Description

Summary

I believe Adobe is a high quality business that can deliver a long-term IRR of ~16-17% at today's price.

Business Description

Here is a good description of Adobe from its 10-K:

Founded in 1982, Adobe is one of the largest and most diversified software companies in the world. We offer a line of products and services used by creative professionals, including photographers, video editors, graphic and experience designers and game developers; communicators, including content creators, students, marketers and knowledge workers; businesses of all sizes; and consumers for creating, managing, delivering, measuring, optimizing, engaging and transacting with compelling content and experiences across personal computers, smartphones, other electronic devices and digital media formats.

We market our products and services directly to enterprise customers through our sales force and local field offices. We license our products to end users through app stores and our own website at www.adobe.com. We offer many of our products via a Software-as-a-Service (“SaaS”) model or a managed services model (both of which are referred to as hosted or cloud-based) as well as through term subscription and pay-per-use models.

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Adobe’s products are segmented as “Digital Media” and “Digital Experience.”

Under Digital Media the company has its Adobe Creative Cloud, which includes Acrobat, Photoshop, Lightroom, Illustrator, Premiere Pro and others.

This segment has $11.8 billion in trailing twelve month revenues, growing ~22% year-over-year on average over the last two years.

Under Digital Experience, adobe has a number of commerce, analytics and advertising solutions, including Adobe Analytics, Adobe Audience Manager, Adobe Customer Data Platform (a CDP that competes with Twilio Segment), Adobe Commerce (a small Shopify competitor), tools to manage customer journeys, ad targeting, and others.

Digital Experience has $4 billion in trailing twelve month revenues, growing ~19% year-over-year on average over the last two years.

Business Merits

I believe Adobe is a high-quality business with high quality cash flows. Its products are in many ways mission-critical to its customers. Personally, I use Lightroom (for photography), Audition (for podcasting), and Acrobat to manipulate PDFs, and it’s hard to imagine not paying for these subscriptions (the company does not share churn or retention data).

I have been following Adobe for years and believe its product development to be exceptional: the company keeps adding features to its products and rarely raises prices. Some of the AI-driven features it has released for Adobe Lightroom, which I use the most, are so good, they’re in “science fiction” territory. When it has raised prices, its commentary has been that it did not see any elevated churn, because customers appreciate all the incremental value they have received from the products over time. 

The company has gross margins approaching 90% and free cash flow margins that have averaged 42% over the last two years. 

The company has been retiring shares outstanding since 2016, with about $10 billion remaining in its current repurchase authorization. Given the low reinvestment rate required to run the business, I expect the company to keep buying in its shares over time.

The balance sheet is good, with cash equal to debt of about $4.6 billion. The company generated nearly $7 billion of free cash flow in the last twelve months.

Valuation

As far back as I have data (Q1 2013), Adobe has traded at a price to free cash flow ratio of 29-34x (median) and 31-38x over the last 5 years (median).

Currently it’s at 26x free cash flow.

My model shows a near-term IRR of ~20% assuming top line growth of low teens (13% revenue growth expected this year), a multiple of 28x free cash flow (below the long-term median). I’m using this lower multiple simply because I’m assuming the company might grow more slowly going forward.

Given the high ROIC nature of this business (~30%) and high ROE (~50%), I expect the multiple to remain high.

Longer term the IRR should converge to the following:

Entry FCF yield: 3%

Margin expansion: 0.5%

Share count shrinkage: 1.5%

Free cash flow growth: 11-13%

IRR: 16% - 17%

This assumes revenue growth continues in the low teens. The company believes it has an addressable market of $205 billion (current revenues: $16.1 billion). Like all ambitious companies, Adobe has expanded its addressable market over time.

Why it's Cheap

Adobe stock is down ~34% YTD. The company disappointed on earnings; the disappointment was a slowdown in sales growth, which was attributed to an extra week in the year-ago period, so you'll see a lot of "on an adjusted basis" growth cited in Adobe's latest earnings release. 

The question is: is management lying or not? Is this a real decel or not? The stock is also getting downgraded for its ecommerce and advertising analytics tools, given a slowdown in that sector. Earnings are tomorrow (16th) so we'll likely see some volatility ahead.

However, fundamentally I believe this is a strong franchise with a bright future and substantial growth ahead. See the risks below.

Risks

Adobe’s management team is excellent, but I think the biggest risk is complacency and competition. Canva is a startup that made inroads in browser-based, simple design tools, and Adobe took a few years to respond. It now has, with Adobe Creative Cloud Express. This new product still does not have feature parity with Canva, however management has emphasized that this is a first product and they’ll collect feedback from users and iterate quickly.

Another risk is poor capital allocation. Adobe has made smart tuck-in acquisitions (like Marketo, Omniture and Frame.io). Let’s hope they remain smart. 

A risk to the upside would be Adobe growing faster than I expect and trading at a higher multiple. For example, 14% growth and 30x free cash flow results in IRRs of ~23%.

Catalyst

Continued growth and innovation in its software tools for creators and marketers.