Adobe Stock: High Multiple And Leaky Equity Bucket (NASDAQ:ADBE)

This article was first published for DGI+ Club members on April 5, 2022.

Adobe: Investment Thesis

I recently published an article, “Ecolab: High Multiple And ‘Leaky Equity Bucket’“, which drew a comment from a reader, “Good article, what is your opinion on ADBE as far as equity leakage?” I replied, “I don’t know. I will take a look.” I find similarities between Adobe Inc. (NASDAQ:ADBE) and Ecolab Inc. (ECL), some, good and some not so good, as well as some distinct differences. My first observation is both corporations appear to have competent management, operating businesses with sound fundamentals. Ecolab pays a dividend yielding a little over 1%. Adobe does not pay a dividend, so it would need slightly stronger share price growth to match returns from Ecolab. Both companies show large differences between earnings reported on a non-GAAP versus GAAP basis. Methods of accounting for employee stock compensation, result in additional effective outflows from equity not recorded in either non-GAAP or GAAP earnings. As a result, for both companies, earnings actually available for distribution to shareholders are far less than the reported non-GAAP earnings. From 2017 to Q1-2022 inclusive, Adobe reported non-GAAP earnings totaling $21.9 billion. After taking into account the ~$7.0 billion value of shares issued to staff over that period, earnings available for distribution to shareholders reduced to $14.9 billion. This is a clear case of what I refer to as a ‘leaky equity bucket’. The other concern is, if earnings reduce by one-third, P/E ratio increases by 50%, and Adobe already has a 36.89 P/E ratio based on non-GAAP EPS. In the case of Ecolab, over the 5 years to Dec 2021, reported non-GAAP earnings totaling $7.1 billion excluded ~$1.7 billion value of shares issued for employee stock compensation. The balance $5.4 billion was further reduced by other items not included in non-GAAP earnings, including the loss on the spin-off of ChampionX, leaving $2.9 billion balance available for distribution to shareholders. Of this $2.9 billion balance, $2.6 billion was distributed to shareholders by way of dividend. So, in answer to the reader’s question, yes, Adobe has a ‘leaky equity bucket” similar to Ecolab. But while I rated Ecolab a Sell in the article linked above, I have a different view on Adobe due to superior EPS growth performance and the strength of its balance sheet. Per Table 1 below, Adobe grew non-GAAP EPS by 37.8% from 2016 to 2019, and analysts EPS estimates indicate average yearly EPS growth ~19% from 2019 to 2024. While analysts’ EPS estimates indicate similar strong EPS growth for Ecolab from 2022 through end of 2024, this is deceptive due to Covid distortions. A clearer picture can be obtained by looking at longer term EPS growth for Ecolab pre and post 2019. Ecolab grew non-GAAP EPS by 9.9% from 2016 to 2019, and analysts EPS estimates indicate average yearly EPS growth ~5.9% from 2019 to 2024. From a balance sheet perspective, over the past 5.25 years Adobe has increased net assets used in operations by $8,643 million, reduced share count by 22.3 million and still has cash net of debt of $576 million at end of Q1-2022. In contrast, Ecolab has funded an increase of $2,354 million in net assets used in operations with $2,031 million increase in net debt and $323 million in equity. Additionally, Ecolab has paid $2,560 million in dividends over the period. Net debt as a percentage of net debt plus equity has increased from 48.0% at end of 2016 to 53.7% at end of 2021.

In summary –

Both Adobe and Ecolab have ‘leaky equity buckets’ and what appear to be excessively high P/E multiples. However, strong EPS growth, maintained over a sufficiently long period, will bring EPS multiples down. The past record, and analysts EPS estimates, suggest Adobe will likely outperform Ecolab in this respect. For that reason, and despite its high multiple, I rate Adobe a Hold versus the Sell rating for Ecolab.

My usual detailed structured financial analysis follows below for Adobe.

Looking for share market mispricing of stocks

What I’m primarily looking for here are instances of share market mispricing of stocks due to distortions to many of the usual statistics used for screening stocks for buy/hold/sell decisions. The usual metrics do not work when the “E” in P/E is distorted by the impact of COVID-19. And if the P/E ratio is suspect, so too, then, is the PEG ratio similarly affected. I believe the answer is to start with data at the end of 2019, early 2020, pre-COVID-19 and compare to projections out to the end of 2022 or later, when hopefully the impacts of COVID-19 will have largely dissipated. Summarized in Tables 1, 2, and 3 below are the results of compiling and analyzing the data on this basis.

