Owning a Slice of Adobe’s Toll Bridge

February 1, 2008 by Joe Ponzio

On Wall Street, growth and value are anything but joined at the hip. Stocks are typically split into two groups: growth and value. When a growth stock gets hammered down, it becomes a “real bargain” growth stock; when a value stock drops in price, it is a “better value” at the lower price.

So, is Adobe a real bargain, a better value, or a pass?

With 80% market share and a new word in our vocabulary (“googled”), it is safe to say that Google is the internet. I can’t remember the last time I met someone who didn’t know what Google was.

Such is the case with Adobe. Even if you don’t know the company’s name or product line, you have seen and/or used their stuff. You probably have Adobe® Reader® to view and interact with PDF documents. If you’ve ever visited YouTube (e.g., to watch Rick Santelli yelling at Jim Cramer), you’ve seen Adobe® Flash® because you, like 99% of all internet users, have the Flash plugin in your browser.

Adobe equals Design

Photoshop and Illustrator are the standards for photo editing, and hence web image design (pictures don’t get doctored, they are “photoshopped”); Dreamweaver is the standard for drag-and-drop web design; After Effects is the movie-editing tool of choice for web developers and is used in Hollywood for both traditional and animated movies (watch the credits for “After Effects editor”); Acrobat is the tool of choice for creating portable business documents. The list goes on and on.

Suffice it to say, Adobe has a very durable and competitive moat. One of the truly amazing things about this moat is that developers have crossed the moat, and yet their products never truly compete because every non-Adobe design/animation software is seen as a poor man’s fix. (This doesn’t include super high-end, specific software used in video games or movies. Adobe owns the personal and casual market and have decent market share in the super-niche market as well.)

It’s practically an ATM

Adobe generates cash. It’s tough to figure out how much cash it will generate simply because the gigantic Macromedia acquisition from a few years back is still working its way through the financials. Still, Adobe generated about $980 million in owner earnings last year, up from $580 and $540 million in 2006 and 2005, respectively.

When a new Adobe product comes out, people want it – and they pony up the cash. After all, you aren’t going to get an FWA award without After Effects video work or some stunning Photoshop design thrown into Flash.

It is financially sound (some other ratios to look at)

For every dollar of tangible long-term assets, Adobe has just $0.36 of long-term liabilities(1) . The company has no long-term debt (could be good or bad, but “none” is better than “too much”) (2) and generated 21% owner earnings on its equity last year(3).

What does all this mean?

  1. Management is doing a great job of managing the balance sheet and helping secure our claim in the company;
  2. If management doesn’t believe that additional debt will fuel growth, it shouldn’t assume any. In Adobe’s case, this “growth” company seems to realize that rapid growth doesn’t have to be highly leveraged.
  3. The company is utilizing assets well and seems to be well positioned (and durable) should it experience some difficulties.

Price versus Value; Growth versus Value

Though Adobe is typically considered a growth stock, its financial position, dominance, and ability to generate dependable (and perhaps predictable) excess cash makes it look more like a value stock. Of course, why buy “value” stocks if you don’t expect them to grow, and why buy “growth” stocks if their businesses have no value? Buffett said it best:

Growth and value investing are joined at the hip.

Right now, some kids are banging away at computer code, trying to become the next Google. In 10 years, Google went from nobody to leader. Who will be the leader in another 10? But Adobe? This is one of those rare technology companies that have such a durable and broad moat that any competition is going to have to be extremely well funded and large, and will have to survive many years of losses during the software development stages, all while trying to keep up with Adobe’s products, innovations, and possible buy-out attempts.

You can run through the price on your own (see How to Value a Business), but I come up with a value around $44 a share. I was extremely conservative (in my mind, at least) by using a 14% growth rate for 3 years, followed by 12% for 3, followed by 10% for the next 4. And so, throughout 2007, Adobe traded right around its intrinsic value. As the markets tumbled, so did Adobe, and now it appears to be about 25% underpriced.

Is it a steal? Personally, I know the company well and I think my assumptions are on the conservative side. As Buffett said,

It is far better to buy a wonderful business at a fair price than a fair business at a wonderful price.

I’d be happy to buy Adobe today and hang on to it for the long term. Any mistake I made in my valuation will likely work itself out in my margin of safety and through the company’s aggressive stock buyback program. (If I made a valuation mistake and the company was constantly increasing its outstanding shares, I’d be up a certain creek without a paddle.)

Sound business. Largely insulated. Fair price. What are your thoughs?

Sorry for the late post

And I’m sorry for the late post. Today’s snow storm slowed or completely paralyzed the city and knocked me offline for the entire morning.

(Before you load up on Adobe, take a look at this post.)

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