Adobe: Getting Comfortable With The Premium Price

Summary:

• Adobe has been trading at a premium price for ages and value investors shout “Not at these prices” when Adobe’s name comes up.
• Investors should get smart about the business to understand that the premium price comes with premium quality i.e. it may be worth its price.
• One has to build conviction that Adobe can sustain its high growth rates for several years to have a compelling investment case.
• I’m getting more and more comfortable with Adobe’s price but I still can’t see enough growth to get invested.

Introduction – The Origin Story

Adobe (NASDAQ:ADBE) was founded by John Gaffney and Charles Geschke in 1982 and had its IPO in 1986. Back then, Adobe’s flagship product was PostScript, a page description language that revolutionized the laser printing industry. It became the standard language in laser printing until the PDF file format came along in 1993 (also developed by Adobe).

Fast forward to today and Adobe has transformed from a single-product company to a global software enterprise that provides software tools for content creation (sub-segment defined as Creative Cloud), document management (Document Cloud), CRM tools (Digital Experience) in addition to legacy products such as PostScript (Publishing and Advertising). The legacy products have become irrelevant as they’re less than 2% of total revenues. I will therefore not focus on them in this article. Creative Cloud and Document Cloud are both sub-segments and are included in the larger segment called Digital Media.

Products

Creative Cloud

Adobe has a broad product portfolio with over 20 products. You can buy these products separately or in a bundle as a monthly or yearly payment that renews automatically unless you cancel the subscription. With these products, you can edit and design almost any media (images, photos, videos etc.) for almost any application you can think of such as books, magazines, movies, ads and much more. The latest and perhaps most hyped product of late is Adobe Firefly which is an AI tool that can create images based on text inputs (“text to image”).

Document Cloud

Most people know Adobe Acrobat and Adobe Acrobat Reader which are used for managing PDF files. Adobe has developed these offerings and now includes Adobe Web (same as Adobe Acrobat but online instead of an installed product on your computer), Adobe Scan (easily convert pictures to PDFs through your mobile phone) and Adobe Acrobat Sign (electronic signing of documents).

Experience Cloud

Here you have Adobe’s perhaps less-known products which are, in essence, CRM tools. Adobe sells its customers (small and medium-sized businesses) tools that facilitate customer data management and customer targeting. This can be done by centralizing customer data, building customer profiles and much more.

Markets

Creative software (Creative Cloud)

According to Statista, the creative software market is $9.10 billion in size and is expected to grow 4.3% during 2024. The market is expected to grow relatively slowly, only 2.6% per year up to 2028.

Adobe is the market leader in this segment with its 49% market share and none of the other players presents immediate threats to weaken its dominance. Apple (AAPL) has an 11% share, Canva 7% and Alludo 5%.

Someone may question Statista’s definition of the creative software market as Adobe’s Creative Cloud revenues were $11.5 billion in 2023 i.e. more than 100% of the creativity software market! The most likely reason is that Adobe’s Creative Cloud products touch several different markets and Statista has allocated only a certain amount of Adobe’s revenues to the creative software market.

Document Cloud

Here, as in creative software, we have to realize that Adobe’s solutions can be allocated to several different markets. Part of the revenues can be allocated to the

Document Management System (DMS) market which is estimated to be $5.5 billion in size. The market is expected to experience high growth rates of over 15% annually up until the year 2030. Here they compete against players such as Microsoft (MSFT), Oracle (ORCL), IBM (IBM) and Xerox (XRX) just to name a few.

Adobe is also active in the e-signature market with its product Adobe Sign. The market’s estimated size is not huge, ranging between $3.2 to $5.5 billion in 2022 (Statista is in the middle with $3.9 billion). The market is, however, expected to experience rapid growth. The same studies estimate the market to grow to anywhere between $38.2 to $43.1 billion by the year 2030. This corresponds to an annual growth rate of around 36%. Some of the notable competitors here are DocuSign, SIGNiX, Zoho, OneSpan, GlobalSign, IdenTrust, PrimeKey, Visma, PandaDoc and BOX. DocuSign seems to control the majority of the market according to Deloitte. However, the research is from the year 2020 i.e. DocuSign may not be as dominant as back then. The main takeaway for me is that Adobe’s Document Cloud operates in markets with massive growth tailwinds behind it.

