On Dec. 31, Lee Ainslie (Trades, Portfolio) reported adding to Adobe Systems Inc. (ADBE, Financial). So let's take a look at this company in an industry that is highly competitive and characterized by rapid changes in technologies and software and in customer preferences.
Changing Its Business Model
Adobe 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. It operates three segments: Digital Media, Digital Marketing, and Print and Publishing.
A key driver for growth is shifting its business model away from sales of licenses to cloud and subscription services. The firm's launch of Creative Cloud (for $50 a month) allows consumers to pay a monthly fee to subscribe to various Creative Suite applications like Photoshop, Illustrator, Dreamweaver and others. Cloud-based service seems to be good to consumers because they can always have access to the most recent updates and to online storage. We think this new model, apart from improve profitability, will also generate predictability. We have to take into consideration as well that switching costs have gone down so it is easier to switch to competing platforms.
Digital Marketing & Acquisitions
Acquisitions have been a key part of Adobe's expansion. In 2011, the company made six acquisitions and two asset purchases. In 2012, the firm bought Efficient Frontier, as well as other companies such as Omniture, Day Software, Demdose and Auditude. The last acquisition was the Paris-based Neolane, searching for multi-channel campaign management capabilities.
Relative Valuation
In terms of valuation, the stock sells at a trailing P/E of 120.5x, a premium compared to an average of 23.8x for the industry. To use another metric, its price-to-book ratio of 5.1x also indicates a premium versus the industry average of 2.5x, and the price-to-sales ratio of 8.6x is above the industry average of 1.93x. All these metrics indicate that the stock is relatively overvalued relative to its peers.
Earnings per share (EPS) have experienced a decline in the most recent quarter compared to the same quarter a year ago. Also, they have demonstrated a downward trend over the past three years which is a bad signal. We include in the next graph the stock price because EPS often lead the stock price movement.
Finally, I always like to see one of the most important financial ratios applying to stockholders, the best measure of performance for a firm's management: the return on equity. The ratio has greatly decreased when compared to its ROE from the same quarter one year prior. This is a signal of weakness and is not attractive for investors.
Let's make a comparison in the next table:
| Ticker | Company | ROE (%) |
| ADBE | Adobe Systems | 4,3 |
| AAPL | Apple Inc. | 30 |
| MSFT | Microsoft Corporation | 27,7 |
Adobe´s ROE is lower than that of Apple (AAPL, Financial) and Microsoft Corporation (MSFT, Financial). Furthermore, it is lower than the industry mean of 6.9%.
Final Comment
As we have seen, the fact that the stock is now selling for more than it peers is not reason enough to justify a sell at this time. But we have covered multiple weaknesses throughout the article which are warning signals to keep in mind if we are long in the company.
Hedge fund managers have also been active in the company. Gurus like George Soros (Trades, Portfolio), Stanley Druckenmiller (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio) and Steven Cohen (Trades, Portfolio) have invested in it. On the other side, Jim Simons (Trades, Portfolio), Jeff Ubben (Trades, Portfolio), Andreas Halvorsen (Trades, Portfolio), John Hussman (Trades, Portfolio) and the funds Primecap Management, Pioneer Investments (Trades, Portfolio) and Dodge & Cox reduced or sold a position in the last quarter of 2013.
Disclosure: Victor Selva holds no position in any stocks mentioned.
