Adobe: Don’t Expect It To Beat The Market Long-Term (Rating Downgrade)

Summary:

• Adobe’s strategic AI integration solidifies its dominance in professional creative software, potentially outperforming emerging competitors.
• While Adobe is poised for growth due to increasing demand for digital content, it faces competition from emerging AI-powered tools and cost-effective alternatives, potentially impacting market share.
• Adobe’s current valuation is favorable compared to historical levels, but future growth is expected to moderate. A projected 11% 10-year CAGR suggests a stable but low alpha investment opportunity.

I last covered Adobe (NASDAQ:ADBE) in January; I put out a Buy rating at the time, and since then, the stock has lost around 14% in price. In large part, I consider this to be because the stock was slightly overvalued at the time. After the recent reduction, I think the stock is more reasonably valued, but I am downgrading my rating to a Hold after more thorough research into the company, which assesses its long-term price CAGR over the next 10+ years as being unlikely to significantly outperform the market. The company has a portfolio of strong software offerings, and while it has developed arguably its most significant moat in creative applications, in my opinion, its CRM solutions are likely to continue to be accretive and scale. I consider Adobe strong because it is integrating AI into its offerings, and I think its flagship product, Photoshop, is likely to significantly outcompete generative AI competitors because of its advanced capabilities, including nuanced editing. Adobe’s moat is in professional creative applications, and I don’t expect this to change—in fact, it has the potential to continue scaling as the technology sector and trends in digitalization continue to expand. However, new vulnerabilities in the changing creator economy warrant caution from investors seeking high long-term price returns.

AI-Augmented Professional Creative Sevices

Adobe is currently heavily integrating AI across its Creative Cloud, Document Cloud, and Experience Cloud. AI tools like Adobe Firefly are enhancing the capabilities of applications like Photoshop, Illustrator, and Premiere Pro. Considering the company’s core market has always been professional creatives—a broad market of designers, photographers, videographers, and marketers—the addition of AI arguably places Adobe in an even stronger position than before. I find it unlikely that competitors like OpenAI’s Sora or other generative AI models will be able to compete significantly any time soon in the advanced creative domain. For the foreseeable future, Adobe is likely to retain its moat as the go-to application suite for creative professionals.

The commercial release of Firefly and its integration into Adobe’s products has already provided evidence that the company’s operational future is bright. Features such as Generative Fill in Photoshop and AI-enhanced video editing tools in Premiere Pro will likely create a new era in the creative profession where old skills become less useful, and the strategy of content creation and the quality of imagination become paramount.

The company’s enterprise solutions should also not be underestimated, with offerings like GenStudio combining content ideation, creation, production, and activation with generative AI. This domain enhances its moat in professional creative services by placing it as a foundational player in the enterprise content supply chain.

In my opinion, investors would be wise to notice the quality that Adobe is well known for and has retained through its many decades of operation. The company is well known for being reliable, sophisticated, innovative and advanced relative to the status quo in creative technology. As such, investors should ask themselves whether they believe the company’s values are conducive to long-term and stable stock returns. In my opinion, management has evidenced the correct dose of agility and reinforcing commitment to its biggest technological moats.

Growth Catalysts & Competitive Threats

With the growing demand for digital content, Adobe’s creative tools and content management solutions are arguably well-positioned for expansion. By expanding its presence in the enterprise sector and through strategic partnerships, such as the integration of Adobe Experience Cloud with Microsoft 365, marketers are likely to be able to work more efficiently, driving customer acquisition and retention. In addition, the partnership focuses on uniting data, content, and processes, and the opportunity for further strategic partnerships remains strong for further future market accretion.

There are also emerging technologies like augmented reality and virtual reality, which are likely to have heavy creative components, which open up new market opportunities for the company. Adobe Aero is a powerful tool that allows users to create interactive AR experiences, integrating seamlessly with Photoshop, Illustrator, Substance 3D and other Adobe applications. This can be used to create content from virtual exhibits in museums to interactive marketing campaigns. Adobe Substance 3D is a suite of tools designed for creating and texturing 3D models, supporting the creation of immersive VR environments used in fields like gaming, architecture, and entertainment. Management is already preparing for the metaverse by developing tools that can facilitate the creation of interactive 3D worlds. Brands like Coca-Cola (KO), Epic Games, and NASCAR are already collaborating with Adobe to build such experiences.