Customer Relationship Management (Digital Experience)

The customer relationship management (CRM) market is huge compared to the creative software, DMS and e-signature markets. The market size is estimated to be $70.1 billion in 2022 and is expected to grow to $131.9 billion in 2028. This corresponds to a CAGR of a healthy 11.1%. The dominant player in this market is, you guessed it, Salesforce with a 31% market share according to Statista. Adobe is in third place with 6% of the market, just behind Oracle which has an estimated market share of 8%.

Conclusions

The creative software market is estimated to experience lackluster growth in the years ahead. Almost 60% of Adobe’s revenues are generated in this market which is some cause for concern. The silver lining is that about 40% of Adobe’s revenues are exposed to the high-growth markets like DMS, e-signature and CRM. Adobe is however not as dominant in these markets as in creative software and faces more competition which has led to lower margins compared to the creative software segment.

The Business Model

Adobe is a true software company in every sense of the word. Compared to other popular tech stocks such as Alphabet, Microsoft and Amazon, the company doesn’t need huge capital investments to grow or maintain the status quo (which sounds a lot like Apple although they’re obviously very different in other aspects). Adobe doesn’t build or operate data centers such as the three companies mentioned above nor does it need logistical operations which are also asset-heavy (i.e. Amazon’s business model).

Adobe’s business model is in essence software development which it sells through a Software-as-a-Service (SaaS) business model. The customers typically buy a monthly or yearly subscription which is automatically renewed if not proactively cancelled. Below I’ll go over the key considerations I go through when evaluating a business such as Adobe.

Attractive financial profile – Adobe has high revenue predictability as subscription revenues account for 94% of total revenues. The company also has high operating margins of over 30% and has historically grown topline over 15% p.a. (5-year and 10-year CAGR). Adobe also has a strong balance sheet with negative net debt i.e. it has more cash than debt on its balance sheet.

Asset-light – Adobe’s business model is asset-light, evident by the fact that the company’s capex are about 3% of annual sales and cash conversion over 100% (free cash flow as a percentage of EBITDA).

Moderate pricing power – I would argue Adobe’s pricing power is moderate. There’s a bunch of free software tools customers can switch to if Adobe would increase prices aggressively. However, the company recently increased prices by ~10% for individual users of Creative Cloud which is obviously not insignificant. In assessing pricing power I would also take into account that Adobe’s products are not mission-critical in the sense that customers can use other tools to complete the same tasks although efficiency would surely suffer in the short term. In addition, I would classify Adobe’s product stickiness as “only” moderate. There is a learning curve when using new software but most of these tools are fairly intuitive and you can get up to speed quickly these days. The switching cost is therefore low to moderate in my opinion as the cost can be defined as the time spent learning to use the new software.

Moderately diversified product portfolio – Although Adobe has diversified its product portfolio over the years through acquisitions and innovation, it is still moderately concentrated. Adobe has over 20 products but some of them come in a bundle and are interlinked with each other meaning it’s ultimately not entirely separate products.

Moderate market growth – About 60% of Adobe’s revenues are exposed to a market characterized by slow growth (low-to-mid single digits) while 40% is exposed to markets with high or even very high growth rates.

Strong market position – Adobe is the dominant player in creative software and one of the key players in its other market segments.

Non-cyclical – Adobe’s customers operate in several different end-markets which limits the exposure to a single cyclical market.

Low customer concentration – None of Adobe’s customers account for over 10% of revenues i.e. it has a broad customer base and is not dependent on a single customer.

Low share of wallet – Adobe’s products are most likely only a small part of its customers’ total costs as you can e.g. buy the Creative Cloud subscription for $34.49 per month (before any size or other discounts for larger enterprises).

Moderate disruption risk – The software market is inherently susceptible to disruption (you can define this as terminal value risk). The reason is the asset-light nature of software i.e. you only need two guys and a garage (or one guy/gal equipped with a laptop in his parent’s basement) to start a software business. With the advent of generative artificial intelligence investors have started to ponder whether the opportunities and threats it presents are a net positive or negative to incumbent players like Adobe. If you’ve read my previous article on Alphabet and ChatGPT you know that I don’t speculate on new technologies as I don’t feel I have an advantage in estimating who will be the ultimate winner. What I do know is that it has created uncertainty for incumbent software providers which in and of itself means that disruption risk has increased.

Slightly Overvalued Despite The Quality Label

I have applied two valuation frameworks to value Adobe. In the first framework, I used a cash flow model or more precisely the discounted cash flow model (‘DCF’). The Dividend Discount Model (‘DDM’) is not applicable for Adobe as they do not pay a dividend.

