Not a peep about Adobe?! What a fantastic quarter. Below is the Smith Barney Citigroup upgrade of ADBE.
Doughboy.
Smith Barney Citigroup Research
ADBE: Strong quarter, raising ests, price target and rating to Buy
Adobe Systems Inc (De)(ADBE)
Rating: 1H
As of 03/20/2004
Last Changed 03/18/2004
Smith Barney Citigroup Research ~ March 19, 2004
Printable PDF Version
Adobe Systems Incorporated (ADBE)
Smith Barney
See Appendix A-1 for Analyst Certification and Important Disclosures
Smith Barney is a division of Citigroup Global Markets Inc. (the 'Firm'),
which does and seeks to do business with companies covered in its research
reports. As a result, investors should be aware that the Firm may have a
conflict of interest that could affect the objectivity of this report.
Investors should consider this report as only a single factor in making
their investment decision.
ADBE: Strong quarter, raising ests, price target and
rating to Buy
BUY (1)
High Risk (H)
Mkt Cap: $8,839 mil.
March 18, 2004 SUMMARY
* Adobe reported a strong quarter, with revenues and EPS
APPLICATION well above Smith Barney and Street estimates, driven by
SOFTWARE strong Creative Suites results.
Tom Berquist * Business momentum continues to be better than expected,
and the company has raised FY04 guidance twice since late
January.
Lewis Kaufman, * Given the outperformance and our views that PC/Apple
CFA unit demand will remain strong for the balance of 2004
(thereby positively impacting application sales) and a
strengthening economy will add creative professional
jobs, we are raising our FY04/FY05/FY06 estimates.
* A component of our valuation approach has changed from
a Peak/Trough PE analysis to a discounted five-year
forward PE analysis.
* We are raising our price target from $40 to $47 and
upgrading our rating from Hold to Buy.
FUNDAMENTALS
P/E (11/04E) 24.0x
P/E (11/05E) 21.7x
TEV/EBITDA (11/04E) 16.2x
TEV/EBITDA (11/05E) 14.3x
Book Value/Share (11/04E) $5.01
Price/Book Value 7.2x
Revenue (11/04E) $1,553.0 mil.
Proj. Long-Term EPS Growth 12%
ROE (11/04E) 3080.0%
Long-Term Debt to Capital(a) NA
ADBE is in the S&P 500(R) Index.
(a) Data as of most recent quarter
SHARE DATA RECOMMENDATION
Price (3/18/04) $36.27 Rating (Cur/Prev) 1H/2H
52-Week Range $45.83-$30.55 Target Price (Cur/Prev) $47.00/$40.00
Shares Outstanding(a) 243.7 mil. Expected Share Price Return 29.6%
Div(E) (Cur/Prev) $0.05/$0.05 Expected Dividend Yield 0.1%
Expected Total Return 29.7%
EARNINGS PER SHARE
FY ends 1Q 2Q 3Q 4Q Full Year
11/03A Actual $0.25A $0.28A $0.28A $0.34A $1.12A
11/04E Current $0.50A $0.38E $0.31E $0.32E $1.51E
Previous $0.41E $0.29E $0.26E $0.34E $1.30E
11/05E Current $0.39E $0.40E $0.42E $0.46E $1.67E
Previous NA NA NA NA $1.37E
11/06E Current $0.44E $0.45E $0.47E $0.49E $1.84E
Previous NA NA NA NA $1.47E
First Call Consensus EPS: 11/04E $1.43; 11/05E $1.48; 11/06E $1.62
OPINION
ADBE reported a strong quarter, with revenues and EPS of $423.3 million and
$0.50 exceeding our estimates of $395.0 and $0.41, Street estimates of $395.2
and $0.40, and ADBE's mid-quarter revenue guidance (raised in late January)
of $380 - $405 million and EPS guidance of $0.36 - $0.42. The company was
also assisted by a lower tax rate (adding $0.01 to EPS). The remainder of the
upside was driven primarily by strength in the company's Creative
Professional suite of products, with revenues in the segment up 48%
sequentially and 84% year-over-year to $107.0M. The company also saw
strength in its Intelligent Documents (ePaper) line of business, with
revenues of $130M up 10% sequentially and 43% YoY. Performance in this
segment was stronger on the desktop side of the business, with revenues up
10% sequentially and 44% year-over-year to $109M; while growth on the
enterprise side was similar in percentage terms, it came off of a much
smaller base and was up only $1.8M sequentially and $5.9M YoY to $21.3M.
