Why Adobe's iPhone Fight Was a Flash in the Pan

Antoine Gara - The Street  DEC 14, 2012 3:55 PM

Adobe's turnaround story has big implications for the tech sector and post-crisis growth bets.

 


Four years ago many would have said Adobe (NASDAQ:ADBE) would be dead in the water if it's Flash Player wasn't a big part of blockbuster Apple (NASDAQ:AAPL) iPhone launches and an upstart Google (NASDAQ:GOOG) - Android ecosystem.

The Flash Player's days are now numbered on smartphones. Apple stopped carrying Flash in 2010 and in late 2011, the company said it would stop putting the player on mobile browsers and instead commit Flash software to PC browsing, mobile apps and its replacement, HTML5.

While Apple may have precipitated the death of the mobile Flash Player in the early innings of a smartphone boom, the move hasn't turned out to be the crucible for Adobe that many had predicted.

In fact, after reporting stronger-than-expected full-year earnings on Thursday, Adobe briefly traded at four year highs as the company shows signs that a multi-year software industry turnaround effort will yield strong earnings growth in coming years.

Adobe's non-iPhone revival is an important story in a technology sector riddled with the muddled turnaround efforts currently underway at the likes of Hewlett Packard (NYSE:HPQ), Dell (NASDAQ:DELL) and even Microsoft (NASDAQ:MSFT), as they try to adapt to a shift from personal computing to mobile devices. It's also a good example of the quiet work some companies are doing to come out of the so-called Great Recession with new growth prospects that could drive top-line earnings in coming years.

In the tech sector, Adobe's earnings raise the prospect that mergers and acquisitions can drive turnaround efforts, in spite of highly publicized multi-billion dollar write-offs at Hewlett Packard and Microsoft. Meanwhile, Adobe also shows that a post-financial crisis focus on building the foundation of earnings growth over cost cuts may pay off for investors.

In late April, Jeffrey Ubben, the head of ValueAct Capital detailed to the TheStreet why the hedge fund was betting on an Adobe turnaround at the company.

Ubben's argument boiled down to two crucial points:

Deals like a $1.5 billion acquisition of online publishing analytics specialist Omniture in 2009, once deemed as expensive, may actually pay big dividends in coming years as Adobe transitions from software developer to a more full service provider of technology needs in digital publishing and cloud services. Meanwhile, companies bold enough to use the financial crisis to cut acquisitions and increase spending may put them in a unique position for growth as an economic recovery takes hold.

Ubben highlighted the wisdom of the Omniture acquisition and called the business a "crown jewel" within Adobe's portfolio of digital publishing, software and cloud businesses, which includes a still strong Acrobat, Flash and Photoshop products. Although neither Omniture nor Macromedia were yet to return much above their cost of capital, according to Ubben's comments, he added, "I'm much more tolerant of low return strategic deals than I ever have been because no one is doing it."

ValueAct Capital is Adobe's second-largest shareholder, with a 6.32% stake in the company's shares worth over $1 billion, according to Securities and Exchange Filings compiled by Bloomberg, as of Sept. 30.

Ubben's comments came at the IMN Active-Passive Investor Summit, and while the likes of Carl Icahn and Barry Rosenstein of Jana Partners rolled off stories of C-Suite excess, the hedge funder presented Adobe to a roomful of activist investors as a story of corporate turnaround. It was enough to cause some in the audience to shake their heads, amid skepticism Adobe is little more than a PC era dinosaur.

Thursday's earnings signal that Adobe's earnings picture is poised to improve materially in coming years, even if a real post-crisis share price recovery remains years off. JMP Securities analyst Patrick Walravens upgraded the company to 'market outperform' in the wake of Adobe's fourth-quarter earnings beat and noted that Adobe's 2013 earnings guidance puts a floor on how much the company's turnaround efforts hit margins.

"One of our concerns on this name had been that the transition to a cloud business would pressure the company's EPS -- which has now played out as Adobe guided to FY13 non-GAAP EPS of $1.40 versus consensus of $2.35 and is likely to show gradually improving EPS as we move beyond FY13," Walravens wrote, in a note to clients.

"With the estimate cut out of the way, the most painful part of the transition may be behind Adobe, leaving the stock poised to work its way higher as the company benefits from the inherent advantages of a subscription and cloud-based model," he added.

Adobe shares rose over 5% in Friday afternoon trading, putting the company near post-crisis highs and at 2012 share gains in excess of 30%.

The software maker's share gains compare favorably to other notable tech sector turnaround efforts like Hewlett Packard, Dell and Microsoft. They even exceed stock gains of software and services giants like IBM (NYSE:IBM) and Oracle (NASDAQ:ORCL), who are widely perceived as adaptive to a fast-changing tech sector.

At the IMN conference, Ubben highlighted Adobe and other large ValueAct investments, like an acquisition hungry Valeant Pharmaceuticals (NYSE:VRX), as reason to cut against a general trend of cost cutting across Corporate America. "We're always fighting the last war in this age of austerity. The problem is that like people don't trust the government, they don't trust their companies," Ubben said.

"The scarcity in two to three years is going to be absolute growth... [Investors] are afraid of capital expenditure, research & development; they just want more buybacks." the sometimes activist investor added, during a panel discussion.

Still, as Adobe may prove, bets on M&A and turnarounds could take time to bear fruit, amid a still-uncertain economic backdrop and an investor focus on short-term earnings.

Adobe's 2013 outlook - which takes account of the EPS hit its Creative Cloud and digital marketing bets may have on the company's bottom line - caused some Wall Street analysts to temper their forecasts heading into the new year.

Credit Suisse analysts cut Adobe's fiscal 2013 revenue and EPS estimates from $4.306 billion and $2.25 to $4.554 billion and $1.60, respectively, and highlighted some skepticism on whether the company can deliver on forecasts of new subscriber adds to its Creative Cloud and digital marketing offerings.

"We remain cautious on Adobe's stock during the transition to a subscription-based licensing model for Creative Suite and as Adobe invests in digital marketing opportunities," the analysts wrote, in a note to clients.

The Credit Suisse analysts also questioned whether Adobe's best days continue to be in the rear-view mirror. "Although we view revenue growth as the main driver of future operating income growth, we also believe that many of Adobe's solutions are maturing, the combination of which would reduce forward revenue and EPS growth as compared to the past decade and, therefore, limit multiple expansion," the analysts added.

Adobe's earnings continue a debate on whether companies deemed to have been left behind in the race from PCs to mobile devices can find second life. They also unequivocally show that predictions of Adobe's Apple iPhone-related demise were unfounded.

Also watch ValueAct's bet on Adobe as a leading indicator of whether similar contrarian growth and merger efforts at the likes of Eaton (NYSE:ETN), Walgreen (NYSE:WAG), Bed Bath & Beyond (NASDAQ:BBBY) and Starbucks (NASDAQ:SBUX) bear fruit in coming years, amid a consensus of skepticism.