Adobe (NASDAQ:ADBE) is a leader in digital media software in a world that continues to become more digital. I believe Adobe has a strong moat because of the leading software they offer as a part of their Creative Cloud and Document Cloud segments. In my opinion, subscription-related revenues from Creative Cloud applications protected by high switching costs and PDF network effects will support ventures into new, potentially high growth areas. With the potential support from Creative Cloud ARR (annual recurring revenue) and high PDF adoption, Adobe may continue developing newer products and platforms like Adobe Sign, Adobe Sensei (AI services), and the Adobe Experience Cloud. By creating a holistic suite of product offerings built on top of their currently widely used platforms/applications, I believe Adobe’s sales force can attract new customers while getting current ones to consolidate their software-based workflows onto Adobe products.
I believe Adobe is a staple company with multiple flagship products like Photoshop and PDF that are regularly used as verbs. With the stock currently 44% off highs and trading at the bottom of a decade-long P/E range, entry into this industry leader with solid growth prospects may be excellent.
Breaking down Adobe’s business by the three segments they report in is the simplest way to understand the business in my opinion.
- The digital media segment is broken up into two main sub-segments; Adobe Creative Cloud and Adobe Document Cloud. Adobe Creative Cloud is a subscription service that grants users access to cloud-based applications:
- Applications accessible on Adobe Document Cloud are below:
The Adobe Experience Cloud is an integrated platform containing applications that serve customers with tools and services aimed to optimize analytics and commerce. Customers for the digital experience suite include marketers, advertisers, agencies, publishers, merchandisers, merchants, web analysts, data scientists, and developers.
The Adobe Experience Platform intends to provide businesses and brands with a robust system to transform customer data into customer profiles that update in real-time using artificial intelligence to personalize the consumer’s experience.
The specific solutions and products within Adobe Experience are below:
- Data Insights & Audiences: Adobe Analytics, Adobe Experience Platform, Customer Journey Analytics, Adobe Audience Manager, and Real-time Customer Data Platform.
- Content & Commerce: Adobe Experience Manager.
- Customer Journeys: Marketo Engage, Adobe Campaign, Adobe Target, and Journey Optimizer.
- Marketing Workflow: Adobe Workfront.
Publishing and Advertising
This is Adobe’s smallest segment and is broken up into two parts:
- Adobe Advertising Cloud: Delivers an end-to-end platform for managing ads across digital formats.
- Legacy Publishing Products: License their technology to OEMs that manufacture workflow software, printers, and other output devices.
All of the Adobe products I listed are centralized on their website at Adobe.com and if you want to read about each product in-depth, page 9 of their most recent 10-K is a great start.
The support from Adobe Creative Cloud is a key part of my thesis because I believe it will supplement younger and potentially high growth areas of Adobe’s business. Adobe Creative Cloud has grown significantly over the past decade as Photoshop and other applications on the platform have become staples in digital media. Over the last five years, Creative Cloud and total digital media ARR have compounded at 24% and 25%, respectively:
Even though Adobe doesn’t directly report its net dollar retention rate [NRR], I believe it is fair to assume NRR has been over 120% over the past five years because ARR has sustained 20% growth per annum. Also, management is guiding for an additional $440 million net new ARR for the digital media segment in Q2, representing 5.3% growth QoQ partially driven by new express web-based products and explosive demand for video content.
Document Cloud growth has also been exceptional, driven by accelerating PDF productivity including editing, converting, sharing, scanning, and signing. In Q1 ’22, Document Cloud growth was 29% YoY. With trillions of PDF files out there and billions more being created daily, I believe PDF monetization is still young. Because of the mass usage rates and network effects involved with PDF, I believe Adobe will be able to continue growing earnings in the Document Cloud segment, especially with program additions like Adobe Sign.
I believe the stability (and future growth) in digital media earnings will continue driving product innovation and leadership in their respective areas of operation. Adobe’s leadership profile is already impressive according to industry analyst reports but I believe growth in the Experience Cloud, AI workloads, and programs like Adobe-Sign will drive not only further leadership but earnings for the company.
Some notes before sharing my model:
- I forecast a sharp slowdown in top-line growth in FY ’23 due mostly to revenue cyclicality associated with a potential economic slowdown. Not trying to bring too much macro into my forecasts but wanted to stay conservative.
- Management still forecasting mid-teens revenue growth and 100%+ NRR for the year.
- I believe share repurchases will continue to accelerate with the stock down and I’ve forecasted the diluted share count to be down ~5% by FY ’26. As of the end of Q1 ’22, the buyback program initiated in December 2020 still has $10.7 billion remaining of the $15 billion authorized.
- In my opinion, Adobe’s digital media segment will continue driving the majority of total earnings in the short term which may keep margins elevated over the next five years.
I believe Adobe stock has historically traded between 20x and 40x NTM EPS since the late 90s and over the past decade has traded more consistently between 26x and 39x NTM EPS. The channels I have drawn below avoid times of peak valuation (tech bubble, 2014, and COVID-era) and despair (Great Financial Crisis/early recovery following):
(White lines represent my long-term channel and purple represents the last decade)
I believe the moat Adobe has built around its business warrants the elevated valuation seen over the last decade but also realize the macro environment plays a role. Low interest rates have potentially supported higher multiples which could be reversed moving forward.
Below are my next twelve month [NTM] price targets with a tactical risk to reward table below:
Below are my FY 5 PTs:
I believe Adobe has a cyclical business because a lot of digital media and experience-related revenues are spurred by general business activity. Because Adobe plays an important role in marketing for many businesses, if growth slows in the economy, the potential for ARR churn from Adobe products may be likely.
I believe a mitigant to this risk lies within Adobe’s wide range of clientele. Outside of small businesses or individuals using the platform, Adobe also serves virtually every industry and sub-sector from the smallest to the largest players. Recent Document Cloud enterprise customer additions include Medallia (MDLA), Mercedes-Benz (OTCPK:DMLRY), Raytheon (RTX), Ricoh Europe (OTCPK:RICOY), Shimizu (OTCPK:SHMUY), and UnitedHealth (UNH). Q1 Experience Cloud customer additions include Crowdstrik (CRWD), Deutsche Telekom (OTCQX:DTEGY), IBM (IBM), Jaguar Land Rover (TTM), JPMorgan Chase (JPM), McDonald’s (MCD), and UnitedHealth (UNH).
Even though I believe Adobe has healthy growth prospects that may support elevated valuations relative to the broad market, I do think the macro backdrop paints a stark picture regarding potential multiple compression. Over the past 20 years, Adobe has traded 29x NTM EPS on average. In the past 10 years, the average NTM P/E was 35x. While I believe Adobe has developed an excellent moat, strong network effects, and delivered strong earnings growth in the past decade, I also played am not blind to the fact the interest rate environment may have a key role.
As the 10-yr Treasury yield continues to climb (+150 bps in the last twelve months), historical data shows that equity valuations may be subject to compression if yields continue on their upward path.
After trading down ~44% from all-time highs, Adobe’s valuation is starting to look more attractive in my eyes. Given what I believe is a bearish macro backdrop that may affect stocks systematically, a stock like Adobe trading at 27x NTM EPS may still be in for a volatile ride. But for long-term focused investors, I believe Adobe is well-positioned for future growth as a strong leader in digital media software supported by a world continuing to become more digital. Adobe still has incredible growth prospects with a diversified customer base and product offerings that may provide additional support in the midst of turmoil market conditions, in my opinion. After the stock price was virtually cut in half over the last six months and is trading below its historical valuation averages, Adobe may be poised to show strong returns in the future to come.