I'm a believer in growth stocks. As an analyst for our Motley Fool Rule Breakers service, I think you should be a believer too. But even I have to admit some growth stories are bogus, hence this regular series.
Next up: Adobe Systems (Nasdaq: ADBE). Would it make sense for Microsoft (Nasdaq: MSFT) to buy this maker of graphics and web software, as the rumor mill is suggesting? Let's get right to the numbers.
Foolish facts
|
Metric |
Adobe Systems |
|---|---|
| Motley Fool CAPS stars (out of 5) | *** |
| Total ratings | 2,076 |
| Percent bulls | 94.9% |
| Percent bears | 5.1% |
| Bullish pitches | 339 out of 363 |
| Highest rated peers | Intuit, Nuance Communications, Autodesk (Nasdaq: ADSK) |
Data current as of Oct. 8.
For those who didn't see the headlines yesterday, analysts and talking heads took to the web and television to report that Mr. Softy was mulling a bid for Adobe, sending the shares 11% higher on the day. The stock is giving back some of those gains as I write this.
Technically, there's merit to this combination. Microsoft has been slow to adopt the HTML5 standard that both Apple (Nasdaq: AAPL) and Google (Nasdaq: GOOG) back, remaining mostly supportive of Adobe's Flash video playback system while also creating its own, called Silverlight. Combining them under one roof would give Mr. Softy a hammerlock on video playback technology as the transition to HTML5 continues.
Also, it could allow Microsoft to distinguish its phones and tablets as compatible with standards that Apple, in particular, has been lax to support. (Namely, Flash and Silverlight.)
So a deal could make sense, but at what price? Adobe's closed at $28.69 a share, for an implied market cap of roughly $14.9 billion. Microsoft CEO Steve Ballmer certainly has the ability to pay that much, but should he? I'm not convinced.
The elements of growth
|
Metric |
Last 12 Months |
2009 |
2008 |
|---|---|---|---|
| Normalized net income growth | (0.6%) | (30.6%) | 16.3% |
| Revenue growth | 14.4% | (17.7%) | 13.4% |
| Gross margin | 89.3% | 89.9% | 89.9% |
| Receivables growth | 71.9% | (12.1%) | 46.9% |
| Shares outstanding | 518.7 million | 522.7 million | 526.1 million |
Source: Capital IQ, a division of Standard & Poor's.
Why? This table shows growth in all the wrong places. Let's review:
- First, gross margin, while high, is declining. Adobe may be losing its once-vaunted pricing power in key areas such as graphic design software.
- Revenue growth has returned, thankfully, but earnings growth hasn't. It's as if the untold millions Adobe has spent on share buybacks has had no effect.
- Finally, receivables are growing far faster than revenue, just as margins are declining. This suggests discounting, which only works when you're the low-cost provider. Historically, cheap software hasn't been Adobe's forte.
Competitor and peer checkup
|
Company |
Normalized Net Income Growth (3 yrs.) |
|---|---|
| Adobe | 2% |
| Apple | 55% |
| Autodesk | (18.8%) |
| Eastman Kodak (NYSE: EK) | 25.7% |
| 25% | |
| Microsoft | 8.1% |
| Yahoo! (Nasdaq: YHOO) | (3.6%) |
Source: Capital IQ. Data current as of Oct. 7.
We don't need to say much here, do we? Adobe ranks among the industry laggards, despite its market-leading position in video-playback technology and graphic-design software. Barring a breakthrough innovation, the stock appears fairly valued, at best.
Grade: Unsustainable
But I don't expect valuation to stop Microsoft. The competitive dynamics of the smartphone and cloud-computing markets have forced Mr. Softy to suit up for battle, and the company's $36 billion war chest is one of its chief weapons. Acquiring Adobe at a premium may be the company's only logical move -- if, that is, regulators were inclined to approve such a deal, which they may not be.
Either way, I don't like Adobe at these levels. There's too much speculation and not enough competitive advantage. As a result, I'm making a short-term underperform call on the stock in my CAPS portfolio.
Now it's your turn to weigh in. Do you like Adobe Systems at these levels? Let the debate begin in the comments box below. You can also ask Tim to evaluate a favorite growth story by sending him an email, or replying to him on Twitter.
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