A Wealth of Woe at Macromedia
By Scott H. Kessler
The stock market has been going down for three years. Heck, we're in a bear market -- especially for technology companies. So why, after massive declines had already taken place, did I downgrade the shares of Web-development software company Macromedia to 1 STAR, or sell? It had already fallen a staggering 63% year to date through August 7, the date I cut its rating.
The answer is simple: I strongly believe Macromedia has much more downside risk. Yes, I wish I had been more aggressively negative on the stock at times over the past year. But I take solace in the fact that my recommendations evidence that I have expected the shares to underperform the S&P 500 since June 28, 2001.
Not surprisingly for a Web-development software company, Macromedia's problems stem from the excesses of the dot-com boom. The money was flowing freely as Web development reached a fever pitch (remember those signing bonuses and free Porsches?) and companies that supplied the tools used to build Web sites found revenues easy to come by. However, as the Internet boom turned to bust and demand for Macromedia's products declined, so did its stock price. That makes perfect sense.
About a year after the dot-com bubble burst, in March 2001, Macromedia made a huge strategic error in an attempt to jump-start growth. Amid the continued weakness in technology spending, the company acquired Allaire, a provider of Web-server software products, in a transaction valued at $428 million. Macromedia plunked down 5.6 million common shares and $83.3 million in cash, betting on synergies with Allaire and a tech-spending rebound. The company also assumed Allaire's options and warrants, whose "fair value" was staggering $297.9 million. In 2000, Allaire lost $8.9 million on $119.3 in revenues.
Macromedia's wager was poorly timed. Some 17 months after the company bought Allaire, demand for its products is still weak and there's no recovery in sight. In effect, the company doubled down and lost.
More recently, Macromedia, like many other technology companies, has been struggling in the face of weak demand for its products. The company has been particularly hard hit, because its software is used for creating Web sites -- hardly a priority for Corporate America at this point. On July 17, Macromedia reported a 5% revenue decline for its fiscal fourth quarter, and losses on both an operating and GAAP (generally accepted accounting principles) basis. (The company posted earnings per share on a pro forma basis.). Importantly, Macromedia acknowledged that its new MX product line wasn't catching on very fast. This is not surprising given the uncertain economic backdrop, but has significant negative implications for the company.
Another negative sign: On July 31, Macromedia's primary competitor, Adobe Systems, announced that demand had been much weaker than expected across all products and geographic areas, especially Europe and Asia. Macromedia derived 40% of its fiscal 2002 (ending March) revenues outside North America.
In sum, the company's fundamentals are worrisome. We believe that the company's goal of pro forma profits in the September quarter is in jeopardy, and that our fiscal 2003 forecasts might have to come down.
Macromedia's shares have historically traded at a premium to its peers and the broader market, reflecting the company's growth potential and attractive franchises. Given the uncertainty around Macromedia's performance and prospects, however, we don't believe the shares now deserve the valuation of a leading company.
The stock recently traded at 59 times Wall Street's consensus pro forma fiscal 2003 EPS estimate of $0.11. With projected 19% annual long-term growth, on par with its end-markets, its price-earings-to-growth multiple is 3.1. Based on current p-e and p-e-to-growth measures, Macromedia appears overvalued. Just compare its numbers with those of Adobe (which recently had a p-e of 20 and PEG of 1.1, using consensus Wall Street estimates), the S&P 400 Software Industry index (p-e of 20 and PEG of 1.0) and the S&P 500 (p-e of 16 and PEG of 1.2).
Although Macromedia recently had $169.2 million ($2.84 per share) in net cash, cash equivalents, and short-term investments, we would note that it has amassed quarterly operating losses (even with the help of pro forma exclusions) since the March 2001. As we'll discuss later, some of this cash would likely be used if the company undertook a restructuring or made moves to reprice or reissue its outstanding stock options. Moreover, many software companies trade in line with, or at discounts to, their cash per share, especially if they are losing money or are only mildly profitable.
Remember the options that Macromedia had to assume from Allaire? Well S&P believes that options-related issues are going to become increasingly problematic for Macromedia. Stock-option expenses using the SFAS No. 123 accounting standard (which requires calculating the fair value of all employee stock-based compensation plans using the Black-Scholes option pricing model ). Based on SFAS 123, these expenditures would have negatively impacted per-share results by $0.14 in fiscal 2000, $0.91 in fiscal 2001, and a staggering $1.57 in fiscal 2002. These increases reflect the Allaire acquisition and several other ill-fated deals.
In December, 2001, the company effected a stock-option reissuance because the options held by the company's executives and employees had lost substantial value in the wake of poor share performance. The stock has fallen dramatically since that time, and we estimate that more than 82% of the company's options are under water. This implies that a repricing or another reissuance might be necessary for Macromedia to retain and attract talent. These actions cost money, could be dilutive to earnings, and raise red flags about the company's belief in its future.
Macromedia took $81.8 million in restructuring charges in fiscal 2002 to downsize the company after the Allaire merger and amid the continuing tech-spending drought. We believe that additional efforts along those lines may be necessary. The company's revenues per employee are much lower than Adobe's and those of many other software companies. Macromedia just completed the development and releases of its new MX software line, and we believe that some of the people responsible for those products and the former Allaire server offerings could be let go to for a leaner workforce.
S&P acknowledges that Macromedia makes some great products that users love. But an investment decision, especially in today's treacherous market, has to be based on fundamentals and valuation. Using these criteria, we believe Macromedia shares could fall to new lows. We recommend investors get out.
Analyst Kessler follows Internet software and services stocks for Standard & Poor's