Adobe: Generative Credits Offer A Direct Path To AI-Driven Profitability
Contributor since 2021 / 700 Followers
Summary:
- Adobe’s Q3 results beat analyst estimates, but the stock fell 11% due to softer-than-expected Q4 guidance, attributed to timing issues.
- The company is making significant progress in monetizing its AI tools, particularly through Generative Credits, which could drive future revenue and earnings growth.
- Despite competition and uncertainties in AI monetization timing, Adobe’s fundamentals remain strong, with robust performance in Creative and Document Cloud segments.
- Valuation remains attractive post-selloff, with a price target of $667, representing a 28% upside; I maintain a STRONG BUY rating.
Dmytro Varavin
Investment Thesis
The last time I wrote about Adobe Inc. (NASDAQ:ADBE), I talked about how the company has started to monetize its AI tools and argued why the company is only in the early innings of its AI journey.
Since the article was published in June 2024, the stock has been marginally down 0.12%, significantly underperforming the S&P 500, which gained 4.2% during the same period. However, the underperformance does come with a caveat, with ADBE’s stock losing nearly 11% since its Q3 earnings report, which came out earlier this month.
In this article, I dissect the company’s third quarter results and analyze the company’s progress made towards its AI monetization. I also argue how the company’s AI-related Generative Credits can be a whole new source of top- and bottom-line growth for the future.
Third Quarter Highlights
ADBE had yet another solid quarter in my opinion, with both top- and bottom-lines beating analyst estimates. Q3 revenues came in at $5.41 billion, up 10.6% y/y and beating analyst estimates by $34.9 million. Non-GAAP diluted EPS came in at $4.65, up 13.7% y/y and beating analyst estimates by $0.11. The company’s remaining performance obligations (RPO), once again, were very strong, coming in at $18.1 billion, which translates to a y/y growth of 16% in constant currency. Both the Creative and Document cloud segments continued their upward trajectory, growing at double-digit rates y/y.
Despite the strong quarterly performance, ADBE’s stock tanked after-hours and finished the trading session, down 8.5%. The massive drop can be attributed to the softer-than-expected Q4 guidance. ADBE management now expects Q4 revenues to come in between $5.5 and $5.55 billion, with the midpoint of the guidance ($5.525 billion) falling short of analysts’ expectations. Q4 non-GAAP diluted EPS is now expected to come in between $4.63 and $4.68, with the mid-point of the guidance ($4.655) also falling short of analysts’ estimates of $4.67. Management also announced that the company had repurchases 5.2 million shares during the last quarter, and the company still has $20.15 billion allocated to buybacks.
ADBE Offers More Color on Path Towards AI Profitability
There has been considerable debate about companies’ ability to make money from their AI investments. ADBE’s case has been no different, as investors continue to question the impact of its AI tools on future profitability. In my last article on the company, I did offer evidence on how the company has firmly laid the foundation to monetize its AI tools. This quarter, we got more evidence on ADBE’s monetization efforts. And it involves generative credits.
Generative Credits are how users can deploy ADBE’s gen AI features, powered by Firefly, in any of the company’s applications that the user has subscribed to. Depending on the generated output’s computational cost and the value of the gen AI feature that the user has deployed, the user consumes these credits. For now, the company has not instituted any caps on the amount of generative credits, which a user can consume. As the adoption of Firefly accelerates, which is something that the management noted during the third quarter, the company plans to institute caps on generative credits, beyond which, users will most likely have to pay for them. Management is already seeing a higher rate of consumer retention for its products that have generative AI features, which has subsequently accelerated the consumption of Generative Credits. This does suggest that the demand is there. Therefore, as Firefly becomes more widely used, which is inevitable in my opinion, given how effective the tool has been, monetization via Generative Credits could happen a lot faster than anticipated.
