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Thesis on Investment
Adobe Inc. (NASDAQ: ADBE) has been a market favorite for many years, surpassing S&P’s performance over a spectacular period of time. Many times we glanced at this stock and thought, “This is probably overvalued, “and we continue to eat our words. With stock corrections since high post-COVID, it’s a good time for an Adobe skeptic like myself to take a deep Dive into this stock to check if it is really the real deal.
Adobe is well positioned as a business. On the one hand, it has a Digital Media business, which is monopolistic in nature and has a huge moat. On the other hand, Digital Experience seems to be growing aggressively, aiming to carve out the marketing aspect of the digital economy. Both areas of business are highly profitable, and management has a good track record of allocating profits to further improve shareholder returns.
Although economic factors may affect growth here, we think demand will remain stable. As prudent investors, we want to see an immediate rise against a company’s appreciation. For the first time in a long time, we think Adobe is trading at an attractive discount on its fair value.
Company Description
Adobe is one of the largest global software enterprises, specializing in creative software solutions for individuals and professionals.
Adobe operates 3 main segments:
- Digital Media-This is the largest area of business, allowing individuals and companies to create and publish many different digital innovations. This includes Adobe’s Creative Cloud and Document Cloud services.
- Digital Experience – Provides services for the creation, implementation, monitoring and optimization of digital marketing material. This includes Adobe’s Experience Cloud service.
- Publishing-Provides services for authoring and publishing needs.
Software companies have lost in recent months due to worsening economic conditions and rising interest rates. Investors expect growth to slow and future profits will be reduced by a larger amount. Software businesses are trading at a premium because of this growth and are also the first to be on the chopping block when things start to slow down.
Adobe shares dropped 33.5% YTD and had 2 consecutive quarters of “shaky” earnings. I call them thrilled, because Adobe is performing moderately well and the markets don’t seem sure how to react. We believe there is a level of fear driving the share price movement, which markets expect things to get worse, even if things look okay at the moment.
Adobe’s Market
As part of its annual review, Adobe announced that it has upgraded its overall addressable market estimate for 2024 to $ 205BN, suggesting that the value of outstanding growth for the business is great. Much of this growth is expected to come from their Experience Cloud offering, which Adobe believes will grow subscriptions by 20% this year. With the global economic development and technological advances, more and more of the world’s operations are online. Adobe developed its Experience Cloud offering as a way to monetize back-end data.
Moving to Adobe’s creative cloud platform, it faces little competition in the market. Over a decade, Adobe has been able to optimize its offering to the extent that no other business has achieved market position. According to Gartner, Adobe is a leader in Digital Experience Platforms, which enhances the quality of their products. With a monopolistic market position, Adobe is able to absorb most of the new customers in the market. Such a market is supposed to grow as in previous years due to the amount of productive work that is constantly moving to the internet. For this reason, we’re not concerned about slowing growth in Adobe’s core operations and explain why Adobe expects Digital media to grow by 17% in the coming year.
Will the Economy Affect Adobe?
I’m sure it’s not news to people that economic growth is slowing and many now fear stagflation. The effect is that demand is likely to decrease, while discretionary income decreases. The further complexity of inflation will exacerbate this, as even those who have not lost their jobs/struggled will still see their cost of living increase and will remain emotionally low.
In theory, we see Adobe as relatively resistant to recession. The reason for this is that many use Adobe services to conduct their business, whether they are professional photographers who use Photoshop, service companies who use Acrobat Reader or influencers who use Lightroom. Growth will certainly be slow because less demand means less business, but recurring revenue must remain stable, with demand sticking. This is purely in theory however, if we look at the actual results, we will see the following.
Adobe growth versus US GDP growth (TIKR Terminal and Trading Economics)
Over the past 16 years, US GDP growth has dropped below 2% 6 times. Adobe’s average growth dropped to 7%, half of its average 14% growth over the same period. As growth persists, this is good news, although 2009 is certainly a bit worrying.
