- Shares of Adobe Systems have declined after the company provided lower-than-expected FY 16 guidance.
- The company, however, provided favorable guidance for the next three years.
- Adobe stock can make healthy gains over the forecast period while the PE can fall to a more favorable level.
Shares of the world’s leading photo-editing software maker Adobe Systems (NASDAQ:ADBE) have been selling off heavily after the company provided below consensus FY 16 guidance during an event where the company provided its three-year growth strategy. Adobe said that it expects FY16 revenue of $5.7B and EPS of $2.70, both of which came in below consensus of $5.93B and $3.19. The company expects Marketing Cloud (online ad software) and Digital Media (Creative Cloud, Document Cloud) revenue to both rise 20% Y/Y in FY 16 with Digital Media annualized recurring revenue (ARR) growing 25% and Marketing Cloud bookings rising 30%.
Source: CNN Money
Although short interest in Adobe stock has been gradually building up over the past one month, it still clocks in at a mere 1.2% of available float with just a day to cover. The lower-than-expected guidance made investors completely miss out on the bier picture and the healthy three-year guidance that the company provided. Adobe forecast a 20% revenue CAGR from FY 15-FY 18 with Digital Media ARR, Marketing Cloud revenue, and Digital Media revenue expected to see 20%+ CAGRs. Meanwhile. The company expects a 30% EPS CAGR and 25% operating cash flow CAGR.
Improving bottom line
The main reason why investors were not happy with the guidance is because of heightened expectations surrounding the company. The last quarter marked the first time that the company was reporting earnings after it successfully completed the transition from a software licensing revenue model to a subscription-based model. Adobe’s net income jumped 290% on a GAAP basis during the third quarter after languishing for several years. It’s likely that investors expected the company to maintain this momentum for a couple more years.
Adobe’s bottom line was badly hurt by the cloud transition. The company realized net income of $833 million on revenue of $4.2 billion in 2011, the year just before it begun moving its products to the cloud. By the end of 2014, Adobe’s net income clocked in at just $268 million on revenue of $4.1 billion.
The dramatic bottom line contraction was to be expected with a subscription model. Using its old licensing model, Adobe used to charge $700 for a single Adobe Photoshop software license. Using the new subscription model, Adobe charges just $10 per month for the same software. The upshot of it is that the company is able to realize a recurring revenue stream over an indefinite period while the old model involved selling its software for a large one-time fee. The much lower costs for its products allows Adobe to grow its user base quickly. But it unfortunately means trading off profitability.
Adobe's PE Ratio Will Moderate
But assuming Adobe’s EPS guidance of 30% CAGR over the next three years is accurate, then there is every reason to like the shares. Adobe’s PE ratio skyrocketed over the last three years due to its lower income growth. The shares average a PE ratio of 112 in 2014, almost 4 times the company’s historic average of 25.
But with the company growing its bottom line at the forecast 30% annual clip, Adobe’s PE ratio can fall from the 2015 average of 56 to just 26 over the next three years while the shares make healthy gains of about 120% over the period.
This will be a win-win scenario for Adobe shareholders--realizing healthy share gains while the valuation of shares falls to more palatable levels thus minimizing their downside potential. Investors should wait till the Adobe stock hit its nadir then buy for the long haul.