Adobe is one of the Software-as-a-Service winners of 2013. These SaaS names saw significant multiple expansion last year. Apparently, investors are much more willing to pay a high multiple for a subscription business rather than a software business. The thinking is that the subscription business is more attractive given the recurring revenues.
As a result, even though ADBE is slated to earn around $1.20-$1.25 EPS in 2014, about half of what it earned in 2011, the stock is trading double what it was trading in 2011. In other words, the stock’s P/E multiple has almost quadrupled, to around 55x today. The expectation, of course, is that future earnings growth will be much higher as a result of the business restructuring, turning a stagnant legacy business into a growth machine.
Color me skeptical. Adobe was selling Adobe software products 3 years ago, and it is still selling Adobe software products today. The potential market for its products, the profile of its customers, and its competition has not changed. Add it all up, and I simply don’t see the investment rationale for paying a significantly higher valuation for what is, to me, a business that is almost identical to what it was a few years ago.
In any case, we had a winning trade in March on ADBE, which was more predicated on the technical situation rather than the fundamental view, mainly since the fundamental view has not mattered for several years as ADBE remained in a strong uptrend with no hint of selling pressure. ADBE could not rally to a new high on earnings for the first time in several quarters, which we took as a sign of potential buyers’ exhaustion, and successfully played for a slight fade after the event.
The technical situation has finally changed, and ADBE looks ripe for a deeper correction given its rich valuation on what seem to be tenuous grounds. The daily chart shows that the 50 day moving average is now downward sloping, though ADBE remains above its 200 day moving average:
[caption id="attachment_39911" align="alignnone" width="600"]
ADBE daily chart, 50 day ma in pink, 200 day ma in yellow, Courtesy of Bloomberg[/caption]
The stock’s breakdown below has created a resistance area between $65 and $70 that we think will be hard to breach. The ideal entry for a short position would be on a rally back up to near the $65 level, at which point we’d look to play for a move down to the 200 day ma, now near $57.
Implied volatility in ADBE is at the higher end of its 2 year range, even though the next earnings report is not until mid-June:
[caption id="attachment_39912" align="alignnone" width="600"]
30 day implied volatility in ADBE, Courtesy of Bloomberg[/caption]
As a result, if we do initiate a new trade in ADBE, we will look for a structure that mitigates the high level of implied volatility.
In the meantime, we will hold off for now, with our finger on the trigger if ADBE nears resistance.