Adobe Flashes Cash

Inflation is back! This week the bogeyman of investors and consumers alike made news on Wall Street; actually it made Wall Street. Inflation “appears” to be trended downwards, which means a higher spending power for consumers going forward.

If consumers can keep up their spending binge the economy may not slip into recession in 2007. At least that’s what the bulls think. However, I would say another month’s data is needed to really clarify where inflation is headed.

Nevertheless, the tide that lifted boats on Wall Street this week didn’t leave the folio behind. The manager is back to winning ways this week, thanks in part to ADBE, after two weeks of playing second fiddle to the S&P:

Worst-known +1.30%
S&P +1.22%
Dow +1.12%
Nasdaq +0.81%

ADBE sizzled this week. The “acrobatic” software powerhouse released fiscal Q4 2006 and fiscal 2006 results on Thursday and the stock just took off. The acquisition of rival Macromedia in December 2005 has started to filter to the bottom line.

A quick run of the annual numbers reveal a mixed picture overall. Key profitability indicators – NOPAT margin (net operating profit after tax/sales), earnings growth, and return on equity (ROE) - have become depressed:

Period Ending	NOPAT Margin	Earnings Growth	ROE
12/01/06	19%	-16%	14%
12/02/05	29%	34%	37%
12/03/04	26%	69%	36%
11/28/03	20%	39%	30%

This is not surprising after such a major acquisition. Earnings were particularly hit by stock-based compensation expenses and acquisition-related costs. The company’s target for operating margin in fiscal 2007 is 25% to 27% – this will get margins up to pre-Macromedia acquisition levels. I think this is doable with the planned release of a major product.

An immediate benefit of the acquisition is a buffed-up balance sheet, so ADBE now has more money to burn on R&D and further acquisitions.

Back in October when I decided to get into the stock instead of Apple, http://worst-knownportfoliomanager.blogspot.com/2006/10/beta-on-my-mind.html, and http://worst-knownportfoliomanager.blogspot.com/2006/10/new-portfolio-ready-for-holiday-season.html, I wasn’t aware of how huge the opportunities that await the firm were.

Other investors may be buying into ADBE because in fiscal Q2 2007 it’s going to release Creative Suite 3 (CS3), which is its most ambitious product and will be the biggest revenue driver yet, but this isn’t my primary motivation.

As I’ve done more homework on the application software industry and the worldwide migration of digital content to mobile devices, my conviction that ADBE could make a killing in this environment - provided it doesn’t lose its mojo - has got stronger. This firm thrives on innovation and adaptability. This is why am into ADBE.

Despite the absorption of Macromedia, it can still comfortably grow revenue by about 14% in fiscal 2007. I feel comfortable with this stock going forward.