Why Macromedia May Weigh Adobe Down

Moments after midnight one recent Monday, Adobe Systems (ADBE ) unveiled its plan to buy Macromedia (MACR ). By day's end, shares of the two software makers had reacted predictably. Adobe was off nearly 10%, while Macromedia gained almost 10%. The clearest winner may be mutual fund giant Fidelity Investments. Days earlier it reported owning 11.3% of Macromedia.

While Fidelity did not disclose the cost of its Macromedia stake, securities filings indicate it picked up nearly 5.6 million shares in the first quarter. At the period's average closing price, that would mean Fidelity enjoyed a swift gain of more than 20% on the Macromedia it added this year, plus a lot more on the 2.2 million shares it got last fall when they were much cheaper. For Fidelity and its fellow shareholders, the question now is whether to hold on once this $3.4 billion all-stock merger is consummated. Known best for its Acrobat and Photoshop document- and picture-editing programs, Adobe aims by fall to have closed its deal for Macromedia, maker of the Dreamweaver and Flash programs for Web developers, plus Flash Lite, a hot seller for mobile devices.

AT ITS NOMINAL VALUE, $3.4 BILLION, this deal isn't cheap. In the fiscal year that ended on Mar. 31, Macromedia earned $42.5 million on $436 million in sales. That means Adobe is paying nearly eight times sales and 80 times earnings for Macromedia. Viewed more closely, Macromedia's price tag looks a bit lower. For one thing, the $3.4 billion figure does not reflect some $378 million in cash that Macromedia, which has no debt, brings with it. It also does not account for a total of $589 million in tax-loss and research-credit carryforwards. An Adobe spokesman confirmed that these tax assets were a factor in its bid, yet precisely how much of them Adobe will be able ultimately to apply against its own future tax liabilities is uncertain. A back-of-the-envelope guesstimate suggests that at, say, Adobe's average effective tax rate over the past three years (30%), the carryforwards might be worth up to $170 million or so.

Dealmakers eager to rationalize mergers often note cash positions and tax breaks of the sort Macromedia may bring to Adobe. They would put the deal's true cost closer to $2.9 billion. Even so, Macromedia remains a rich morsel for Adobe -- and not just on multiples of sales (6.7 times) and earnings (68 times). To see what I mean, take a glance at the table. Adobe, a disciplined company with no debt and steady delivery of earnings, agreed to pay a premium price for a plainly less-efficient operator. Adobe's operating margin is almost three times as wide, a chasm in profitability that is most starkly seen via operating profits per employee at each of the two companies: The average Adobe employee's profit runs four times higher.

Closing that gap, in part by cutting overhead at Macromedia, is one element in the deal's potential. Yet in describing his plan to Wall Street analysts, Adobe CEO Bruce Chizen emphasized that the merger is predicated on capturing more revenue, not squeezing out efficiencies. In the first year his best hope is for a slight addition to earnings. "Keep in mind, long term, this is obviously all about growth," he said. "The explosion of visual content, the fact that we'll be able to provide our customers with a more complete solution ...lead[s] us to believe that this combination will, over time, clearly generate greater growth."

From Silicon Valley, where competitive edges dull fast, "long term" and "over time" are dangerous words. That's why I won't be surprised if we look up one day and find that Fidelity has made a securities filing disclosing that it has started cashing out its quick profit on Macromedia.

By Robert Barker

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