The company noted strong performance across all geographies; EMEA increased
to 34% of revenues (versus 31% last quarter) on both strong demand and
currency effects, with Americas representing 43% of revenue and APAC back up
to 19% of revenue. Cash flow from operations came in at $179.4M, with the
company's overall cash and ST investments up to $1.249 billion. DSOs were
down to 28 days (from 37 days last quarter) due to the overseas launch of
Creative Suite early on in the quarter, strong collections on outstanding
receivables from Q4, and a decision to bring inventories below historical
levels due to given their lack of experience with CS sales. This decision and
the resulting lean inventories should bode well for May results.
NEW SMITH BARNEY ESTIMATES
The company guided revenues for the May quarter to a range of $365M to $385M
and EPS to a range of $0.33 and $0.39, with R&D expected to make up 19-20% of
revenue, sales and marketing 32-34%, and G&A 9-10%. The company expects its
share count to be in the 247-249M share range. Our estimates are generally
consistent with this guidance, though our revenue estimates (and in turn our
EPS estimates) are at the high end of this range due to our belief that the
economy continues to accelerate in ADBE's creative professional end markets.
For the full year, the company increased its revenue guidance to between
$1.48 to $1.50 billion (up 14-16% YoY) from $1.43 billion, and set EPS
guidance at $1.40-$1.46 on operating margins of 31-32% (up from a 30% target
previously). Our FY04 estimates assume operating margins of 32%.
In light of the company's strong performance this quarter and management's
new guidance for May, we are raising our 2Q04 revenue estimate to $383.5
million, versus $347.0 million previously. Our EPS estimate increases to
$0.38, versus our prior estimate of $0.29, and we regard management's
guidance for May as conservative. For FY04, FY05 and FY06, our revenue
estimates increase to $1,553.0, $1,695.0 and $1,882.0 million, versus our
previous estimates of $1,437.0, $1,520.0 and $1,593.5 million. We note that
our FY04 revenue estimate is approximately $50 million above the high end of
management guidance due to our belief that Adobe will continue to benefit
from an improving economy (to which ADBE's end markets are particularly
sensitive) and CS adoption for the balance of the year. Our EPS estimates for
these periods increase to $1.51, $1.67 and $1.84, versus our previous
estimates of $1.30, $1.37 and $1.47. We believe that the current CS cycle may
have a longer tail than in past cycles due to the fact that the Adobe user
community is still becoming familiar with the Creative Suite, which was not
available prior to its launch this winter.
DETAILED ANALYSIS OF THE QUARTER
The upside in the quarter was driven by strength in the Creative Professional
segment (and in particular the Creative Suites (CS) product), which at $158
million was up 47.8% sequentially. The company also stated that channel
inventories were low as the company continues to remain cautious on 2Q sell
through given their lack of experience with CS sales. As we have said
earlier, our fear has been that CS would cannibalize sales of standalone
Photoshop and Illustrator products, however the company maintained that those
products exceeded estimates as well (NPD data has shown some declines in
standalone sales as CS sales have grown). Given these results, it seems that
CS is net adding revenue and margin to the business and so we appear to have
been too conservative in our views.
The demand drivers for CS should remain strong for the balance of 2004.
Businesses (particularly small businesses) and consumers are upgrading their
personal computers and many appear to be adding and/or upgrading applications
as they do so. This upgrade cycle is particularly strong on the Apple (AAPL,
$25.67; 3H, covered by Richard Gardner) Macintosh platform where in addition
to purchasing new hardware, users are also purchasing OS X, a relatively new
operating system that offers an improved user experience and better
performance. The new CS suite uses OS X and, as a result, it appears that
Adobe products are driving Mac purchases and vice versa. We note that the
Macintosh platform gained share from Windows in the quarter, jumping to 29%
of sales from 27% last quarter and 26% for all of FY2003. Surprisingly,
customers continue to buy more "premium" bundles than "standard" bundles. In
addition, the company believes it is gaining share from Quark (IPG, an
advertising agency) is coming back for more licenses.