The company’s AI tools has already led to increased demand for its products, as evidenced by the strong growth in both the Creative and Document Cloud segments. In a way, the AI tools are already having an indirect impact on the company’s top- and bottom-lines. Introducing caps on Generative Credits would lead to these tools directly impacting both the revenues and earnings, thereby opening up a new source of earnings growth.
Finally, there’s also the company’s generative AI video creation tool, dubbed the Adobe Firefly Video Model, set to be launched later this year. The Model, set to compete with the likes of OpenAI’s Sora, could also be an area where users would consume a substantial amount of Generative Credits, especially since it is “designed to be commercially safe.” Assuming that the Firefly Video Model also sees strong demand, which is a realistic scenario, especially since the likes of Sora have been subject to ethical and legal concerns in the past, ADBE’s text-to-video generator could be a massive catalyst for the company’s efforts to monetize its AI tools via Generative Credits.
It’s too early to say to what extent these monetization efforts would contribute to the company’s earnings growth. However, unlike some of its peers, ADBE has a blueprint to directly monetize its AI tools.
Soft Revenue Guidance is Not as Worrying as Investors Think
As I mentioned earlier, the main culprit behind ADBE’s recent downward spiral (the stock is down nearly 11% since it released its earnings report) was its softer-than-expected Q4 guidance. However, when one digs a little deeper, the soft guidance can be perfectly explained by a couple of factors. For instance, management mentioned that some deals, which were expected to close in the fourth quarter, closed in Q3. Furthermore, traditionally, both Black Friday and Cyber Monday occur in the fourth quarter. This time, Cyber Monday will fall in Q1, which implies that those revenues would occur in Q1 of FY25, as opposed to Q4. It’s the timing issues that led to a soft Q4 guidance. Moreover, although the guidance was soft, it was the highest target that the company has ever issued.
When one looks into the overall business, the company’s divisions are firing on all cylinders. The demand for both the Creative and Document Cloud segments continue to remain strong. More specifically, revenues from the Creative Cloud grew 11% y/y in constant currency and its ARR grew to $13.45 billion. Document Cloud saw its revenues grow 18% y/y, and its ARR now stands at $3.31 billion.
Then there’s ADBE Express, which continues to show strong growth. In my last article on ADBE, I mentioned how Express can allow ADBE to be a leader in AI-driven marketing. In the current quarter, we got more ways through which, Express is adding value to ADBE. The company recently launched Express for Enterprises and Express for Education, the last of which, comes at an opportune time given that we are in the back-to-school season. These launches allowed the company to onboard over 1,500 businesses and millions of students, a significant universe of prospective clients who can continue to drive the company’s growth. The company, at the same time, is also seeing a significant uptick in free-to-paid conversion, thanks to its Google Chrome and Microsoft Edge Extensions.
All of the developments mentioned in this section, along with other achievements such as record RPOs, demonstrate that the company’s fundamentals remain intact. As such, in my opinion, the reaction to the soft Q4 guidance, was clearly overdone, especially since it was a result of timing and had nothing to do with any structural weakness.
Valuation
|
Forward P/E Approach |
|
|
Price Target |
$667.00 |
|
Projected Forward P/E Multiple |
31.3x |
|
PEG Ratio (NTM) |
1.9 |
|
Projected Earnings Growth |
16.5% |
|
Projected FY25 EPS |
$21.30 |
Source: Company’s Q3 Earnings Release, LSEG Data (formerly Refinitiv), Seeking Alpha, and Author’s Calculations
As mentioned earlier, the company now expects Q4 diluted non-GAAP EPS to come in between $4.63 and $4.68. There is a lot of reason, in my opinion, to be optimistic about the odds of the company beating or at-least matching the high-end of the guidance. For instance, in the Document Cloud segment, the usage and monthly active user growth via the likes of Google Chrome and Microsoft Edge are driving free-to-paid conversions, which should boost the bottom-line. The demand for Adobe Express continues to remain strong, and the company is seeing an uptick in the number of users upgrading to higher-value Creative plans within this segment. Finally, the company’s strong RPO should also be a catalyst for strong earnings. Taken things together, I have assumed the Q4 non-GAAP EPS to come in at $4.68 for my calculations, which translates to FY24 EPS of $18.29.
