$ADBE Fiscal Q4 Earnings Preview

by Enis December 11, 2013 10:05 am • Commentary

Event:  ADBE reports its fiscal Q4 earnings on Thursday, December 12th after the market close.  The options market is implying about a 5.5% one day move, which is below the 4 quarter average of about 6.25%, but above the 8 quarter average of about 5.25%.  The stock has risen on each of the past 5 earnings reports.

Sentiment:  Wall Street analysts are mixed on the stock, with 13 Buys, 10 Holds and 2 Sells, with an average 12 month price target of around $57.  The stock is up 47% in 2013, breaking out to a new all-time high in September 2013.  Short interest is down to 1.5% of the float, from a high of around 7% of the float in the spring of 2011.

Options Open Interest:  Open interest actually has more puts than calls outstanding (74k vs. 64k), but as with many stocks that have rallied to new all-time highs in 2013, a bulk of the put open interest is no longer relevant since the stock has rallied far away from those strikes in the past year (downside in Jan14).  The volume over the past month has been just about evenly split between calls and puts.

Yesterday did see a good bid of Jan14 55 calls trade, mostly selling in the morning at 2.10, almost 5k.  That strike is the largest open interest of any on the board, with over 20k of open interest.

Price Action / Technicals:  ADBE’s push higher this year has been especially impressive since the stock has broken through prior areas of resistance seen at the stock’s highs in 2000 and 2007:

ADBE monthly, Courtesy of Bloomberg
ADBE monthly, Courtesy of Bloomberg

The 2007 high was $48.47.  That level acted as obvious resistance throughout July, but the stock finally broke that level convincingly on the earnings gap in September, on big volume.  The stock has not touched the $48.47 level since that gap higher.

On the daily chart, I’ve drawn that level (in red) given its long-term importance.  The recent high in November is $57.99, and the $53 level is likely short-term support (green) if the stock sells off on the report:

ADBE daily, Courtesy of Bloomberg
ADBE daily, Courtesy of Bloomberg


Fundamentals:  ADBE shifted strategy in 2011, and the stock has taken off in the past 18 months as investors have become more optimistic about the new Software-as-a-Service (SaaS) model paying off.

Bloomberg had a great article on Monday detailing that shift:

During five days in August 2011, Adobe Systems Inc. (ADBE)’s top executives sequestered themselves in an 18th-floor boardroom atop the software maker’s Silicon Valley headquarters to address an emerging threat: the cloud.

Customers in growing numbers were opting for upstart competitors’ software, delivered instantly over the Internet and slowing purchases of Adobe’s programs. That jeopardized Adobe’s leadership in desktop publishing with products such as Photoshop, Illustrator and InDesign.

What followed was a wrenching decision by Adobe to eventually dump its lucrative licensing business in favor of a monthly subscription offering called Creative Cloud. The same shift is underway across the technology industry, as vendors includingMicrosoft Corp. (MSFT)Oracle Corp. (ORCL) and SAP AG (SAP) vie for a bigger slice of the $36.8 billion cloud software market, which will balloon to $67.3 billion by 2016, according to IDC.

“It was probably one of the most important moments in the company’s history,” said David Wadhwani, an Adobe senior vice president who attended the meetings. “I don’t think this was one where we were going to increment our way to the right solution.”

While the choice was met with angst among managers and engineers, the stock has almost doubled in the past two years. Even so, Adobe and fellow vendors are still playing catch-up to younger companies such as Workday Inc. (WDAY) and Salesforce.com Inc. (CRM) For Adobe, analysts project an 8.2 percent drop in sales and 65 percent plunge in net income this year, according to data compiled by Bloomberg.

ADBE is not expected to regain its 2011 earnings peak until 2015, but analysts project 30%+ annual earnings growth out to 2017.  Investors have shown their willingness to give ADBE a pass on current earnings as long as it can show strong subscriber growth in the interim.  Its last earnings report did just that, and the stock surged as a result.

In my WDAY Deep Dive post last month, I discussed the possibility that many of the cloud services companies might not achieve the profitability targets investors currently expects:

More specifically, my simple take is that the overall business of cloud-based enterprise software might not be nearly as lucrative as the hype might suggest.  Oracle and SAP are Workday’s biggest competitors, and you can bet that their battle for enterprise contracts is fierce.  Moreover, a company like Salesforce.com (an indirect, and potential future competitor) has been a public company for almost a decade now, and though it is profitable, its profit growth has hardly been stellar (the stock price appreciation is a different story altogether).  So the company’s expectation that achieving scale will lead to significant profits seems dubious.

While ADBE is in a different business than WDAY, the stock’s rich valuation (41x forward P/E) seems to be driven by the same high expectations surrounding its SaaS model.  While investors have been willing to pay a continually higher valuation for more than 2 years now, we continue to place this stock in the Do Not Touch bucket given a valuation backed more by future promises than actual results.

Volatility:  Implied volatility in ADBE is in the low-30’s, near where it has been for the prior earnings reports this year:

ADBE 30 day implied vol (red) vs. 30 day realized vol (blue), Courtesy of LiveVolPro
ADBE 30 day implied vol (red) vs. 30 day realized vol (blue), Courtesy of LiveVolPro

Realized volatility in the stock has been quite subdued since the 9% earnings move higher in September.  Implied volatility should decline to the low 20’s after the event.

Our View:  ADBE is a stock that has a fundamental valuation that is much too high for conservative investors like ourselves.  We have not traded the stock in 2013 though, since it’s a name (like AMZN) that has not made sense to us for a long time.  The stock remains in a technical uptrend, and the $49-$50 is likely a good spot for a long entry for a short-term trade.  But in the long run, we think this stock is a recipe for disappointment.