In addition, with the upturn in the economy, advertising services are picking
up and that should cause incremental hiring on the creative design side of
these businesses. Historically, there has been a strong positive correlation
between advertising agency stock performance and Adobe stock performance.
Since ADBE is no longer a pure creative design application provider this
correlation will likely be weaker in the future, however, more than half the
company's revenue continues to come from this area and so we continue to
monitor the advertising market.
The news on the enterprise product segment was also good, though not as good
as on the creative professional segment. Intelligent document initiatives
(ePaper, etc.) continue to gain traction and grew approximately 10%
sequentially. The client side of the business grew slightly faster than the
server side of the business on a much larger base. In discussions with
management, it is still not completely clear to us why an organization would
use intelligent forms processing as the "front end" for a custom developed
application versus a more open HTML/web form front end. This may explain why
the server side of the business has remained at relatively low levels over
the past five quarters (21.3m, 19.5m, 17.5m, 16.5m, 15.4m). However, the
average server size is growing, and the company is forming partnerships with
application server/web application infrastructure software providers, so the
technology appears fairly complementary today. We believe the business will
continue to grow, however, we are still trying to understand the size of the
opportunity and the potential for competitive overlap with other
infrastructure providers over time. We intend to spend more time with the
company and its customers in this area in order to better quantify what could
be a big enterprise opportunity going forward.
Consumers/hobbyists continue to purchase/use the company's products, however,
they continue to be fairly price sensitive. Currently this area is not
material to the company's revenues, and we don't expect it to become material
in the near term.
VALUATION
Our new $47 target price for Adobe (revised from $40) is based upon a
combination of our P/E and DCF-based methodologies. Please note that we have
changed several components of our valuation methodology. While we still use
a DCF for valuation, we have raised our WACC from 8.0% to 11.0% due to our
view that the previous WACC was low compared to WACCs for our other software
companies. Separately, we have changed our second valuation approach from a
peak/trough PE analysis to a discounted five year forward PE analysis, which
gives us the ability to look at more normalized operating margins for the
company and which is consistent with our valuation approach for the other
companies we cover. Both valuation approaches are described in greater detail
below.
For our DCF analysis, we employed a risk-free rate of 4.0%, a beta of 1.40, a
WACC of 11.0% and a terminal FCF multiple of 12.5x. Our terminal free cash
flow multiple is derived from our aforementioned WACC calculation of 11.0%
and a growth rate of 3% in perpetuity. This analysis suggests a value of
$47.05 per share.
For our P/E-based methodology, we first attempted to determine the
appropriateness of a premium P/E multiple going forward. Software companies
have historically traded for a 1.4x premium to the broader market on a P/E
basis. In our view, this premium is warranted, as supported by our FCF yield
analysis. Software companies have very low capital requirements, as
virtually all investment (i.e., research and development (R&D)) flows through
the income statement. By contrast, for companies outside of software,
reinvestment takes the form of both R&D and capex, with costs flowing through
both the cash flow and income statements. In our view, this is why P/E
multiples are significantly higher for the software industry than for the
broader market. In our analysis, we compared the FCF yield for the software
group to the FCF yield of a basket of other companies with high returns on
capital, high profit margins, low financial leverage, and significant amounts
of intellectual property (Coca Cola, IBM, Intel, Johnson & Johnson (Not
Rated), Merck, 3M, Proctor & Gamble, and United Technologies). We found that
the ratio of FCF to net income for software companies as a group is 2.4:1.0,
versus 1.1:1.0 for our basket of IP-based companies. We also found that the
software group trades at only a very modest premium to our basket of IP-based
companies (4.2% versus 4.7%), where a premium is defined as a lower FCF
yield. This compares to an average forward four-quarter P/E multiple of 36x
for the software companies we looked at, versus 20x for the aforementioned
basket, further suggesting that high P/E multiples for the software industry
are justified based on the group's strong cash generation characteristics.
We believe this analysis provides strong support for the continuation of the
historical premium of the software group to the broader market. For this
reason, we use target P/E multiples that are above the valuation for the
broader market.
