Adobe Systems Incorporated (NASDAQ:ADBE) put up another solid quarter recently. It beat expectations on all fronts. And yet, ADBE stock stalled out since then. Has something gone wrong with the business, or is this just an understandable round of profit-taking after a huge 2017 rally?
On the negative side, ADBE stock looks really expensive. Like, even more so than usual. Toward the start of the year, ADBE stock traded in the mid-20s forward profit-earnings range. Despite a massive year of earnings growth, the stock’s rapid appreciation outpaced earnings per share, causing the company’s PE ratio to expand even further. And it’s unclear what the company can do to drive faster earnings growth in the future.
The pluses are strong though. The company’s lead in creative software seems nearly insurmountable. And while I expect earnings growth to slow a bit, there’s no denying that the subscription model and ability to raise prices will keep Adobe’s business on an upward trajectory for years to come.
ADBE Stock Cons
Expensive Stock: Last week, ADBE stock was trading at 55x trailing earnings and 31x forward earnings. This is potentially acceptable for a company with a massive earnings growth rate. However, Adobe has not historically been a company that grows earnings at a supercharged rate. 2017’s EPS explosion was an exception, not the rule.
At this point, you have to ask yourself how things could get any better for Adobe. Sure, the future looks exceedingly bright for the company. But the ADBE stock price already reflects that.
It’s All Priced In: What can the company do to turn up growth further? Sure, this year EPS grew at a 40% clip against 25% revenue growth. That speaks to the massive margin gain you get from moving customers from one-time purchases to recurring subscription revenue. But that switch-over has already largely been made. What’s the next lever to boost EPS?
Let’s face it. Adobe grew earnings at a compounded 15% annual rate over the last five years. That’s commendable. But analysts see this spiking to 23% annualized growth over the next five years. If you somehow think the company can boost its earnings growth rate by an additional 8% per year going forward, then ADBE stock is cheap here. But I think that prediction is fanciful.
Think of it this way: If Adobe’s earnings continue to grow at its recent 15% annual average clip, and the stock price were to stay flat for the next five years, Adobe’s PE ratio would still be in the low 20s at the end of year 2022. You need Adobe to continue accelerating its earnings growth from an already fast rate to hyperspeed for it to expand into its valuation within a reasonable time frame.
Technical Concerns: Fellow Investorplace contributor James Brumley noted that ADBE stock is facing some technical issues in the near-term. Brumley correctly notes that with a 31 forward PE, ADBE stock is expensive, and thus ripe for profit-taking. He suggests ADBE stock could see the 150s again on a decent correction.
I’d add that Adobe has struggled over the past month. The stock peaked in November, and has failed to get close to making new highs again, despite broad market strength. Technically, ADBE stock is quite vulnerable if it breaks the double-bottom at 165. Below there, the stock has an air pocket that could take shares down to 150 in a hurry if support gives way.
ADBE Stock Pros
Another Strong Quarter: Adobe’s quarterly results, announced in mid-December, again beat expectations. The company delivered $1.24 on EPS, fully a dime ahead of estimates. And revenues of $2 billion topped estimates by $50 million.
Creative Cloud grew revenues by 31%, well ahead of the company’s overall total. And the Experience Cloud continues to post solid gains as it transforms into an increasingly viable alternative to Salesforce.com, Inc.’s (NYSE:CRM) dominant platform in that space. Margins continue to rise, as earnings growth outpaces already stellar revenue growth. In short, there’s nothing to complain about for ADBE bulls.
Guidance Wasn’t Bad: Now to be clear, ADBE stock didn’t trade up on this earnings announcement for a simple reason. The market was apparently expecting Adobe to raise its 2018 guidance. Instead, it delivered revenue guidance in line with analyst estimates. And it suggested EPS will come in at $5.50, two pennies shy of what analysts were suggesting.
The market initially sold off ADBE stock on the news. However, keep in mind Adobe has been smashing analyst estimates for years now. They’re a classic sandbagging company; set the bar low, and then exceed it comfortably. By suggesting that 2018 will be as just about as good as analysts anticipated, Adobe is actually subtly signaling to expect yet more upside for earnings. Now perhaps it won’t be enough upside to please investors — we’ve already established that Adobe is an expensive stock. But don’t read too much into the guidance numbers.
Creative Cloud Price Hike: Not that long ago, Adobe transitioned most of its user base from one-time software purchases to a recurring subscription-based model.
Now that users have become accustomed to Adobe’s subscription model, it’s time to start taking advantage of the locked-in consumers. Adobe is now launching its first set of price hikes since Creative Cloud launched. We don’t know how much customer pushback there will be to higher prices. That said, given the lack of viable high-quality alternatives to Adobe’s offering, expect most of the price hike to fall through straight to Adobe’s bottom line. We should watch customer churn rates closely, but I don’t expect many problems for Adobe.
Verdict on ADBE Stock
ADBE stock is a victim of its own success. The company had a fantastic year operationally. But the stock is up 70% year-to-date. There’s little that management can do to make the stock worth its aspirational valuation at the moment.
The company is on pace for another solid year in 2018. And over the long run, there is reason to think it can keep growing earnings at an annual rate of 13-18%. But that’s simply not enough to justify the $175 price today. Given overhead technical resistance here, I’d watch and wait for a correction back to the 150s before pulling the trigger on Adobe stock.
At the time of this writing, the author held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.