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Tickers in this Article: ADBE, GOOG, MSFT, ADSK, WEBX
After Adobe Systems (ADBE) reported their first quarter March 22nd, market sentiment and much of the press was slightly sour. The price dip unequivocally creates a buying opportunity. Adobe's moat is wide, deep and filled with pricey product bundles. They are well-positioned to benefit from at least two mega-trends: the shift from static to rich media and the rise of the creative professional. Let's quickly review their product strengths and then highlight the numbers.

In a recent interview, Adobe's CEO was asked why he purchased Macromedia. Normally, the rationale behind a $3.4 billion acquisition (all stock, completed in December 2005) would occupy several paragraphs. Bruce Chizen refreshingly offered a one-word response, "Flash."

Flash animates much of web (and my chart below) but it is much more than a creative tool. Flash is vying for leadership as a rich media platform. The current desktop configuration is dominated by a Windows operating system and static HTML-based web browsing.

The key problem with this regime is that it really cannot handle web services; web services are software applications that can send and receive standards-based messages.

A secondary problem is that they are not dynamic: you need a clumsy page refresh to update single components.

The next portal evolution is underway and is loosely called rich media although the market will decide the particulars. AJAX is a set of technologies that grafts on top of the current regime. Google (GOOG) uses AJAX to refresh its search bar simultaneously with your keyboard input. So, AJAX is a rich media but odds are it will continue to co-exist nicely with Flash. (And, in smart fashion, Adobe's upcoming Flex architecture actively courts their co-existence).

Microsoft (MSFT) is embracing rich media with its upcoming Expression Studio suite -- already in public preview mode. Inside the suite is Interactive Designer (formerly code-named Sparkle) and it will compete head-on with Flash. Microsoft's entry into the professional designer market is clearly Adobe's leading challenge, but I would place my bet on Adobe. Fifty million lines of Vista code prove that Microsoft makes complexity like nobody's business, but they have never proven themselves in the designer (as opposed to code-developer) market where simplicity and usability reign.

Along with Flash, Adobe's Creative Solutions segment includes Photoshop and Illustrator (these products will find competition in Microsoft's Expression Graphic Designer), which are wildly popular. With the Macromedia acquisition, Adobe also added Dreamweaver 8, probably the market-leading HTML editor. The segments are charted below according to revenue in the first quarter 2006:
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Knowledge Worker sells Adobe Acrobat which authors the prevalent PDF files. Adobe just addressed the architecture, engineering and construction (AEC) professionals with its well-received Acrobat 3D. It streamlines document workflow between engineers and represents a tiny toehold in the CAD/CAM market dominated by Autodesk (ADSK).

Even before the acquisition, Knowledge Worker was growing at 30% per year owing to Adobe's "intelligent document" strategy, which is, may I say, intelligent. Toward the end of 2006, Adobe will release another upgrade to the Acrobat line. But don't neglect Macromedia's Breeze product in this segment. It is tiny today, and will compete with the likes of WebEx (WEBX). Breeze is a technical triumph that is certain to occupy at least some space is the hyper-growth, hyper-competitive market for web conferencing and web-based collaboration.

Enterprise contains the ColdFusion product, which is a server-side scripting language that competes with Microsoft's ASP. It also competes with the free, open-source PHP. Why would anyone pay thousands of dollars for ColdFusion when they can use PHP for free? It's (much) easier to learn, which in the long-run in many cases actually saves money -- explaining why some notable developers have indeed switched from "free" to "expensive" -- and of course, it integrates nicely with Dreamweaver.

In summary, product strengths include Adobe's winning position in the designer market (Illustrator, Photoshop, Flash), almost guaranteed growth in the Acrobat family, and -- I haven't even mentioned yet -- their strong position in high-end video and audio production (and post-production) segments. The great thing about these post-production markets is that Adobe keeps swimming up the value stack (i.e., open source is at the bottom and where price deflation reigns), where price pressure is not suffocating.

In regard to the numbers, the Macromedia acquisition prevents clean year-over-year comparables. In the old days, a stock merger like this could have been pooled, but now requires purchase accounting (under proposed FASB rules, purchase accounting will converge with international standards and be referred to as the "acquisition method."). Some of the Street apparently misunderstood the impact of purchase accounting: At least $60 million in revenue was "lost" for Adobe's quarter because it was deferred to forward quarters.

Similarly, the bottom line was impacted due to rules that dictate which expenses must be deducted as opposed to capitalized into the future. The net effect of this was to create, for example, the illusion that the mobile segment shrank for the quarter. Don't worry about that. This $10 million segment is growing -- it ought to explode -- and this truth will be revealed in future filings.

The average analyst estimate for the fiscal year ended November 30, 2006 is about $1.30. Presumably that's based on Adobe's revenue guidance of $2.7 billion. Assuming about 625 million shares, that expects net income of over $800 million. Clearly, that must be a non-GAAP expected EPS. Now that implies a 30% after-tax net margin; I think that is too optimistic.

Therefore, I think 2006 could be a rocky ride: the 3rd quarter will be seasonally soft (count on it), option expensing will continue to cloud the picture and put a big wedge between GAAP and non-GAAP, and Microsoft will create negative sentiment with the introduction of the Expression Suite.

If you can wait a year, on the other hand, most of Adobe's products (and it is a broad product line) are growing at double-digits, some in the twenty- and thirty-percent range. They have proven they can work up the value chain, avoid deflationary spirals, and they will be a central player in the rich media future.

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