Is Adobe Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Adobe (NASDAQ: ADBE  ) fit the bill? Let's take a look at what its recent results tell us about its potential for future gains.

What we're looking for
The graphs you're about to see tell Adobe's story, and we'll be grading the quality of that story in several ways:

  • Growth: Are profits, margins, and free cash flow all increasing?
  • Valuation: Is share price growing in line with earnings per share?
  • Opportunities: Is return on equity increasing while debt to equity declines?
  • Dividends: Are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let's take a look at Adobe's key statistics:

ADBE Total Return Price Chart

ADBE Total Return Price data by YCharts.

Passing Criteria

3-Year* Change

Grade

Revenue growth > 30%

30.5%

Pass

Improving profit margin

14%

Pass

Free cash flow growth > Net income growth

31.1% vs. 48.9%

Fail

Improving EPS

55.7%

Pass

Stock growth (+ 15%) < EPS growth

46.1% vs. 55.7%

Pass

Source: YCharts. * Period begins at end of Q2 (May) 2010.

ADBE Return on Equity Chart

ADBE Return on Equity data by YCharts.

Passing Criteria

3-Year* Change

Grade

Improving return on equity

11.8%

Pass

Declining debt to equity

(24.7%)

Pass

Source: YCharts. * Period begins at end of Q2 (May) 2010.

How we got here and where we're going
Adobe comes through with flying colors, earning six out of seven passing grades. Its only failure occurred because net income growth outpaced free cash flow, though its current free cash flow is nearly twice as high in nominal terms as its net income. Adobe's impressive share-price rebound, which began in mid-2011, is still moderate enough on a longer timeline to fall below the growth of the company's earnings per share, which is a great sign for future returns. This is a strong performance, but can Adobe keep up the progress? Let's dig a little deeper to find out.

Fool contributor Richard Saintvilus notes that Adobe has accelerated its transition from its long-standing permanent software license model to a cloud-based services setup. The company now offers online subscriptions of its Creative Suite software. Since then, it has produced half a million paid subscribers, a number expected to reach 1.25 million by the end of the year. However, this shift has crimped near-term growth, and it may take some time for the company to surpass its old sales levels.

Adobe has also been diversifying into other cloud-based services beyond its flagship Creative Suite in both domestic and international markets. Adobe recently acquired a privately held French company, Neolane, for a price of $600 million in cash, to establish a presence in online marketing services. Adobe also bought out Ideacodes, which designs and creates user interfaces for smart applications, digital products, and networked communities. These bite-sized buyouts could produce worthwhile revenues streams in the future, but Adobe will have to avoid spreading itself too thin. Fool analyst Evan Niu also notes that Adobe recently acquired a small mobile app developer, Thumb Labs, to bolster its presence in the social and mobile spaces.

Putting the pieces together
Today, Adobe has many of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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