As I mentioned previously, some analysts are arguing that generative AI from companies like OpenAI, Google (GOOGL) (GOOG), and Microsoft (MSFT) might be able to take market share from Adobe. Partly, this could be true at the lower ends of the market, but I see it unlikely for the bespoke and sophisticated creative markets. There are also high-quality open-source creative tools and free alternatives (like Canva for graphics) that might erode Adobe’s market share. Again, this is likely to be eroded in the market for individual creators or small businesses. The question Adobe’s shareholders would be wise to ask is whether we are moving toward an economy of individual creators as time progresses—an economic quality that might become evermore present as AI becomes more capable of automating corporate functions. According to Goldman Sachs, the creator economy is expected to roughly double from $250B in 2023 to $480B by 2027. Its report states that the number of global creators is projected to grow at a 10-20% CAGR over the next five years.

Financial & Peer Analysis

In my opinion, the top three publicly traded companies that pose a competitive threat to Adobe over the next 10 years are Microsoft, Salesforce (CRM) and Autodesk (ADSK).

1. Microsoft competes in several key areas, including cloud services, productivity software, and design tools.
2. Salesforce competes in the customer relationship management and marketing automation fields.
3. Autodesk competes with Adobe in 3D design, engineering, and entertainment software markets.

	ADBE	MSFT	CRM	ADSK
Historical FWD Revenue Growth 5Y Avg	15.59%	12.99%	19.53%	16.21%
Historical FWD Diluted EPS Growth 5Y Avg	19.06%	15.66%	16.65%	36.66%
Historical FWD Free Cash Flow Growth 5Y Avg	15.76%	12.66%	22.28%	25.39%
Equity-to-Asset Ratio	0.5	0.52	0.62	0.22
TTM Net Income Margin 5Y Avg	30.28%	34.50%	7.32%	15.67%
FWD P/E GAAP Ratio	43.70	37.90	39.55	48.78

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Adobe has a notably high net margin compared to its peers, and its growth rates are highly competitive—better than Microsoft in top and bottom lines and free cash flow growth over the past five years. In my opinion, each of these companies is likely to benefit from margin expansion due to automation and AI, but in my opinion, ADBE, MSFT, and CRM are likely to experience more accretive results from their proprietary AI integrated into their systems bespoke, as opposed to ADSK, whose proprietary AI models such Project Bernini are tailored to specific niche use-cases rather than having broader enterprise applications. Adobe’s Sensei, Microsoft’s Azure AI and Dynamics 365 AI, and Salesforce’s Einstein AI are well-integrated across their respective platforms.

As I mentioned above, Adobe’s integration of AI into its products has been the core driver of its recent success. In Q2 2024 earnings, the company’s generative AI model was reported to have significant adoption, increasing the Creative Cloud subscriber rates. For the quarter, Adobe reported 11% YoY revenue growth, and it attributed its generative AI Firefly model family and the Acrobat AI Assistant as having played a crucial role in driving subscription rates and user retention due to efficiency benefits. In my opinion, the company is on to something crucial here as most of its customers use its products for professional use cases, and the efficiency gains provided by the company’s AI services are likely to boost users’ personal or enterprise cash flows.

Over the next few years, Wall Street analysts are estimating that the firm’s revenue growth is likely to ease to around 11% per annum. I think this is a reasonable expectation, but I also think the company is likely to maintain these still strong growth rates quite consistently over the next decade as its position in advanced AI creative services becomes more prominent. As a result, the current valuation looks quite appealing to me compared to historically, even if we are likely to see a moderate correction in valuation multiples.

Value Analysis & Price Target

Adobe has rich valuation multiples, but as the following table shows, this is not unusual for companies in its field. As we can also see, ADBE stock is currently trading at a discount from its five-year average in both FWD P/E GAAP and P/S ratios. This is warranted because the company’s future earnings estimates are likely to be somewhat lower moving forward, which is the consensus on Wall Street and also logical if we consider the market saturation and growing competitive threats, which include a potentially new creator economy that is evolving to be reliant on cheaper AI creative solutions, like DALL·E, ChatGPT, and cheaper graphic design platforms like Canva—all a significant threat to Photoshop.

