RealMoney Silver - Adobe Looks Headed for a Suite Spot

Adobe Looks Headed for a Suite Spot
By Bill Trent
RealMoney.com Contributor
3/24/2008 1:39 PM EDT

I jumped the gun.

In September 2007, I waxed positive on Adobe (ADBE) after an impressive third-quarter earnings report. Since then, the stock has fallen 27% compared with a 12.4% drop in the S&P 500.

Given my propensity to enter positions by writing puts (which I also discussed in that article), I actually fared somewhat better than that. After one set of puts expired worthless, my November $42.50s were exercised against me. My effective purchase price (including put option premiums received) is about $40 per share.

As they say, there is little difference between being early and being wrong. Checking back on the investment thesis, however, I still feel confident about Adobe's prospects for the remainder of 2008. In fact, I'd argue that the stock is about to enter its "suite spot." Creative Suite 4, that is.

From what I have observed, Adobe's price-to-earnings multiple usually rises into the mid-30s immediately ahead of a major new product release, then retreats to the mid-20s afterward. The last such release was in May 2007, and as if on cue, the P/E multiple has been contracting ever since.

Rising on Anticipation

The anticipation rallies tend to be quite attractive. In the 10 months between July 2006 and the release of Creative Suite 3, Adobe rose 54%, from $28.50 to $44.00. Similarly, between July 2004 and the May 2005 Creative Suite 2 release, the stock surged 57%, from $21.00 to $33.00. Finally, during the 10 months prior to the original Creative Suite launch in October 2003, the stock jumped 77%, from $12.36 to $21.84.

Given Adobe's typical 18-to-24-month product cycle, however, I would expect the next version to be released late this year or in early 2009. So although Adobe raised its guidance for the fiscal year ending in November to a range of $1.86 to $1.92 per share (compared with consensus estimates of $1.82), it is unlikely that it includes much contribution from the next product cycle. That means Adobe is expecting 17.5% earnings growth this year without new product launches. I'm impressed.

What's more, although Adobe rose 6% after a recent strong earnings announcement, the high end of the new guidance is also 6% higher than the prior estimate. So effectively, the P/E ratio hasn't changed.

Adobe has also generated nearly $1.5 billion in free cash flow over the last 12 months, which gives it a free-cash-flow-to-enterprise-value-yield of more than 9%. That is nearly a 400% premium to the five-year Treasury yield.

Of course, the last six months have shown that attractive valuations can get you nowhere (or even put you in the hole). That is why the catalyst provided by the likely release of Creative Suite 4 becomes so important.

If Creative Suite 4 pans out like any of the last three product cycles, investors should start getting excited about it sometime between now and July. With consensus 2009 earnings estimates already at $2.07, a P/E expansion to 30 times gives a potential target of $62, up from a current $35.

If the thesis continues to play out, I'll be able to stop kicking myself for jumping the gun.