Insightful analysis and commentary for the US and global equity investor
Contributors: Douglas McIntyre Jon C. Ogg

Previous Posts

Monday, September 18, 2006

Adobe Follow-up

By William Trent, CFA of Stock Market Beat

Last Friday we wrote how pleased we have been that Adobe Systems (ADBE) shares appear to be following the script of our investment thesis. Today we comment on what some others have said in the wake of the strong earnings report.

Eric Savitz provided a nice run-down of commentary from the major brokerage firms covering Adobe. Short summary: they liked the earnings report.

Other followers, however, sounded some sour notes. Motley Fool wrote that Adobe is Snoozing Toward Excellence, posting such good results each quarter that it has become boring.
The only real problem at Adobe is its valuation. At a rich P/E of 35, and an enterprise value-to-free cash flow ratio of 37, it’s just too expensive for my value-investor blood. Perhaps Mr. Market will give us a blue-light special one day soon.

We have found the rally from recent lows far from boring, and believe Mr. Ellis missed his blue-light special earlier this summer with the stock closer to 25x earnings. Better luck next time.

And George Gutowski weighed in with concerns about their restructuring liability:
You have to wonder about the new liability category entitled accrued restructuring. Appearing in both short and long term liabilities the obligation now amounts to just under $37 million. Not insignificant when you realize this amount exceeds 10% of the first nine months of net income. Restructuring costs are notoriously notorious. Is this the Trojan horse? Will this one bite Adobe and burn shareholder values?

The quick answer is “no.” For one thing, Gutowski is double-counting the impact of the restructuring charge. A restructuring charge is accrued when it is recognized in net income. So the $322 million in 9-month net income that the restructuring laibility exceeds 10% of already reflects the restructuring charge. (Pro-forma numbers that exclude the restructuring charge are another story.)

The main reason to be concerned about restructuring charges is if the company is repeatedly incurring them (recurring non-recurring charges) and asking investors to ignore them. In Adobe’s case, the restructuring is a rare occurence related to a large acquisition they made, and as long as there aren’t a string of future charges this one seems legit.

Accounting rules dictate that the estimated costs of any restructuring be charged to income when the decision to restructure is made. Since the costs typically occur in a later accounting period, the reduction in net income is matched by a liability. Amounts that are expected to be paid within one year are “current” liabilities and those expected to be paid later are “long-term” liabilities. It is not that different from an account payable, which arises when the company buys something but has not yet paid the supplier. In this case, the supplier is primarily labor. When the actual severance payments are paid, rather than being reflected in net income at that time (since they have already been deducted from income in the period the decision was made) the liability is reduced.

If you want, you can use the information to adjust the financial statements to reflect the expense in the period(s) they actually occur. To do so, you would add back the restructuring charge to net income in the most recent period, and would reduce net income in future periods by the change in the restructuring liability.

In Adobe’s case, the $12 million of current liabilities are about 3% of this year’s pre-restructuring operating income. The long-term liability may represent 5% of next year’s operating income. So when Yahoo! reports that Adobe is trading at 25.69x 2007 earnings, the investor may want to adjust that to reflect the restructuring charges as they are incurred, which would result in an adjusted price/2007E of 28.02x. Not enough to scare us away (though Motley Fool’s Ellis is probably another story.)

Disclosure: Author is long Adobe call options The author may hold a position in the securities discussed. A current list of the author's holdings is available here.

Powered by Blogger