An in-depth look at Adobe

1) As promised, I'm coming back to software giant Adobe (ADBE) for a deeper look...

In my September 20 e-mail, I shared comments from some of my readers about the company. And in my September 23 e-mail, I took a first look at the financials, where I concluded that:

[Adobe] is an incredible company with mouth-watering economic characteristics: predictable, growing revenues, sky-high margins, huge cash flows, and minimal [capital expenditures ("capex")].

But the stock is trading at nosebleed valuations and artificial intelligence could be a threat...

So today, I'll do a deeper dive to see if the shares – which have been rangebound for more than four years – might be compelling enough to buy at these levels.

For background on Adobe, I'll share some details from its 61-slide presentation from the company's Investor Meeting on March 26.

Adobe has three reportable segments: Digital Media – which includes Document Cloud (e.g., Acrobat) and Creative Cloud (e.g., Photoshop, Firefly, and Express) – Digital Experience, and Publishing & Advertising. This chart from the investor presentation shows the revenue breakdown last fiscal year (ending December 1, 2023):

As this next slide from the presentation shows, the Digital Media segment – which accounts for nearly three-quarters of revenue – has grown steadily over the past three years:

Adobe has become a much better business in the past decade thanks to a successful pivot from selling mostly software in a box to almost entirely a subscription model, which delivers highly predictable, high-margin revenues. Take a look at the slide below from the presentation:

In summary, I agree with an anonymous member of Value Investors Club – my favorite stock-idea website – who posted the following comment (No. 40) in response to one of my friends' pitch for Adobe in June 2022. Excerpt:

Adobe is one of the best businesses I have ever studied in my investment career.

• It is basically a monopoly provider and the system of record for digital content creation (the vast majority of movies you watch, social media ads you view, edited YouTube videos, gaming worlds you play in are built on Adobe's products). Pro designers are trained on it early in their careers at any business that creates digital content and when you survey them would never switch. The market is global, it's very large, and I only see it growing as our lives become increasingly digital. 

• It has significant pricing power that it rarely exercises (only two price hikes in the last decade) which in my view is the healthiest type of pricing power.

And as the member continued:

• It organically grows revenue high-teens (including this year) with almost no capex and is immensely profitable (50% EBITDA margins, 45% non-GAAP EBIT margins, 39% GAAP EBIT margins). Note [that] stock-based compensation is minimal (6% of revenue, 12% of net income, and annual dilution has been ~0.7% of shares outstanding the last several years). And the Company generates significant free cash flows, much of which goes toward share repurchases (with net shares outstanding declining every year given repurchases are well above annual share issuances to employees).
• The business is basically 95%+ subscription/recurring revenue, leaving the business largely recession-proof as customers view their use of Adobe as non-discretionary and essential.
• The Company has a net cash balance sheet.

So why has the stock been rangebound for more than four years?

There are two primary answers...

The first is that the valuation went from justifiably high to truly absurd.

As you can see in the 10-year chart below of the forward price-to-earnings (P/E) multiple, the stock traded between 30 times and 40 times, but then spiked to more than 50 times in late 2020 and again in late 2021.

Then, as tech stocks got hammered in 2022, the forward P/E multiple shrank to as low as 18.4 times... rebounded to the mid-30s at the beginning of this year... and now sits at about 25 times – well below its 10-year average of 33.3 times. Take a look:

A multiple of 25 times next year's earnings is reasonable for such a great business, so it's time to run out and buy the stock, right?

Not so fast...

One of the reasons investors are putting a lower multiple on the stock is because they are concerned that AI could be a real headwind for Adobe because it could eliminate a meaningful amount of work for designers – and therefore a lot of Creative Cloud seat licenses.

This is a valid concern.

Consider what my friend who runs a medical-device company located in Silicon Valley told me (from my April 17 e-mail):

As a company, we have a large number of (internal) promotional posters. In the past, we had to engage world-class artists on projects that typically took four months, 15 hours of my time, and cost $4,000. Now, using AI, these projects only take two weeks, three hours of my time, and cost $700.

Once we have our final design, we use another AI source to make the resolution 10 times better. We used to use the artists for their creativity... now we use ChatGPT for its creativity, and the artists just do the easy administrative fixes at the end to polish it up as a finished product.

AI is much more creative than the best artists in the world – it's not even close. The intricacy and breadth of the ideas is mind-blowing. It's a fabulous source for prototyping.

If I were an artist, I would be terrified.

To address this threat, Adobe is incorporating AI into nearly all of its products – and to address investor concerns, it mentioned AI 74 times in its investor presentation. Here's an example in this slide:

This is what my friend who posted the Adobe pitch on Value Investors Club had to say in the comments after his write-up:

I've come to the opposite conclusion after worrying about that scenario [the threat from AI].

I think that generative AI is good for Adobe and will widen their moat because it gives customers more convenience, faster time to value, and speedier execution of their creative process.

For those who want quick results, they can use Adobe Express. For those who want control and process, Photoshop, etc. Both of those apps and others will have generative AI capabilities.

I believe consumers pay for convenience and Adobe's tools are still the most convenient way to create and collaborate.

It will also likely expand its TAM [total addressable market]. People who are not designers can now design through text prompts and use sliders to get alternatives and variations.

I'm not an expert in AI or in Adobe's various software products. But my gut tells me AI will be a modest headwind for Adobe for the reasons my medical-device entrepreneur friend cites.

This doesn't mean Adobe is going to go into decline... just that its growth rate might, say, be 10% instead of 12% for the next five years.

If so, then 25 times forward earnings is probably a fair multiple.

So what does this mean?

Well, if I had bought the stock a couple of years ago at the lows around $300 per share as part of a long-term portfolio of super-high-quality businesses, I would be very comfortable holding it at these levels because I think the stock will do a bit better than the market over, say, the next five years.

But the bar is a lot higher when I think about adding a new position...

Before doing so, I would have to be almost certain that other investors are making a huge mistake in assessing the future of a business such that its stock is really cheap and, therefore, it'll do a lot – not a bit – better than the market.

In short, to quote an old friend of mine, I would need to be "trembling with greed."

Adobe met this test two years ago when its forward P/E multiple dipped below 20... but it doesn't today. So I'm going to put the stock on my "bench" and hope a better buying opportunity comes along at some point in the future.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.