Adobe´s Business Model Looks Good

In this article, let's take a look at Adobe Systems Inc. (ADBE, Financial), a $35.58 billion market cap company that provides a line of software and services used by marketers, knowledge workers, application developers, enterprises and consumers. The company markets and licenses its software to enterprise customers through its sales force and to end users through app stores and its website.

Pricing model

The company is shifting its business model away from sales of licenses to cloud and subscription services. It launched the Creative Cloud (for $50 a month) which allows consumers to pay a monthly fee to subscribe to various Creative Suite applications like Photoshop, Illustrator, Dreamweaver and others. The transition to the cloud with a subscription pricing model is effective for it and also maintains frequent updates. This is great for consumers because they can always have access to the most recent updates and to online storage. This new model will also generate predictability and a more stable pattern of cash flows.

We must say that competitors offer cheaper alternatives and switching costs have gone down, so it is easier to switch to competing platforms.

Acquisitions

In order to expand and search for new opportunities, the company has made several acquisitions in the past years.

In 2011, the company made six acquisitions and two asset purchases. In 2012, the firm bought Efficient Frontier. Other acquisitions were: Omniture, Day Software, Demdose, Auditude. The last acquisition was the Paris-based Neolane, searching for multi-channel campaign management capabilities.

Revenues, margins and profitability

Looking at profitability, revenue growth by 5.7% led earnings per share increased in the most recent quarter compared to the same quarter a year ago ($0.17 vs $0.15). During the past fiscal year, the company reported lower earnings of $0.57 versus $1.66 in the prior year. This year, the market expects an improvement in earnings ($1.23 versus $0.57).

Finally, let´s compare the best measure of performance for a firm's management: the return on equity. The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

The company has a current ROE of 4.31% which is lower than the industry peers. In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment. So for investors looking for those levels or more, SAP SE (SAP, Financial) could be the option. It is very important to understand this metric before investing, and it is important to look at the trend in ROE over time.

Relative Valuation

In terms of valuation, the stock sells at a trailing P/E of130.8x, trading at a premium compared to an average of 47.1x for the industry. To use another metric, its price-to-book ratio of 5.73x indicates a premium versus the industry average of 2.92x while the price-to-sales ratio of 8.9x is above the industry average of 2.36x. All these metrics indicate that the stock is relatively overvalued.

As we can see in the next chart, the stock price has an upward trend in the five-year period. If you had invested $10,000 five years ago, today you could have $21,714, which represents a 16.8% compound annual growth rate (CAGR).

The stock price increased by 59% over the past year, and we feel this has driven it to a level that is now expensive compared to the industry.

Final comment

As outlined in the article, the products are the “industry standard” for creative professionals. With respect to the pricing model, we can say that monthly subscription gives more predictive revenue stream.

So, I would recommend adding this stock to long-term portfolios. Hedge fund gurus like Louis Moore Bacon (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Steve Mandel (Trades, Portfolio), Lee Ainslie (Trades, Portfolio) and Ray Dalio (Trades, Portfolio) added this stock to their portfolios in the second quarter of 2014.

Disclosure: Omar Venerio holds no position in any stocks mentioned