Adobe Building on Firm Foundation; Boxed in at Office Depot

Adobe Systems (ADBE)

Jim: Buy

Mike: Buy

Jim: You would never know from looking at Adobe Systems that there’s been a “tech wreck” in the stock market, Michael. Boy, this outfit is the exception to the rule, because its share price has more than doubled this year.

Mike: What’s notable is that Adobe was the exception to the rule when there was a tech stock boom going on, too. Adobe lagged some of the other tech companies on their way up, but, unlike them, its stock is still rising. And you know what? I just love Adobe.

Jim: Then do you need to continue?

Mike: No, I’m going home now.

Jim: Well, I agree. I’d buy this stock, too.

Mike: I love Adobe because I happen to know its founders. This is another testament to the history of Xerox PARC, the Silicon Valley fount of so many of today’s computer technologies. The founders of Adobe, Chuck Geschke and John Warnock, got their start at PARC.

Jim: There you go again, dropping names. Anyway, there’s no getting around that Adobe has risen head and shoulders above the whole tech sector in terms of both its business performance and its stock price.

Mike: Let’s back up. Adobe Systems is a premier provider of graphics software, the programs that help professionals and consumers draw, animate, publish and print on the computer and the Web.

Jim: Many of our readers know Adobe by the Acrobat Reader program. Say you want to look at a document--for instance, a corporate annual report you’ve taken off the Internet. Before you can see it properly, the Acrobat Reader software launches on your PC . . .

Mike: So you can read the report easily and look at its pictures and graphics. Now, Adobe also makes software that helps people design Web sites and create photographic images in a computer.

Jim: The Times also uses one of Adobe’s premier products, Photoshop, to help prepare its photographs for publication.

Mike: In fact, I use Photoshop at home to work on photographs from my digital camera. A lot more people will be doing so, I’d wager, because Photoshop will be packaged with many of these new digital cameras.

Jim: Adobe has two major things going for it: a great lineup of products, which we just referred to, and good management that executes well. That has been evident this year. In its third quarter, Adobe’s operating earnings surged 47% to $106 million, as sales jumped 26% to $329 million.

The company is hitting on all cylinders, and the stock reflects that: It’s up more than 125% this year. Adobe just split the stock again, 2 for 1.

Mike: So this is by no means a cheap stock . . .

Jim: No kidding. It’s now trading for 73 times anticipated 2000 earnings per share.

Mike: But I think it’s still worth buying. Geschke and Warnock, who are co-chairmen--though Warnock is CEO and Geschke recently retired as president--work together so closely that for a time you would have thought the first name of the top guy at Adobe was “Chuckenjohn.” They’ve been professional partners for nearly 30 years.

This company always appreciated the engineering talent on its payroll and, more to the point, made sure that its engineers knew how to move products to the marketplace. That’s the hardest thing for a big company to do--are you listening, Xerox?

Jim: We should note that Adobe’s stock has been volatile in recent months because of concerns that the recent slippage in PC demand could be bad for the company. We saw that in the middle of October, when an analyst cut his rating on Adobe because, among other things, sales of Apple Computer’s iMac might be slowing.

That briefly knocked Adobe’s shares for a loop. They have come roaring back but, you must agree Mike, the stock’s lofty price-to-earnings multiple doesn’t leave much room for Adobe to mess up.

Mike: Sure, but I don’t think this is a company whose fortunes are dependent on new PC sales. Even after we have PCs in every home, people are still going to look for new and interesting ways to use them. And that’s where Adobe comes in.

Office Depot (ODP)

Jim: Don’t buy

Mike: Don’t buy

Mike: I took one look at Office Depot, Jim, and had an instant reaction.

Jim: What’s that?

Mike: There’s nothing but bad news coming out of the state of Florida. The company is based in Delray Beach, where they may or may not be counting ballots as we speak.