	ADBE	MSFT	CRM	ADSK
FWD P/E GAAP Ratio	43.70	37.90	39.55	48.78
FWD P/E GAAP Ratio 5Y Avg	45.57	31.04	NM	94.09
FWD P/S Ratio	10.94	13.58	6.14	8.51
FWD P/S Ratio 5Y Avg	13.09	10.37	7.47	11.05

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This comes at a time when Microsoft, arguably Adobe’s largest competitor, has an expanding P/S and P/E ratio. Again, this is arguably warranted because the company has been expanding its net margin much more aggressively than Adobe over the past 10 years, whose net margin has actually contracted from its median over the time period by about 2 percentage points.

In my opinion, it is not unreasonable to expect Adobe’s P/E GAAP ratio to contract slightly more over the next decade as its fundamental growth begins to stabilize into more moderate annual rates. I believe a P/E GAAP ratio of around 35 is one reasonable prediction for the company in 2034. In addition, I am forecasting 12.5% annual EPS growth over the next decade, resulting in a 2034 price target of $1,272.95, as the current basic EPS is $11.20. The implied 10-year CAGR is 9%, as the current stock price is $526.88.

However, there is also the possibility that its P/E ratio does not contract as much as this. In an alternative scenario where the company’s P/E ratio contracts to only 40 over the period, the 2034 price target would be $1,454.80. The implied 10-year CAGR would then be 10.7%.

I think 12.5% EPS growth over the next decade is reasonable to predict because while there might be gains in growth in creative markets as a result of administrative jobs becoming automated, as I mentioned in my operations analysis above, the economy of individual creators with smaller budgets is also likely to grow. If, as one would hope, they choose the sophisticated and slightly more expensive models offered by Adobe, the company may be able to achieve a 10-year 15% EPS CAGR, which would result in a price target of $1,902.77 if the company’s P/E ratio is 42 in 2034. The implied CAGR in this instance would be 13.9%.

In my opinion, the likely outcome here is a 2034 stock price of approximately $1,500 and a 10-year CAGR of approximately 11%. For this reason, primarily, my rating is a Hold despite the operational positives surrounding AI that the firm has set itself up to deliver.

Risk Analysis & Closing Sentiments

I consider Adobe to be an excellent company. Part of what I admire about it and why I believe it offers a good place in portfolios despite it being unlikely that it will outperform the market long-term is that it offers a slow and steady approach to wealth accumulation. In my opinion, Adobe is a good investment for those who are risk-averse. However, such investments don’t provide exposure to the higher returns one might be looking for in the technology markets.

Momentum and value investors might benefit from short-term results related to AI integrations and a cheap valuation compared to historically, but over a long-term horizon, investors should expect this to stabilize into more moderate annual growth unless certain catalysts like advances in the individual creator economy prove to be highly accretive to Adobe despite growing cost-effective competition.

The future economy that could arise with the growing utilization of digital economies like YouTube and the metaverse could catalyze Adobe’s growth, but it also opens up areas of vulnerability. As artificial intelligence capabilities scale, a period of rapid technological change is likely to ensue. This creates shifting business models and arguably a software market that becomes democratized. There are already multiple AI-led companies that are producing cheaper software solutions, like Photoshop, at a huge reduction in price but with high levels of technical capability.

Adobe would likely benefit from adapting its strategy and reducing costs or offering versions of its applications, which are stripped back for casual content creators if the economy continues to become less enterprise-driven and more about independent freelancing. A strategy such as tiered subscription models would likely work better in the creative economy I think we are moving toward, led in the West and eventually across the globe. Management may also be able to mitigate risks through partnerships with freelance platforms like Upwork (UPWK) and Fiverr (FVRR) and even seek out partnerships with leading AI companies to consolidate its moat in advanced offerings at accessible prices through popular platforms.

Conclusion

Adobe will be one of many companies facing heightened levels of instability during this time of technological change. In my opinion, there are many opportunities for management to capitalize on, but also many areas of vulnerability if its operational strategies are not thoroughly planned and executed well. In a realistic scenario where the company manages notable successes but also concedes market share to competitors in certain areas, the company is probably likely to generate a CAGR of around 11% over the next decade, in my opinion. While this estimate could be beaten by higher levels of adoption of Adobe’s services, it is likely going to take a more agile approach to the business model and product development to achieve this—there has not been mounting evidence so far from the company that it is preparing enough to take this more proactive approach to combat growing market pressures.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of GOOGL, CRM either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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