Is Adobe Still Worth the Patience?

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

Although it’s still too early to assess how effective Adobe’s (NASDAQ: ADBE) transition has been, the company is proving that it’s been making good use of the time that it has gotten from patient investors. However, concerns about the stock remain, particularly over the high P/E of 23 that it carries.

Although it is not uncommon for tech stocks to sport high multiples, Adobe is trading at near 52-week highs and its P/E ratio is almost double that of Microsoft (NASDAQ: MSFT). From that standpoint, investors are wondering if they will ever get the sort of returns that the valuation presumes. But did the company do enough in its fourth quarter earnings to prove that the high valuation is deserved?

The Quarter That Was

The good news is that Adobe beat on both its top and bottom line estimates. The company reported net income of $222.3 million, or 44 cents per share on revenue of $1.15 billion. On a year-over-year basis, revenue arrived relatively flat, but it improved 7% sequentially. Adobe’s digital media segment was a bit tough to read, however. Although revenue increased 5% sequentially, it declined 2% year-over-year. What did this mean?

This has to be a concern. As the company is migrating from selling individual pieces of software to a cloud-based subscription model, Adobe can’t afford declines in digital media if it wants to assure investors that it can enact this changeover without meaningful disruptions to the stock. Should investors be concerned by the 2% drop in Q4 whereas in Q3 digital media grew by 3%?

On the other hand, the company was able to grow its digital marketing segment by 5% year-over-year and 10% better than Q4; and this didn’t impact profitability, which arrived strong. Despite gross margins shedding 70 basis points, the company still logged 22% year-over-year growth in operating income, while besting Q4 by 11%. Adobe’s CEO, Shantanu Narayen offered this:

"I think people are really seeing the benefits of always having access to the latest applications...The new products we're delivering as part of the cloud are seeing significant adoption, which I think bodes well for us."

Moving Forward

After several successive quarters of slowing revenue and earnings growth, management decided “enough was enough” and began transitioning its traditional boxed software model towards a more efficient cloud-based subscription service. The company deserves a considerable amount of credit for what it has been able to accomplish in such a short period of time.

However, this relative success came at a cost, including $94 million restructuring charge the company had to absorb in the fourth quarter. But it seems it was worth it. Still, I worry that companies, such as Google (NASDAQ: GOOG), that offer free Adobe alternatives like Google Apps will continue to add pricing pressure to hurt Adobe's margins.

It also does not help that PCs are on their last legs and being replaced by tablets and smartphones. The proliferation of these devices has hurt Adobe particularly for the fact that Apple (NASDAQ: AAPL) refused to adopt Adobe’s Flash player in favor of HTML5. Recently, Adobe decided to no longer offer support for Flash on several devices, including Google’s Nexus 7 tablet.

The impact this has had on Adobe has been negligible. However, the company will need to address mobility in some way if it wants to maintain its revenue growth. As I’ve said recently, there continues to also be plenty of M&A chatter involving Microsoft, Google and possibly Apple. But I question whether the synergies are really there.

In terms of acquisition, I see Microsoft as more of a possibility since its flagship MS Office suite has wide support for several of Adobe’s popular titles, including PageMaker, Illustrator and Dreamweaver. But then again, these two have been rumored to pair up for quite some time – it’s just never happened. It would be interesting, though, to see how it would unfold since both Adobe and Microsoft have mutual hatred for Apple and Google.

Bottom Line

I like Adobe’s business and so far the transition is going well. Although the stock is not as risky as some of the other tech names with inflated valuations, Adobe is proving that there is little risk to the downside. As much as I’m willing to loath a P/E of 23, it's not often one finds a company the size of Adobe that is growing operating income year-over-year by 22% either. I always cringe at stocks sitting at near 52-week highs, but as part of a long term hold, Adobe is now as good of a play as any other stock.

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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