Adobe, the Financial Powerhouse
Adobe’s financial performance is incredible. In Q2 of 2022, Adobe achieved the following.
| Origin: | Adobe | ||
| $ ‘000s | Kita | YOY Growth |
New ARR (DM)/Sub Rev (DE): |
| Digital Media | 3,200 | 15% | 464 |
| Digital Experience | 1,100 | 17% | 961 |
As we have noted, Adobe is growing in strong double digits and essentially generating new business. ARR/Subscription revenue is a better indicator for SaaS revenue, as it better reflects real revenue compared to accounting revenue recognition, and shows that Adobe will achieve another 15-year. 20% growth.
The growth of the digital experience is the key metric here, it is likely to be the future of Adobe and so seeing consistently strong growth in subscriptions will ensure a fruitful future for the business.
When evaluating a business’s KPIs, we want to look at them in the context of similar businesses. In the case of Adobe, we compare them to other Software businesses.
Peer Comparison in Tech Enterprises (TIKR Terminal)
We noticed that Adobe was noticeably more profitable than the peer group we selected, with only ServiceNow (NOW) generating more FCF. This is a direct return to shareholders and suggests that Adobe is the most profitable software business, when adjusted for size. Its partnership with a market-leading ROCE suggests that management has been incredibly successful in allocating capital.
The only concern is that analysts expect Adobe to grow the slowest in the pack. Since the Digital Experience component is still in its growth stage, analysts are likely to be hesitant about how growth will develop. The likely reason for peer group differences is the natural differences between the services offered. Salesforce is almost a must for businesses of particular size and ServiceNow is leading the cloud computing revolution we’ve seen in recent years, so at another point in its life cycle.
Adobe is a mature business, still putting up strong double-digit growth, the epitome of GARP. For us, the primary metric for business is the FCF generation, as it directly increases shareholder wealth. Adobe is a market leader here.
Appreciation
We have now moved to the place that has always worried me. Like most Software businesses, Adobe traded at a premium during “good times” to reflect the aggressive growth we’ve seen over the past decade. However, with the recent correction, things may have changed.
Market -based valuation
As we mentioned in the table above, Adobe certainly holds its own against the peer group. Yes, growth is expected to be lower, but the FCF margin pays off. Over 10 years, FCF’s 12.1% growth and 35.1% margin is a superior combination of 28%. Because of this, a 23x multiple looks fair.
Based on this valuation, we get a valuation of $ 450.
NTM EV/EBITDA Analysis (TIKR Terminal)
This suggests an increase of 16.1%. Given the 1.08 beta and lack of volatility, this is a strong comeback.
DCF
Usually, we want to practice at least two estimates. We have been careful with our assumptions, expecting FCF growth to be lower than the previous 5 years and the exit multiple will be 18x.
This gives us a valuation of $ 513 per share, with an IRR of 16%.
Adobe DCF valuation (author’s own calculations)
Therefore, Adobe’s rise looks strong based on the company’s ongoing. In the past, the business seemed overvalued based on the metrics at the time, but innovation allowed the business to exceed expected assumptions. This can certainly happen again, with growth driven by Digital Experience. Regardless, in its current position only it looks attractive.
Investment Risks
UBS analyst Karl Keirstead downgraded Adobe earlier this year believing marketing spending was presented in 2020 and 2021. This is a logical hypothesis, as businesses look to take advantage of the most -COVID overspending. This could mean lackluster growth in the next 24 months, importantly the loss of revenue could result in negative price action. That said, at the time the shares were trading at $ 532.55 after the news, and so the risk was likely to be priced.
Final Thoughts
We’ve been an Adobe skeptic for as long as I can remember. The reality, however, is that you have to pay a premium for a best in-class Software business. Adobe is certain that this, with leading to free cash flow generation and sticky requirements, Adobe should have no navigation issues in the coming period of time. At its current price, we may not be able to repurchase Adobe at such a discount. Adobe is a premium business with no premium attached, and so if you want to invest in this business at a cheap price, we believe now is the time. As such, we rate this stock as a purchase.