Baerrus Magnus
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Adobe A Solid But Highly Overvalued Business

I have a idea of a short forming in my head as I ponder Adobe Systems valuation. ADBE is priced to perfection sporting PE of 111. Who would have thought that an old tech software company can run with momentum darlings like Netflix and Tesla. This idea is unlike most options trades I do, where I post about immediate opportunities. Here I expect the breakdown to play out at the end of the year, when ADBE has to provide FY 2016 guidance. But let's look why I am getting rather bearish.

My bearishness has little to do with what Adobe does. Indeed the company has one of the most diversified SW offerings around. Add to that the fact that Adobe can credibly claim to be a true leader in many markets that it serves.

ADBE Valuation

My problem is the company's valuation. Historically ADBE traded with PE around 20-25, but something happened in 2012-2013. That something was the Cloud. ADBE totally embraced the cloud as a marketing buzzword and to a lesser degree as a new business model. They embarked on (rather forced into) transforming its upfront perpetual sales model into cloud based subscription model. That allowed ADBE to claim to have moved into the brave new world of the Cloud with a valuation premium attached to that. Look at the PE chart below and note how 2013 witnessed incredible multiple expansion. It is even more impressive if you consider that earnings per share were dropping at the same time. Wallstreet fell in love with ADBE all over again!

While ADBE has made commendable progress on the said transformation. Its growth in terms of absolute numbers was dismal. Yet the Wallstreet analysts expect the payoff to occur in 2016-2017, projecting dizzying rates of growth. For example Wall street expects next year non-GAAP EPS of $3.23 versus 2015 estimated $2.05. That is an astonishing 56% growth! Can Adobe deliver that? - We will find out in December. If the FY16 guidance comes up short then blood will be flowing in the streets. The stock is going to be re-priced lower, much lower. Possibly, over time toward historical PE~20. Mind you these are all non-GAAP numbers due to tons of Stock Based Compensation and amortization of intangibles, real GAAP earnings are about half of that.

ADBE Insiders Have Been Selling

Adobe is led by its CEO Narayen Shantanu, an ADBE veteran of 17 years. And he has been riding that camel hard. Selling more than $20M worth of stock in most years since at least 2004. In good years like the 2013 his sales alone were in excess of $40M. 2015 is shaping up as another good year and Mr Shantanu is already over $20M threshold in his insider sales. Let's not judge the man! I would do the same thing were I in his shoes. At least he is consistent and no one can accuse him of dumping everything right before the fall.

ADBE Short Thesis

The short thesis is simple. The analysts community estimates and, more importantly, the premium valuation demands ADBE to show some incredible growth in both revenue and earnings over the next couple of years. I read that some people expect it to earn $5 in 2017! Call me a cynic, but I am failing to see how this growth is about to materialize. Make no mistake Adobe is doing good. Running its stable business, most of it in milking mode. They can show 10-20% rate of growth in certain areas in some quarters. But that is a far stretch from wholesale revenue and EPS increases that Wallstreet expects. In December they will have to provide FY2016 guidance, which I expect will be far below $3.23. Some would dismiss this kind of analysts by saying that 'haters will hate, hate, hate...'. Well, I am far from being an ADBE basher since I traded ADBE based on the Bollinger Bands system from the bullish side earlier in 2015. I simply smell the blood of an overpriced stock.

Trading ADBE

The rest is mechanics of whether one can construct a short position with a decent hedge and carry it for a few months. But the specifics of an options position is still work in progress. I will update this post later. We have time in this case, as I do not expect the wheels to come of before FY2015 is in the bag. In fact we are still to hear about Q3 on September 17.