Adobe Riding Internet Rally as Bulls Ignore Profit Drop

Options trading in Adobe Systems Inc. suggests the market’s infatuation with Internet stocks is alive and well.

Even after a year of falling profit, calls on Adobe shares are the most expensive relative to puts in three years, according to data compiled by Bloomberg. Among the five contracts with the highest ownership, four are betting Adobe will extend a 12 percent rally this year.

Chief Executive Officer Shantanu Narayen is steering the largest maker of graphic-design programs to sell more web versions of its Photoshop and Illustrator applications, reducing its reliance on the slumping personal-computer market. Adobe, which gives quarterly results tomorrow, is expected to return to profit growth in the fourth quarter as it signs up more customers making recurring monthly payments.

“Investors understand once they completely shift their user base to the cloud model, profit will materially expand,” Derrick Wood, an analyst with Susquehanna Financial Group LLP in San Francisco, said in a phone interview on March 14. “There is just so much runway.”

Adobe is riding an industry shift to deliver software over the Internet, as opposed to selling upfront contracts through licensing agreement. The company, one of the leaders in desktop publishing software, has promoted web subscriptions to a suite of online tools called Creative Cloud as customers migrate to smartphones and tablets.

Technology Rally

The stock hit an all-time high of $69.92 on Feb. 27. The gain mirrors a broader rally in technology stocks, with the advance in the Nasdaq Internet Index topping 45 percent since June. That compared with a 15 percent increase in the Standard & Poor’s 500 Index.

Puts protecting against a 10 percent drop in Adobe shares cost 2.50 points more than calls betting on a 10 percent rally, according to three-month data compiled by Bloomberg. The price relationship known as skew fell to 1.99 on March 7, the lowest level since November 2010.

Jodi Sorensen, a spokeswoman for the San Jose, California-based company, declined to comment on the options trading.

Adobe has said it’s on track to surpass its target of attracting 4 million Cloud subscribers by the end of 2015. Subscriptions will reach 8 million by the end of fiscal 2017, according to Ross MacMillan, an analyst with Jefferies Group LLC in New York.

Earnings Slump

The company may say tomorrow that it earned 25 cents a share in the first quarter ended in February, down from 35 cents a year earlier, according to analysts’ estimates compiled by Bloomberg. Profits will decline 16 percent for the whole year before surging 82 percent in fiscal 2015, the data show.

If Adobe fails to meet these expectations, the shares will take a hit, Skip Aylesworth, a portfolio manager at Hennessy Funds in Boston, said in a phone interview on March 13. The stock is trading at 60 times forecast earnings, the highest valuation since 2000, data compiled by Bloomberg show.

“It’s a very expensive stock,” Aylesworth said. His firm oversees about $4.7 billion. “The betting that’s going on is that the stock will continue to do very well and Adobe is having significant growth going forward. If not, there would be hiccups in the stock’s prices.”

The Chicago Board Options Exchange Volatility Index fell 12 percent to 15.64 at 4:15 p.m. in New York. The gauge known as the VIX jumped 26 percent last week. Europe’s VStoxx Index slid 7.5 percent to 21.46 after climbing 13 percent last week.

Online Subscriptions

Investors have been rewarding Adobe for focusing on online subscriptions, with the stock jumping 59 percent last year, even though profit sank.

Traders held more bullish options than bearish ones. The ratio of outstanding calls giving the right to buy versus puts to sell was 1.12-to-1, near the highest level since October, data compiled by Bloomberg show. March $72.50 calls, which had an exercise price 7.9 percent above last week’s close, had the second-largest open interest, followed by March $77.50 calls, the data show.

“The lack of credible alternatives to ADBE’s tools is likely to force the majority of the install base to eventually switch to the Creative Cloud,” MacMillan at Jefferies wrote in a March 12 note.

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