Why It's Time To Sell Adobe Ahead of Earnings

Richard is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Software giant Adobe (NASDAQ: ADBE) is in the midst of doing something that is rarely successful on Wall Street – change its business model. The company wants to convince investors that it can successful migrate from selling individual pieces of software to a cloud-based subscription model. But will it work? As evident by the new 52-week high gained in the stock investors seem to believe it can. Still, does it deserve a P/E ratio of 23 - in my opinion, an expensive valuation.

Q3 growth was unimpressive

While a high multiple is not that all uncommon for tech companies such as Adobe, but it is almost twice the valuation of Microsoft (NASDAQ: MSFT) – who by the way, has a software portfolio that compares favorably. Likewise, while the Street is giving Adobe the benefit of the doubt now, I worry that free software alternatives from the likes of Google (NASDAQ: GOOG) will soon chip away at Adobe’s profits and add margin pressure. But for investors, will it be too late?

I like Adobe, but I just don’t like the stock at this level. Too, the company’s growth trend doesn’t support the current premium that the stock commends. For instance, in its third quarter report, the company logged a 7% increase in revenue with roughly 5% organic growth. While that might be perceived ok, it represented a 4% sequential decline in revenue.

On the other hand, the company was able to grow its digital media and digital marketing segments by 3% and 21% respectively. As well, a 2% increase in operating income is nothing to be disappointed about – especially in tough macro climates. Still, it doesn’t appear that the transition from boxed software to a subscription model is “hiccup-free.”

Although this might have been unfair to expect, nonetheless, revenue declines in core business segments (regardless of reason) can’t be ignored. This is certainly an area of concern as investors must wonder from where the growth will come during this transition. Overall, the numbers were good, but far from great. However, when pinned to a high stock premium investors should question is it deserved?

Will Q4 provide the justification?

On Thursday, the company will report on its fourth quarter results. The Street expects EPS of $0.46. While that is a penny higher from 30 days ago, it is 10 cents lower than three months ago. Is that a sign? Analysts are also expecting full fiscal year earnings of $1.91 per share, which includes year-over-year revenue declines of 4.5% to $1.1 billion for the quarter.

It’s worth noting that although Street estimates have come down, Adobe typically does well in the November quarter. This is likely why the stock has broken out over the past several weeks - a lot of which is said to be attributed to strong demand in the company’s Creative Cloud subscription suite.

While that may be true, investors have to also consider that all of this good news is priced into the stock – thus, its 52-week high level. In the meantime, there also M&A chatter involving Microsoft, Google and possibly Apple (NASDAQ: AAPL). But are the synergies there? 

Though I doubt Apple would make this move, I can also see where Apple can benefit by increasing its in-house software portfolio. This will allow the company to leverage its existing multimedia advantage and give developers more reasons to create advanced content for IOS and Mac.

If nothing else, Apple can do this deal just to block Google and Microsoft from seizing this same advantage. But would Adobe sell to Apple? After all, there is no love lost between the two companies since Apple refused to include Flash into its mobile products - favoring instead HTML5.

Bottom Line

It is still too early to assess Adobe’s transition. The good news is the company has an excellent management team steering the ship. Too, I believe the company has plenty of time to execute this change. The concern is the stock and the incredible expectations that come with it. But at some point, expectations have to be met with execution.

In light of all of this, I would have to sell and take some profits here and take my chances. I think Adobe will have to produce better than in-line results to further this momentum. And even if it does, it's hard to not expect a "sell the news" type of scenario. Also at a P/E of 23 the stock is expensive - there's no way to spin it. But if it drops to $30 on the report, I will have to reconsider.

rsaintvilus is long AAPL and has no positions in the other stocks mentioned above. The Motley Fool owns shares of Apple, Google, and Microsoft. Motley Fool newsletter services recommend Apple, Adobe Systems, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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