Shares of creative software provider Adobe Systems (NASDAQ:ADBE) advanced more than 5% yesterday, after a nice earnings report and an overall jovial day in the market. But at the company's current price and valuation, its industry may offer better valuations.
Don't get me wrong -- Adobe has quite a few trends working in its favor. I like the industry in general because the business model is very scalable. Software can be sold in almost limitless quantities; once you get past its initial design costs, it's easy to produce and distribute. That leads to plenty of excess capital for widely adopted products. In Adobe's case, its free cash flow has exceeded its reported net income by a wide margin over the past three fiscal years, given the popularity of its Adobe Acrobat, Photoshop, and other products among graphic artists and Web designers.
Adobe also acquires other firms to enhance its appeal to creative types. Last year, it acquired primary rival Macromedia and its coveted Flash Web animation and design technology. First-quarter earnings released yesterday included some merger integration charges, but management was still able to offer upbeat forward guidance, since Adobe is poised to introduce a number of new programs and product upgrades.
So far, so good. But at the current stock price, most of Adobe's upside potential may already be priced into its shares. For starters, it's trading at a lofty P/E of just less than 28 times 2007 expected earnings. That's well above the multiples of larger software titans; Microsoft (NASDAQ:MSFT) trades at just less than 19 times, and Oracle (NASDAQ:ORCL) trades for just more than 18 times forward projections.
Additionally, product introductions are an uncertain time for software firms, since it's always hard to gauge how quickly users will embrace upgrades or new products. Customers may even hold off on purchasing older programs in anticipation of an upgrade, or wait before buying that upgrade to see whether it contains any hidden bugs. This hesitance could cause more volatile results at Adobe, either on the upside or the downside.
At current valuations, I've been gravitating toward the larger firms in the space. Their product diversification and deeper pockets should allow them to ride out the uncertainty that accompanies the software product cycles and acquisitions common in the space. Adobe is a fine firm, but I'd like to see more downside protection before I add the stock to my portfolio.
Further Foolishness in a flash:
- Adobe's Acrobatic Quarter: Fool by Numbers
- Foolish Forecast: Deconstructing Adobe
- Adobe Photoshop, Now Free for the Masses?
- 3 Kings of Cash
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Fool contributor Ryan Fuhrmann is long shares of Microsoft 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.
