Shares of software giant Adobe Systems (ADBE 1.27%) have soared over the past three years, nearly tripling during that time. The company is betting big on the cloud, moving to a subscription-only business model for both its dominant creative software and its digital marketing products, and investors so far have clearly been supporting this move. But with competitors like Corel Corporation attempting to take advantage of Adobe's shunning of perpetual licenses, and with Salesforce (CRM 1.30%) making big acquisitions in order to break into digital marketing, is now the time to buy Adobe stock?
Plenty of competition
Adobe's main business is its suite of creative software products, such as Photoshop and Illustrator. These products have become industry standards, and because of this, Adobe has been able to achieve operating margins in excess of 20% over the past decade. But with the company no longer offering traditional perpetual software licenses for new versions of its products, instead pushing customers toward subscriptions, this opens up a window for competitors.
Corel Corporation, a privately held company based in Ottawa, is one such competitor. The company's CorelDRAW product is a direct competitor to Adobe's Illustrator, and by continuing to offer perpetual licenses in addition to subscription options, Adobe customers who tend to upgrade infrequently could be drawn to Corel's offering.
During fiscal 2013, Adobe's revenue from its digital media segment, which contains its creative products, declined by 15% as perpetual license sales decreased and subscription sales increased. This isn't surprising, given that it takes a few years before total revenue from the subscription product matches that of a perpetual license, so there's no reason to worry just yet. But over the next few years, as the transition continues, it will become clear if Adobe is losing market share, or if going subscription-only was the right move.
Adobe's other major business is its digital marketing segment, offering digital marketing and analytics solutions. Revenue from digital marketing grew by 13% in 2013 to $1.23 billion, with 26% marketing cloud growth offsetting declines in legacy products. Digital marketing is now 30% of Adobe's business, up from 22% in 2011.
One of Adobe's largest competitors in this space is Salesforce, a company known mainly for its customer relationship management software. In 2013, Salesforce paid $2.5 billion for ExactTarget, greatly expanding its digital marketing capabilities. Adobe has the key advantage of being able to offer content creation tools in addition to marketing tools, but it does lack its own CRM solution. Salesforce doesn't break down sales by product, although CEO Mark Benioff recently stated that its marketing cloud would soon account for $1 billion in annual revenue, putting it close in size to Adobe's digital marketing segment.
An expensive stock
Adobe's stock currently trades at a mesmerizing P/E ratio of 140, although this is mainly due to the sharp decline in revenue in 2013 related to the transition to a subscription-based model. Using earnings from 2012, the P/E ratio comes out to about 43. Salesforce has been unprofitable on a GAAP basis for the past three years, however both Salesforce and Adobe trade between 8 and 9 times trailing-12-month sales.
The benefit Adobe has over Salesforce is the cash-cow status of its creative software, although the transition to subscriptions is taking a toll, at least temporarily. Adobe's marketing business is growing quickly, but whether that can generate the same level of margins as the creative business remains to be seen. Adobe's operating margin declined from 35.5% in 2004 to 26.8% in 2012, with a huge drop to 10.4% in 2013.
Even if Adobe can recover and reach previous levels of profitability quickly, the stock still seems extremely expensive. There's no dividend despite the company averaging more than $1 billion in free cash flow in each of the past five years, and ever-growing levels of stock-based compensation have led to the $3.4 billion Adobe has spent over the past five years on share repurchases only reducing the diluted share count by about 3.4%. A nosebleed valuation along with actions that don't appear to be very shareholder-friendly are two very good reasons to avoid buying shares of Adobe today.
The bottom line
Adobe is a great company with ubiquitous products and plenty of room for growth, but the price is simply far too high to recommend buying the stock today. Couple that with much of the free cash ultimately going toward offsetting the dilution caused by stock-based compensation, and investors buying the stock today seem to be getting a raw deal.
