Event: Adobe (ADBE) is set to report fiscal Q3 results tomorrow after the close. The options market is implying about a 6.5% move between now and the end of the week, which is rich to the average one day move of 5% over the last 4 quarters.
Price Action / Technicals: ADBE is up 10% on the year, down 8% from its 52 week and all time highs made on August 18th, and up 37% from its 52 week lows made in October. The average price for the stock in 2014 has been about $78, a few % below where it is currently trading. $85 will likely serve as important near term technical resistance, while $74/$75 should stand as important long term support:[caption id="attachment_56917" align="aligncenter" width="600"] ADBE 1yr chart from Bloomberg[/caption]
Volatility Snapshot: As most large cap U.S. stocks have done this summer, short dated options prices in ADBE have gone from multi year lows to multi year highs in just 2 months. 30 day at the money implied volatility usually rises into the low 30% range prior to ADBE’s results and then quickly falls to the low 20s. It is now at 40%, down slightly from the recent highs of 45%:[caption id="attachment_56919" align="aligncenter" width="600"] ADBE 1yr chart of 30 day at the money Implied Vol from Bloomberg[/caption]
Fundamentals / Valuation: Prior to ADBE’s fiscal Q2 earnings report on June 16th the stock was trading at nearly the same levels it is trading at now as I write. The stock declined on the results as the company modestly lowered revenue guidance for Q3 sales and for the full year while leaving earnings expectations the same. The company blamed the expected revunue shortfall on the adverse effects of the strong dollar.
ADBE is in a multi-year process of migrating customers from a licensing model to a subscription model for their Creative Cloud. Until last quarter investors for the most part have disregarded mundane things like earnings and revenue misses in favor of focusing on subscriber growth. Last quarter the company added 639,000 subscribers above the 589.000 previously guided.
Our View: Back on June 17th, the FT’s Lex column summed up ADBE’s transition to the cloud, Adobe: SaaS without the mess:
Software companies often use the idiosyncrasies of the subscription (as opposed to licensing) sales model as an excuse for falling sales or lack of profits — SAP and Salesforce come to mind. But the model itself is not the problem.
Adobe reported record revenues in the most recent quarter. The company’s move from licences to subscriptions (software as a service or SaaS, in the jargon) was initially painful. Sales were flat between 2011 and 2014 because new subscriptions, paid over time, did not fully replace big upfront licence sales. But now the results are coming through. New subscriptions to Adobe’s “creative cloud” software rose 40 per cent in the most recent quarter, and annualised recurring revenue (a key metric for subscription companies) nearly doubled. Analysts expect that sales will rise 18 per cent this financial year — the fastest growth in five years. Software as a service need not be synonymous with losing money.
ADBE’s earnings had been volatile. Investors have given them a pass. The stock trades 25x expected earnings growth of 50% in fiscal 2016, but that is likely not apples to apples as normalized earnings for the last 5 years should be very near where Wall Street consensus now sits. ADBE is an expensive growth stock in the midst of a critical transition. With the stock at the mid point of the six month range I see the upside downside fairly even into the print, up or down about $5, which is essentially in line with the implied move.
But elevated options prices offer the potential to add yield for existing longs by selling out of the money calls. For those looking for protection selling out of the money calls and using the proceeds to buy near the money put spreads make sense.
As for selling calls against long stock I think it is safe to say there is not a ton of risk of a takeout. With a $40 billion market cap and a deal premium of 25%, there are few who could make such a deal, and fewer who could be interested (MSFT, ORCL).