ADBE currently trades at a forward P/E multiple of 26x, according to LSEG data (formerly Refinitiv), which is similar to where some of its peers, such as CRM and ORCL are currently trading at. However, other peers such as Autodesk and SAP trade at higher multiples. ADBE also currently trades cheaply to its own historical levels, with its 5-year median forward P/E and its 10-year median forward P/E multiples being 31.3x and 31x respectively. Last time, I valued ADBE at 31.3x. I have assumed the same multiple for my calculations this time as well, since I believe that the company’s catalysts for earnings growth remain intact, despite the lower-than-expected guidance. Furthermore, the company, in FY24, is on track to achieve a y/y earnings growth of 13.74%, in line with its mean long-term earnings growth. This further justifies a higher multiple, in my opinion.
According to Seeking Alpha, the company’s PEG ratio stands at 1.66, lower than the industry median of 1.9 and its 5-year historical average of 2.21. At a forward PEG ratio of 1.66 and a forward P/E of 31.3x, FY25 earnings growth would be 18.85%, much higher than both its mean long-term growth as well as its trailing 5-year CAGR of 16.22%. With the uncertainty surrounding profitability from its AI products, an earnings growth of 18.85% is too optimistic. At a forward PEG of 1.9, the industry median, FY25 earnings growth would be 16.5%, a more reasonable estimate in my opinion, and in line with its trailing 5-year CAGR. At this earnings growth rate, the FY25 EPS is projected to come in at $21.3, slightly higher than my previous estimate of $20.97.
A forward P/E multiple of 31.3x and an FY25 EPS of $21.3 results in a price target of $667, which represents an upside of about 28% from current levels. The new price target is slightly higher than my previous target of $656. Given the considerable upside from current levels, I am maintaining my STRONG BUY rating on the stock.
Risk Factors
Despite the announcement of Firefly Video Model, the company continues to face strong competition from the likes of OpenAI and Runway. Part of my bull case relies on the Video model becoming a success, subsequently boosting the potential to monetize the Generative Credits. Should the likes of Sora and Gen-3 Alpha outperform ADBE’s Video Model, then the potential for generating earnings growth through this channel could take a significant hit.
Furthermore, the timing of AI monetization also remains a mystery. Management, during the earnings call, did mention about instituting caps on Generative Credits, but did not offer any timeline of when this would happen. A prolonged delay in implementing this strategy, either due to weakening demand or increasing competition, could also have a negative impact on future profitability.
Concluding Thoughts
Despite posting yet another strong quarter, ADBE’s shares suffered, as a softer-than-expected fourth quarter guidance disappointed investors. The stock has been down nearly 11% since its earnings release, wiping out all the gains it made during the year. However, I believe that this reaction was overdone, given the fundamentals of the business remain strong and that the soft guidance was a consequence of timing of deal closures as well as Cyber Monday coming in later than usual. All its segments continue to perform strongly, and the company’s RPOs are at record levels. Adobe Express continued its strong momentum in Q3 as well, and the company’s expansion of Express into Enterprises and Schools offers significant potential for future growth.
The biggest highlight from this quarter continues to be the progress made on monetizing its AI tools. Management, during the quarter, also offered yet another way through which, the company plans to directly monetize its AI tools. Generative Credits have the potential to be a new source of revenue and earnings growth. Given the demand seen for its AI products, instituting caps on Generative Credits would allow the company to directly monetize these tools, which would subsequently boost its future earnings. From a valuation perspective, the company looks even more attractive at current levels, especially after the post-earnings selloff. ADBE continues to be a major AI beneficiary for the long term. One potential soft quarter is not going to change that.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of ADBE 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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