Table 1 – Detailed Financial History And Projections

Table 1 documents historical data from 2016 to 2019, including share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates. The table also includes estimates out to 2025 for share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates (note – while estimates are shown for analysts’ EPS estimates out to 2023, 2024 and 2025 where available, estimates do tend to become less reliable, the further out the estimates go. These estimates are generally only considered sufficiently reliable if there are at least three analysts contributing estimates for the year in question). Table 1 allows modeling for target total rates of return. In the case shown above, the target set for total rate of return is 7.5% per year through the end of 2024 (see line 12), based on buying at the Apr. 4, 2022, closing share price level. As noted above, estimates become less reliable in the later years. In the case of Adobe, I have decided to input a target return based on 2024 year, which has EPS estimates from twelve analysts, because that is as far out as analysts’ estimates extend. The table shows to achieve the 7.5% return, the required average yearly share price growth rate from Apr. 4, 2022, through Dec. 31, 2024, is 7.5% (line 50). Adobe does not currently pay a dividend, so the return on share price is also the total return. Table 2 below summarizes relevant data flowing from the assumption of a target 7.5% total return through the end of 2024.

Targeting A 7.5% Return

Table 2 – Targeting a 7.5% return

Table 2 provides comparative data for Adobe, assuming share price grows at rates sufficient to provide total rate of return of 7.5%, from buying at closing share price on Apr. 4, 2022, and holding through the end of 2024. All EPS estimates are based on analysts’ consensus estimates per SA Premium.

Comments on Table 2 are as follows

Part 1 – Consensus EPS (Case 1.1) (lines 1 to 12)

Part 1 shows the amounts the share price would need to increase to achieve a 7.5% rate of return through the end of 2024. The share price would need to increase by $102.57 from the present $468.81 to $571.38 at the end of 2024, for the 7.5% rate of return to be achieved.

Part 2 – Required change in P/E ratio to achieve target 7.5% return (lines 21 to 23)

Part 2 shows the amount the P/E ratio would need to increase or decrease by, from buy date to the end of 2024, to achieve the share price level at the end of 2024 necessary to achieve the targeted 7.5% return. For Adobe, the P/E ratio at buy date could decrease by (16.6)% through the end of 2024 and the 7.5% return would still be achieved. Being able to achieve a targeted return with a decrease in the P/E ratio would normally be regarded as a positive. However, due to the distortions in earnings and sentiment owing to the COVID-19 pandemic, it’s difficult to judge whether the change in P/E ratio is a positive or the result of a distorted starting point. To overcome this difficulty, in Part 3, I review the necessary change in P/E ratio from a different, pre-COVID-19 starting point.

Part 3 – Projected change in P/E ratios from 2019 to 2024 (lines 31 to 46)

In Part 3, I start with the share price at Dec. 31, 2019, before the impact of the COVID-19 pandemic on earnings and market sentiment. The end point is projected share price at the end of 2024, when it’s assumed the market and earnings are no longer materially impacted by the pandemic, and EPS growth has brought the P/E ratio back closer to historical levels. For Adobe, the share price needs to increase by $241.57 from $329.81 at Dec. 31, 2019, to $571.38 at the end of 2024, and as detailed in Part 1, at $571.38, the targeted 7.5% rate of return would be achieved. For Adobe, there are a number of givens in our assumptions. Using these givens, the change in the share price from Dec. 31, 2019, to the end of 2024, can be expressed as mathematical formulae as follows:

[A] Change in share price, due to the effect of EPS growth rate, equals share price at the beginning multiplied by (1 plus average yearly Consensus EPS growth rate) to the power of number of years invested.

= $329.81*(1+18.7%)^5 = $777.65 (that would be the result if the share price grew in line with EPS growth, and the P/E multiple remained constant)

[B] Change in share price due to change in P/E ratio equals share price adjusted for EPS growth rate multiplied by (1 plus/minus percentage change in P/E ratio).

= $777.65*(1- 26.5%) = $571.38 (price required at end of 2024 to provide 7.5% total return, buying at current share price).

The increase of $447.84 ($777.65 minus $329.81) due to the average yearly EPS growth rate is cumulative, and the share price will continue to increase the longer the shares are held, and the growth rate continues. The decrease of $206.27 due to a change in the P/E ratio ($777.65 minus $571.38) has a one-off effect. A continuing high or low P/E ratio has no impact on future share price growth, only a change in P/E ratio affects share price, not the level of P/E ratio.

