Welcome back to our continuing software saga here in the Rule Maker portfolio. In last Friday's episode, I put up a short list of companies that meet the application software description that we will be taking an up-close-and-personal look at during the course of this industry study. Because companies that sell their products to mass consumers are more aligned with the Rule Maker Criteria than those that don't, we'll start out by looking at software producers that sell software that you, me, and all our friends are apt to use. That doesn't mean we aren't interested in other software companies, and it's definitely my intention to hit a wide range of the software industry in this study. So, if you are big fan of Siebel Systems (Nasdaq: SEBL) or Check Point Software (NYSE: CHKP), just hang with us. We'll get to those companies in due time.

For now, I want to look at software companies that the vast majority of PC users will be familiar with. By the way, we're not only looking for established Rule Makers. We're also interested in companies that have the potential to be Rule Makers. Further, if we see some companies that would qualify as Mini-Makers, well, why not take a look at those as well? I've been following the discussion on the Rule Maker Strategies board, and I will definitely be including your ideas for companies to look at in the future. Today, I'll be starting on Adobe (Nasdaq: ADBE), and I intend to hit Electronic Arts (Nasdaq: ERTS), Symantec (Nasdaq: SYMC), and then Intuit (Nasdaq: INTU) after that, although we could get sidetracked by companies that we discover in the meantime.

So, let's get on with our examination of Adobe. We'll start by heading over to Adobe's website at www.adobe.com. Here's a little capsule summary from the "About Adobe" link:

"Founded in 1982, Adobe Systems builds award-winning software solutions for Web and print publishing. Its graphic design, imaging, dynamic media, and authoring tools enable customers to create, publish and deliver visually-rich content for various types of media. The company's products are used by Web and graphic designers, professional publishers, document-intensive organizations, business users, and consumers. Adobe is the fourth largest U.S. based personal software company, with annual revenues of $1 billion. It employs over 2,400 employees worldwide and has operations in North America, Europe, the Pacific Rim, Japan and Latin America. Adobe's worldwide headquarters are in San Jose, California."

The first thing I'll do is pull down Adobe's annual report for 1999. Of course, you'll notice that you have to have Adobe Acrobat software installed on your PC in order to read it. I'll just shoot to the financial statements before we go any further. Even though I already pretty much know what I'll find with Adobe, we should probably start all of our company reviews with the Rule Maker quantitative criteria. This will give us a good indication of what we're dealing with before we invest any more time looking under the hood.

Here's what I get when I calculate our Rule Maker criteria for Adobe's full-year 1999 results: 

Rule Maker Metrics       1999
Annual Sales          $1.015B
Sales Growth            13.5%
Gross Margin            90.6%
Net Income             237.5M
Net Margin              23.3%
Cash-to-Debt          No Debt
Flow Ratio               0.47
Cash King Margin        24.5%

Fools, these are dominating numbers worthy of a Rule Maker, easily exceeding each of our numerical benchmarks:

  • The annual sales of $1.015 billion exceeds our target of $1 billion.
  • The sales growth of 13.5% is safely above our 10% annual growth target.
  • The gross and net margins of 90.6% and 23.3%, respectively, blow away our targets of 50% for gross margins and 7% for net margins.
  • The company has a strong balance sheet, with cash and short-term investments of just under $600 million as of year-end 1999 and no debt.
  • The Flow Ratio is an awesome 0.47, well below our benchmark of 1.25.
  • Finally, Adobe is generating lots of cash, with a Cash King Margin of 24.5%. (Please note that I backed out both "acquisitions of property and equipment" and "additions to other assets" from the Investing Activities presented on page 54 of the annual report.)

One of the things I noticed, though, was the huge percentage increase in Adobe's net income in 1999 over 1998. This got me to wondering how the company was able to improve so much so quickly. Just to be sure we're not dealing with a one-year fluke, let's look back at 1998 and 1997 results. Here they are: 

Rule Maker Metrics       1998       1997
Annual Sales          $894.7M    $911.9M
Sales Growth            -1.9%      15.9%
Gross Margin            88.7%      87.2%
Net Income             105.1M     186.8M
Net Margin              11.8%      20.5%
Cash-to-Debt          No Debt    No Debt
Flow Ratio               0.73       0.78
Cash King Margin         9.6%      14.5%

Based on this information, I would argue that while Adobe did show dramatic improvement, especially in the Flow Ratio and in generating free cash, some of that improvement can be attributed to a rough year in 1998. When comparing 1999 results to the previous two years, one gets a better sense of the true improvement curve. By looking at the strong 1997 results, I can more easily convince myself that 1998 was an aberration in what looks to be a strong trend.

Just to throw out some other data points, return on assets (ROA) was a very impressive 30.3% for 1999, and return on equity (ROE) clocked in at over 45%. For a company with no debt and lots of cash, these are excellent return metrics. Since Adobe has already announced first quarter results, let's just check in and make sure that the company is maintaining the momentum it established in 1999.

According to the earnings press release, also available on Adobe's website, sales jumped 24% in the first quarter to $282.2 million. Net income was $64.6 million in the quarter, ahead of the $38.3 million posted in the first quarter last year. Net margin is therefore 22.9%, and gross margin was an amazing 92.7%. Cash and short-term investments have increased to over $641 million, up from around $598 million last quarter. Since Adobe was nice enough to provide a complete balance sheet for the first quarter results, we can check the Flowie, which came in at 0.43, a 10% improvement over last quarter. In short, Adobe delivered a great first quarter, and it's no mystery why the company's stock price hasn't flagged a bit, rising strongly in the past several weeks despite the negative investor sentiment lately associated with most of the technology sector.

In summary, as Rule Maker investors, we couldn't be happier with Adobe's numbers. Of course, we're not near being done with our analysis of the company. Although the statheads among us will be tempted to crown Adobe a Maker and be done with it, it would likely be a mistake to make a decision without taking the time to learn about the company's products and competitors, and make a determination as to whether this is a company that has expanding possibilities going forward.

Since direction is more important than current location, I want to know what it is about Adobe that got them to this point, but more importantly, I want some insight into what will be the key value drivers in the future. This is the nature of our more subjective Rule Maker criteria, which we'll hit upon next Friday. If you've got some thoughts on Adobe's products, or some insight on the company's competition, give us the good stuff on the Rule Maker Strategies discussion board!

Have a great weekend!