In the other framework, I have used multiples based on a peer group. The multiples I consider are P/E, P/FCF, EV/Sales, EV/EBIT and P/B. The peers are Salesforce (CRM), DocuSign (DOCU), Autodesk (ADSK), Oracle (ORCL) and SAP (SAP). All of these are software companies. Some do business in a single niche while others are active in several different markets. For example, DocuSign and Autodesk focus on the e-signature and creative software markets respectively and compete with Adobe in only those segments. Salesforce, Oracle and SAP compete with Adobe in the CRM segment although these companies are active in several other segments as well where Adobe is not a competitor. My point is that it’s not an entirely apples-to-apples comparison.

The multiples for the software companies can be seen below. The max/min is the range around the median in percentage terms. I also included Adobe at the top for comparison purposes although the company’s figures are excluded from the statistics (median, max and min). All figures are from Seeking Alpha and I used the non-GAAP figures as they usually (not always) capture the business fundamentals better than GAAP (i.e. better represent free cash flow). When the TTM figures are distorted I have used the FWD multiple (only in two instances). The companies are sorted in order of size (excluding Adobe which is at the top).

Name	Market-cap ($ million)	P/E [TTM]	P/FCF [TTM]	EV/Sales [TTM]	EV/EBIT [TTM]	P/B [TTM]
Adobe	276,600	37.4x	40.2x	13.8x	40.3x	16.6x
Oracle	318,400	21.0x	31.9x	7.6x	26.5x	29.9x
Salesforce	278,100	37.0x	32.1x	8.1x	50.9x	4.7x
SAP	210,400	35.3x	33.8x	5.8x	28.7x	4.3x
Autodesk	57,100	34.7x	32.1x	10.4x	48.8x	35.0x
DocuSign	10,500	17.5x	14.0x	3.5x	13.8x	10.7x
Median		34.7x	32.1x	7.6x	28.7x	10.7x
Max		6%	5%	36%	77%	288%
Min		-50%	-56%	-54%	-52%	-60%

Click to enlarge

The widest multiple range (min and max multiples compared to the median multiple) belongs to the P/B multiple while the narrowest range belongs to the P/E multiple. The companies trade fairly consistently on earnings but not on book value.

I have shown the output from the different valuation methods in the “football field” graph below. When applying the median, max and min multiples to Adobe’s FY2023 financials we get a range of possible share prices.

In the DCF model, I have assumed 10% sales growth during 2023-2028E and 7% as the terminal growth rate. I have used a return on equity that equals 10% as I assume that that’s the best alternative return one could earn by investing, for example, in an S&P 500 index fund. Net debt is slightly negative so I have the WACC equaling the return on equity. Throughout the forecast period and terminal year, the EBIT margin is expected to remain at 32.5% while capex is modeled as 2.0% of sales, depreciation as 25.0% of PP&E and intangible assets and lastly, net working capital as -20.0% of sales.

In the bear/bull case I have adjusted the sales growth rate by +/-2.0% and EBIT margins by +/-2.5% during the forecast period. The terminal year sales growth is adjusted by +/-1.0% and EBIT margins by +/-2.5%. The black line represents Adobe’s current share price of about $604.

The base case and median share prices I get for the different methods are:

• DCF: $477
• P/B: $384
• EV/Sales: $333
• EV/EBIT: $485
• P/FCF: $485
• P/E: $558

All different approaches indicate Adobe is overvalued when you compare its current price to the base case and median value estimates. Adobe’s share price is however within the range and fairly close to the median for all metrics except EV/Sales. The DCF’s base case value is 21% lower than Adobe’s current price, even with a fairly optimistic terminal growth rate. One could argue Adobe deserves a premium multiple compared to the peer group due to its quality label we discussed earlier in the article. I haven’t researched the peer group companies as closely as I have Adobe, so I can’t say for sure whether Adobe is of higher quality. They could be just as high quality as Adobe – or not. I still haven’t mentioned the absolute multiple levels of Adobe. You have to pay up, or more precisely 37x earnings or 40x free cash flow which seems steep on an absolute basis. On the other hand, you’re not buying a cash-consuming cyclical business with customer concentration either. Adobe deserves a high multiple due to its quality label. In the end, it all comes down to whether you have the conviction that Adobe can grow as rapidly as in the bull case of the DCF analysis. I, for one, lack this conviction and have therefore decided to give Adobe a hold rating.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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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