50% Upside as this Tech Stock Moves to "the Cloud"

Ryan Fuhrmann's picture

Tuesday, July 26, 2011 - 1:00pm

by Ryan Fuhrmann

Did you know that Internet traffic in 2010 exceeded all of the traffic on the Internet from its founding through every year up to 2009, according to tech firm giant Cisco (Nasdaq: CSCO)? This pace will most likely continue. So what's the next big growth wave for the Internet? Well, you've probably heard buzz words such as "cloud computing" and "SAAS" (software as a service) gaining momentum. If you're a smart investor, then you know the time to explore these investment areas is now.

In a nutshell, cloud computing is the virtualization of data storage and applications systems. This means information and its related applications can now be stored and accessed via the Internet. A key benefit of working in the cloud includes the ability to access information from anywhere in the world as long as there is an Internet connection. Additionally, data stored in online servers is likely to be more secure than on computer hard drives, which can crash and destroy all its data forever.

Parallel to the cloud-computing concept is SaaS. This model for delivering software solutions via the Internet eliminates the need to buy an actual software package, download it to your computer and have to pay every time an upgrade is needed. Instead, SAAS is available for a monthly fee.

Adobe Systems (Nasdaq: ADBE) is ideally positioned to take advantage of the continued migration of data and software to the online world. The shift to cloud computing will continue to stoke demand for Internet development, which is Adobe's specialty.

The company provides solutions for online and print publishing as well as website production and development. Popular products include the widely-known Acrobat, the software that helps designers develop PDF documents and presentations; Flash, the platform that enables programmers to create web videos and animations; and PhotoShop, used to create and edit digital photos and graphics for print media and the web. 

To complement this scope of products, Adobe acquired web analytics provider Omniture on October 2009, in a $1.8 billion deal.  The company can now help users monitor website usage in order to optimize their online traffic, sales and business profits.   

In Adobe's words, its products continue to revolutionize "how the world engages with ideas and information." With cloud computing being the latest generation of this engagement, it should become a catalyst for Adobe's rapid expansion.

A history of steady growth 
During the past decade, Adobe's annual sales growth has averaged nearly 12%, while profits have gone up by a 10% annual clip. This solid growth is even more apparent in the company's more recent past. In the past three years, for instance, its original software business has grown 8% annually, while Omniture and software for businesses are both up 20% annually in the period. In addition, total company growth has perked up even more recently. During the past 12 months, sales jumped 29% while profits have more than doubled. The stellar growth in Internet traffic in 2010 was no doubt a key reason for this growth.

For 2011, analysts project sales growth of almost 10% and earnings of $2.27 per share. This represents an impressive year-over-year profit growth of 52%. I see this strong growth trend persisting as demand for online development and cloud computing continues to grow. Additionally, Adobe may embrace SaaS by allowing users to pay a monthly fee and avoid the high upfront costs its traditional software model requires. Finally, the viewing of web pages from smartphones and tablet computers will likely increase the need for new and optimized design solutions where Adobe specializes.  

Given the fact Adobe is purely a software firm and still relatively small, it has the potential to grow faster and be more nimble than larger software firms. Research firm Gartner recently estimated the total SaaS market at about $11 billion. And that's just right now. As I said earlier, this market should grow significantly in coming years. Adobe's total market capitalization is $15 billion, so the company can grow right along with this market.

In contrast, Oracle (Nasdaq: ORCL) and SAP (NYSE: SAP) are two of the largest software firms out there with market capitalizations of $165 billion and $72 billion, respectively. So while they can also benefit from the combination of cloud computing and SaaS, these two trends won't have nearly as much of an impact as they will have on Adobe.
 
Action to Take --> Adobe's forward price-to-earnings (P/E) ratio of 13 is very reasonable, given the future growth it is likely to see as information storage and management continue to move online. I see profit growth of nearly 18% a year for the next five years based on the robust demand that rising Internet traffic will probably create for Adobe's software. Discounting the future cash flow I estimate this will lead to, I see 50% upside to the stock.

Ryan Fuhrmann does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of CSCO in one or more of its “real money” portfolios.