality would probably be different.
kfh227
Kfh227 premium member - 6 years ago
When it comes to MS and their Office products, just ask the average person what word editing software they know of. Most will only be able to say Word. While others exist (Open Office for example which is free and compatible with MS Office), the problem is that people only know Word. And even if a product like Open Office was free, I'd guess that most would think that the label of free means junk.

I'll admit though. I think in the longest of long term, nothing has a moat. I think moat is an issue when you have to question a companies position just 5 years down the road. If you can't predict that, how can you predict future cash flows and earnings? And if you can not do that, how can you determine IV?

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