Adobe Aims to Compete

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While reviewing Adobe's (Nasdaq: ADBE) latest quarter, I was surprised to find that 30% of the software companies in my portfolio no longer exist. We mostly have Oracle to thank for absorbing the likes of PeopleSoft and Siebel Systems; its buying spree may not be finished yet, since it's rumored that Larry Ellison's software juggernaut has previously shown interest in BEA Systems (Nasdaq: BEAS). Symantec (NYSE: SYMC) recently snapped up Veritas, while Adobe itself just completed its acquisition of Macromedia. What's with all the acquisitions -- and is Adobe the next juicy target?

There are three primary explanations for the software buying spree. First, the acquirers have sought to purchase faster-growing competitors to supplement slowing organic (or internal) growth. Second, the software business is extremely profitable once development costs are out of the way, which allows the more established firms to throw off plentiful free cash flow. Lastly, with excess capital on hand, the acquirers may seek to protect their growth by buying competitors simply to keep the out of the hands of others -- especially neighborhood bully Microsoft (Nasdaq: MSFT). Adobe has been no exception, but while it's probably one of the firms most fearful for the safety of its business, it's not currently concerned about becoming someone else's acquisition.

Looking at Adobe's recent results, we see that revenue came in slightly below management's goals, in a further confirmation of its increasing slowdown. A clear take on earnings was difficult, primarily because of Macromedia-related charges, but the overall quarter looked rather lackluster. Even worse, the company reduced its outlook for the year; it now expects non-GAAP earnings per share of $1.20-$1.25, down slightly from $1.26-$1.30. The new outlook represents a forward P/E of about 24, representing the low end of Adobe's five-year P/E range.

To keep Adobe's stock price rising, the company must successfully complete the Macromedia purchase, enhancing its growth profile with the graphics-software clout gained from the addition of Macromedia's popular Flash animation software. Buying Macromedia was intended to help continue Adobe's dominance of software for creative professionals in the face of increasing competition from Microsoft. But Microsoft is also moving against Adobe's dominance of its namesake Adobe Acrobat portable document file (PDF); the House of Gates plans to offer a PDF creation tool with Office 2007. Given that Acrobat accounts for roughly one-third of total Adobe sales, it's no surprise that Adobe's made rumblings about getting its lawyers involved, perhaps to play the "bundling" monopoly card that's given Microsoft trouble in the past.

Adobe is a very profitable company with solid Acrobat, Photoshop, and Creative Suite software platforms and strong free cash flow generation. It has a decent growth outlook, but so do a number of other companies in the software space. As a result, you may also want to consider industry leaders Microsoft and Oracle, not to mention Symantec, which has similar concerns about Microsoft's plans to bundle free antivirus software with future versions of Windows. It's a tough call, since these three firms have a much lower forward P/E than Adobe, with equally compelling outlooks.

The positive for Adobe is that its premium valuation will likely keep it out of potential suitors' hands. In addition, the industry's cutthroat dynamics offer downside protection for investors, since any serious missteps by the company could result in a quick acquisition offer. That might make it more difficult for new shareholders to gain a substantial margin of safety, but any pullback to the mid-$20s range could prove to be a good entry point for longer-term investors.

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Fool contributor Ryan Fuhrmann is long shares of Symantec but has no financial interest in any other company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.