Based on the above supporting analysis, we projected net income five years
forward based on a 5-year revenue CAGR of 10.5%, a normalized operating
margin of 35.0% (which assumes only modest improvements 32.0% operating
margin we project for Adobe in FY04), and a tax rate of 30%. We then applied
a multiple of 28x to this net income projection and discounted this number to
the present, which suggests a stock price of $46.78. As noted in our FCF
discussion above, software companies have historically traded at a premium of
1.4x to the broader market, implying a multiple of 25.2x for the software
group based on today's S&P 500 multiple of 18x; our target multiple of 28x
for ADBE is based on a modest premium to the software group, which we believe
is warranted due to significant brand awareness and product leadership in the
company's core markets and the likelihood that the company will be able to
continue increase sales to its installed base of creative professionals and
corporate customers over time.
RISKS
We rate Adobe High Risk primarily based on the company's high price
volatility, which in our view more than outweighs the more medium risk of
Adobe's market capitalization and earnings stability. There are numerous
risks to our outlook. First, ePaper segment revenue growth requires Adobe to
execute well in penetrating the enterprise market, an area where it has
comparatively less experience than it does in the graphic arts market.
ePaper revenues are 35% of total Adobe revenues but account for 44% of
revenue growth we project in 2004. Second, in key Photoshop products such as
Elements, Adobe has recently suffered selling price declines as competitors
have become more aggressive in the space, and in others such as Album
freeware could pose an increasing risk to company revenue growth. The
Photoshop franchise (Photoshop, Elements and Album) comprises 24% of total
revenues we forecast for 2004. Finally, while we believe Adobe's ePaper
initiative holds promise, it is still not completely clear to us why an
organization would use intelligent forms processing as the "front end" for a
custom developed application versus a more open HTML/web form front end.
If the impact on the company from any of these factors proves to be greater
than we anticipate, the stock will likely have difficulty achieving our
target price. Likewise, if any of these factors proves to have less of an
effect than we anticipate, the stock could materially outperform our target.
INVESTMENT THESIS
We rate ADBE shares 1H (Buy, High Risk). Recent earnings reports from HP,
INTU, MSFT, SYMC and others suggest that consumer and SMB (Small and Medium
Business) demand through the retail channel remains robust and could remain
so for longer than we had anticipated earlier this year. Given Adobe's
significant consumer/SMB exposure in its Digital Imaging and Creative
Professional business lines (59% of total revenues in FY03), this is good
news. While we continue to harbor some concerns about the company's decision
to bundle Photoshop in last year's CS launch (given the possibility that
strong CS sales may not fully offset the impact from lower standalone
Photoshop sales, which occur at a higher price point), recent results have
been encouraging. It does appear that CS sales are net positive to revenue
and EPS. In addition, the company should see stronger demand for its
products as the economy improves, particularly in its key end markets of
advertising, marketing, print and digital media production. We also believe
that the company could be well positioned in 2004 and beyond in the larger
enterprise software sector as enterprise spending returns. The company is
gaining traction in large enterprise accounts as a result of its ePaper
initiative, with the company well positioned for key secular trends including
paperless workflow for government/corporate customers; we expect continued
investment in this area to enhance the company's longer-term growth
prospects. We note that the company's enterprise products appear to be
complementary to other enterprise infrastructure products today, however,
there could be overlap in the future as BEA, IBM, and other application
infrastructure providers continue to broaden their presentation management
capabilities.
COMPANY DESCRIPTION
Founded in 1982, Adobe Systems Incorporated is the second largest software
manufacturer, and builds award-winning software solutions for Network
Publishing, including web, print, video, wireless, and broadband
applications. Its graphic design, imaging, dynamic media, and authoring
software tools enable customers to create, manage, and deliver visually-rich,
reliable content. Photoshop, Illustrator, and Acrobat with PDF, are three of
its best known products, and make up roughly 27%, 8%, and 22% respectively,
of total sales in 2002, which reached $1.2 billion.
ANALYST CERTIFICATION APPENDIX A-1
I, Tom Berquist, hereby certify that all of the views expressed in this
research report accurately reflect my personal views about any and all of the
subject issuer(s) or securities. I also certify that no part of my
compensation was, is, or will be directly or indirectly related to the
specific recommendation(s) or view(s) in this report. |