Next, rather than targeting a specific rate of return, I look at historical P/E ratios to see the potential impact on returns of a reversion to these levels of P/E ratio. First of all, I should explain a little about the Dividend Growth Income+ Club approach to financial analysis of stocks.

Understanding The Dividend Growth Income+ Club Approach

Total return, dividends, share price

The only way an investor can achieve a positive return on an investment in shares is through receipt of dividends and/or an increase in the share price above the buy price. It follows what really matters in share value assessment is the expected price at which a buyer will be able to exit shares and expected cash flow from dividends.

Changes in share price

Changes in share price are driven by increases or decreases in EPS and changes in P/E ratio. Changes in P/E ratio are driven by investor sentiment toward the stock. Investor sentiment can be influenced by many factors, not necessarily stock-specific.

“Equity bucket”

Earnings are tipped into the “Equity Bucket” for the benefit of shareholders. It’s prudent to check whether distributions out of and other reductions in the “Equity Bucket” balance are benefiting shareholders.

Adobe’s Projected Returns Based On Selected Historical P/E Ratios Through End Of 2024

Table 3 below provides additional scenarios projecting potential returns based on select historical P/E ratios and analysts’ consensus, low, and high EPS estimates per Seeking Alpha Premium through the end of 2024.

Table 3 – Summary of relevant projections Adobe

Table 3 provides comparative data for buying at closing share price on Apr. 4, 2022, and holding through the end of 2024. There’s a total of nine valuation scenarios for the year, comprised of three EPS estimates (SA Premium analysts’ consensus, low, and high) across three different P/E ratio estimates, based on historical data. Adobe’s P/E ratio is presently 36.89. For many companies, their current P/E ratios are distorted by the impact of COVID-19. For Adobe, the present P/E ratio is a little below the range of historical P/E ratios. Table 3 shows potential returns from an investment in shares of the company at a range of historical level P/E ratios. This analysis, from hereon, assumes an investor buying Adobe shares today would be prepared to hold through end of 2024, if necessary, to achieve their return objectives. Comments on contents of Table 3, for the period to 2024 column follow.

Consensus, low, and high EPS estimates

All EPS estimates are based on analysts’ consensus, low, and high estimates per SA Premium. This is designed to provide a range of valuation estimates ranging from low to most likely to high based on analysts’ assessments. I could generate my own estimates, but these would likely fall within the same range and would not add to the value of the exercise. This is particularly so in respect of well-established businesses such as Adobe. I believe the “low” estimates should be considered important. It’s prudent to manage risk by knowing the potential worst-case scenarios from whatever cause.

Alternative P/E ratios utilized in scenarios

1. The actual P/E ratios at share buy date based on actual non-GAAP EPS for FYE 2021.
2. A modified average P/E ratio of 40.78 based on 23 quarter-end P/E ratios from Q4 2016 to Q1 2022 plus current P/E ratio in Q2 2022. The average of these P/E ratios has been modified to exclude the three highest and three lowest P/E ratios to remove outliers that might otherwise distort the result.
3. A median P/E ratio calculated using the same data set used for calculating the modified average P/E ratio. Of course, the median is the same whether or not the three highest and lowest P/E ratios are excluded. In the case of Adobe, I have replaced the median P/E ratio of 41.50 with the current P/E ratio of 36.89, to see the effect if there was no multiple expansion going forward.
4. The actual P/E ratio of 47.33 at Feb. 21, 2020, share price, based on 2019 non-GAAP EPS. The logic here is the market peaked around Feb. 21, 2020, before any significant impact from COVID-19 became apparent. This makes the P/E ratios at Feb. 21, 2020, reflective of most recent data before the distortion of P/E ratios by the impact of the coronavirus pandemic. In the case of Adobe, this P/E ratio appears to be quite high, and likely not to be representative. I have used instead a P/E ratio of 30.0 to enable an assessment of impact on returns of multiple contraction below current level.

Reliability of EPS estimates (line 17)

Line 17 shows the range between high and low EPS estimates. The wider the range, the greater disagreement there is between the most optimistic and the most pessimistic analysts, which tends to suggest greater uncertainty in the estimates. There are twelve analysts covering Adobe through end of 2024. In my experience, a range of 3.4 percentage points difference in EPS growth estimates among analysts is not overly high, suggesting some degree of certainty, and thus reliability.