Jim: Yes, but I suspect we’ll have a new president long before Office Depot gets its act together. This 860-store chain is one of the big-box retailers of office supplies, much like Staples.

Mike: In fact, Office Depot at one point was going to be Staples.

Jim: That’s right. About three years ago Office Depot agreed to be bought by Staples, but the merger was shot down by the Federal Trade Commission on antitrust grounds.

Mike: It seems that was one of the last big mergers the government ever stopped, because it certainly has let some other outrageous ones go through.

Jim: I found the FTC’s logic to be intriguing. I can’t think of many retail sectors that are more fractured than office and stationery supplies, where there are a zillion mom-and-pop outlets. Yet the FTC argued that because there are only a handful of superstore chains, competition would be hurt by the merger of Staples and Office Depot.

Mike: The agency figured that, by reducing the number of superstore chains by one, it would condemn consumers and businesses to higher prices. Whether that would have happened, I’m not sure. But clearly the nixed deal left one company strong--that’s Staples--and one emasculated--Office Depot.

Jim: Office Depot never recovered from that failed merger. A key reason is that, after the deal collapsed, Office Depot went on an ill-advised expansion binge that it’s still paying for.

Mike: Right. In the months leading up to the Staples deal, Office Depot put expansion on hold. When the merger went away, Office Depot figured it was way behind and went hog wild with expansion. It opened far too many stores and yet, in some ways, not enough.

Jim: What do you mean?

Mike: It opened too many stores in that it put pressure on its profit. But if you dissect its expansion, it didn’t move into some cities with enough strength. Staples, for instance, would go into a new city and open 10 or so stores, really cutting into its competitors’ market share. But Office Depot went into new markets with, say, only two or three stores, and thus instantly established itself as an also-ran in those markets.

Jim: The upshot is that Office Depot’s performance has been lackluster, driving its stock price sharply lower.

Back in July it hired a new chief executive--Bruce Nelson--to turn things around.

Mike: He’s got his work cut out.

Jim: No question. He’s looking to slow Office Depot’s expansion, close underperforming stores, bolster remaining operations and get the stock up. It can’t happen soon enough, Mike. This stock has dropped 40% so far this year and now trades for just 10 times expected per-share earnings for 2000.

Mike: Nelson has a problem, though. Half of what Office Depot sells are commodity products, such as reams of paper, pens, pads and other stuff with profit margins that are ultra-thin. That’s because these goods are sold by lots of stores that don’t like being undersold by anyone.

Jim: Including some heavy hitters such as Costco Wholesale and Wal-Mart.

Mike: If you’re a small-business owner and you need to buy a lot of computer paper, you’re just looking for the cheapest price.

Jim: You’re probably also looking for a ladder to reach the top shelves.

Mike: So that leaves Office Depot trying to earn fatter margins selling computers and other office equipment. But in that business it runs into not only the Best Buys of this world--which can undercut Office Depot on price--but also the direct-sales computer makers such as Dell Computer and Gateway.

Jim: Even in that sector, the profit margins are relatively small--not to mention that PC sales nationwide are slowing. Office Depot said as much two weeks ago, when it warned about weaker earnings near term.

So it seems to me that this company is in a box. I wouldn’t buy this stock even at its arguably cheap price.

Mike: Me neither.

Jim: You know what would be interesting? If Staples now tried to buy this company.

Mike: Right. Would the FTC let it go this time? I wouldn’t be surprised if the agency gave it the green light.

Jim: Agreed, given Office Depot’s struggles. Maybe Staples will take another swing at it--though Staples hasn’t indicated anything of the sort.

But barring a takeover, it’s tough to see how Office Depot stock is going to regain much ground any time soon.

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Peltz (james.peltz@latimes.com) covers the markets and corporate financial trends. Hiltzik (michael.hiltzik@latimes.com) covers technology and entertainment. Either can also be reached at Business Section, 202 W. 1st St., Los Angeles, CA 90012.

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