As a shareholder, it has not escaped my attention that Adobe Systems shares have soared in the past year. This leaves me with two questions: Why? Will they continue to rise? My guess is that shares have risen because of the success of Adobe’s transition to software as a service and that its future is looks bright — but a disappointing earnings report could tank the stock.
Adobe has not responded to a request for comment.
In the last year, Adobe shares have spiked 81% — far better than the mere 37% rise in the NASDAQ during that time. To understand why this has happened and whether that steady upward trajectory will persist, it would help to have some way to explain what makes stocks rise and fall.
Regrettably, such models are taught in schools — but they do not seem to work too well in the real world. One popular academic theory is that a stock is fairly valued if its price per share is less than the present value of all its future net cash flows.
To apply that theory, an investor simply needs to make an accurate prediction of how much cash a public company will have left over each year after it pays all its operating expenses, fulfills its obligations to debt holders, and makes investments to expand its market share.
Once that simple task has been completed, the next step is to figure out the right number by which to divide each year’s expected net cash flows to account for the riskiness of the prediction and how far into the future that cash flow will be received.
Sadly, Warren Buffett seems to be about the only person I know of who can apply his personal variant of this method to figure out how much a business is worth with sufficient reliability to make winning investments.
Another technique with some hope of being useful is the beat-and-raise game. Using this model, investors should buy shares in a company before quarterly earnings announcements if they think the company will report higher earnings per share (EPS), revenues, and forecasts than analysts are expecting.
To win here, all you had to do was convince someone to share with you their knowledge of the earnings that a company was about to report before anyone else in the market knew it.
This is a game that prosecutors have alleged was played by employees of SAC Capital Advisors — such as the $1 million in profit that a former SAC portfolio manager, Michael Steinberg, was convicted of making based on inside information about lower-than-expected profit margins in an August 2008 Dell earnings report.
Nevertheless, stocks to appear to move in reaction to these quarterly releases of information and Adobe seems to be moving up because many investors are betting that the company will beat analysts’ ever rising expectations.
Indeed, during February analysts have been boosting Adobe’s target stock price. On February 11, Adobe had an average rating of Buy — with one Sell, 11 Holds, and 17 Buys — and an average target price of $56.57 — 24% less than its current $69.92 price on February 27.
Here are some examples:
- Merrill Lynch set a price target of $80 along with its “Buy” rating in a February 11 research report
- Bernstein and Evercore both raised their price targets to $75 from $70 and $65, respectively, on February 24.
- On February 11, Bank of America retained a buy rating and raised its price target on Adobe from $67 to $80.
At the crux of Adobe’s increased valuation is that software as a service companies like Salesforce.com have much higher valuations than companies that license their software. For example, Salesforce.com’s forward P/E is a whopping 94.
The Bank of America analysts wrote, “We continue to highlight Adobe Systems as the most compelling play on transition to recurring revenues/Cloud.”
The reasons for its increased price target are more people subscribing to Adobe’s Creative Cloud, higher per-subscriber revenues, and increased profit margins. Specifically, Bank of America looks for the number of subscribers to Creative Cloud to rise from 5 million in fiscal year 2015 to 12.5 million by FY 2019; with its average monthly selling price to increase from $35 to $40 during the same period and increased earnings before interest and taxes (EBIT) margins to grow from 55% to 60%.
On February 27, Adobe shares rose 3.1% — possibly in response to an announcement that it would add services to its Marketing Cloud — specifically its digital publishing platform, Adobe Digital Publishing Suite (DPS) and Web experience management solution, Adobe Experience Manager would be integrated with its Adobe Analytics that helps customers figure out which advertisements are working and which aren’t.
Many investors are betting that Adobe shares will drop. “Schaeffer’s put/call open interest ratio (SOIR) of 1.44 ranks higher than 90% of comparable readings from the past year, meaning short-term speculators have rarely been more put-heavy toward the equity as they are now,” according to Schaeffer Research.
And purchases of puts spiked on February 11. That day investors bought 795% more put options – 15,496 compared to the typical daily volume of 1,731, according to WKRB.
Last time Adobe reported in December, it met Thomson Reuters’ forecast EPS of $0.32 and beat revenue expectations of $1.03 billion by $10 million. Since then its stock has risen 15%.
It would not surprise me to see Adobe shares continue to rise as it approaches its next earnings report on March 18.
If Adobe beats and raises, any investors who share the sentiment of those who bought put options — by selling its share short — will be forced to buy in order to cover their position.
My hunch is that the most crucial number in its report will be the number of Creative Cloud subscribers. But I still have no idea how those analysts set their price targets.