Projected returns (lines 18 to 39)

Lines 25, 32 and 39 show if Adobe P/E multiple were to contract from present level of 36.89 to 30.0, positive returns, ranging from 4.3% to 9.9%, would be possible, provided the shares were held through end of 2024. On the other hand, if multiple increased from current level of 36.89 to the historical average of 40.78, returns of 16.7% to 22.9% are indicated. The 16.7% return is based on analysts’ low EPS estimates, and the 22.9% on their high EPS estimates, with a return of 19.1% based on consensus EPS estimates. If multiple remained at current level of 36.89, returns of 12.5% to 18.5% are indicated, with return of 14.9% based on analysts’ consensus EPS estimates.

Review Of Historical Performance For Adobe

Adobe: Historical shareholder returns

In Table 4 below, I provide details of actual rates of return for Adobe shareholders investing in the company over the last seven years.

Table 4

For many stocks where I create a table similar to Table 4 above, I find a wide range of returns indicating a degree of volatility and risk. Table 4 above shows anyone investing in Adobe shares at beginning of 2020 or in the six years prior have achieved outstanding returns. Seven of nine different investors, each investing $3,000 over the six years to beginning of 2020, and holding to the present, achieved returns ranging from 15.1% to 31.7%. The remaining two investors, buying shares from Q2 2020 onward had poor returns of 3.8% and negative (4.2)%. These rates of return, ranging from positive 31.7% to negative (4.2)%, are not just hypothetical results. They are very real results for anyone who purchased shares on the various dates and held through to Apr. 4, 2022. In the above examples, the assumed share sale price is the same for all investors, illustrating the impact on returns of the price at which an investor buys shares.

Checking Adobe’s “Equity Bucket”

Table 5.1 Adobe Balance Sheet – Summary Format

Table 5.2 Adobe Balance Sheet – Equity Section

I often find companies report earnings that should flow into and increase shareholders’ equity. But often the increase in shareholders’ equity does not materialize. Also, there can be distributions out of or other reductions in equity that do not benefit shareholders. Hence, the term “leaky equity bucket.” It is not the worst case I have seen, but this is happening to a worrying degree with Adobe, as explained below.

Explanatory comments on Table 5.2 for the period from end FY-2016 to Q1-2022.

• Reported net income (non-GAAP) over the 5.25-year period totals $21,917 million, equivalent to diluted net income per share of $44.92.
• The non-GAAP net income excludes $3,333 million (EPS effect $6.81) of costs regarded as unusual or of a non-recurring nature. A large component is employee stock compensation expense excluded in calculating non-GAAP earnings and EPS. The rationale for excluding certain expenses from non-GAAP profit constructs is supposed to be to better show the underlying profitability of a business. I struggle with the notion employee compensation is in any way unusual or of a non-recurring nature. Adobe are not alone in excluding employee stock compensation expense from adjusted earnings. But, for Adobe, the true economic cost of this expense is particularly large and significantly reduces shareholders’ equity.
• Other comprehensive income includes such things as foreign exchange translation adjustments in respect to buildings, plant, and other facilities located overseas and changes in valuation of assets in the pension fund – these are not passed through net income as they fluctuate without affecting operations and can easily reverse in a following period. Nevertheless, they do impact on the value of shareholders’ equity at any point in time. For Adobe, these items were $439 million additional income (EPS effect $0.89) over the 5.25-year period.
• The net income figure is arrived at after a charge of $2,628 million for 23.5 million shares issued to employees. The issue of these shares was more than offset by repurchase of 45.8 million shares for $15,300 million. The difference of $4,478 million, between the amount of $2,628 million charged against net income and the estimated $7,035 million paid to offset the shares issued, has come out of shareholders’ equity without being recognized as a charge against net income. Taking this additional cost into account further reduces EPS by $9.04 over the 5.25-year period.
• By the time these various items are taken into account, we find the reported EPS of $44.92 ($21,917 million) has reduced to $29.96 ($14,615 million) for the 5.25-year period. That becomes a rather serious difference when share price is already a multiple of 36.89 times reported EPS.
• The $14,615 million from operations, together with $7,035 million of shares issued to employees, less $15,300 million for share repurchases resulted in the net $6,350 million increase in equity per Table 5.1 above.