Adobe Stock: Why It Might Be Not A Good Idea To Buy Now

Summary:

• Adobe Inc. will report its FQ1 2023 results on Wednesday amid poor market sentiment following the collapse of technology company-exposed banks.
• The article provides a brief overview of Adobe’s fiscal 2022 results, discussing the impact of high inflation and key earnings adjustments.
• I discuss whether ADBE is likely to beat estimates on Wednesday and whether it makes sense to buy or sell the stock ahead of earnings considering the jittery environment.
• I explain my expectations for 2023, my long-term view of the company, and whether I personally would consider Adobe stock for my portfolio, also in light of the skewed valuation.

Introduction

I first covered Adobe Inc. (NASDAQ:ADBE) in September 2022, after management announced its plan to acquire the UX/UI incumbent Figma. I expressed concerns about Adobe’s economic moat, viewing the Figma acquisition as a potential sign of weakness that essentially confirmed that the company’s proprietary solution, Adobe XD, was incapable of becoming a market leader.

Adobe will report its first-quarter results on Wednesday, March 15, at a time of rather weak market sentiment, in light of the collapse of SVB Financial Group (SIVB), a technology company-focused bank. Due to the jittery environment, and considering the fact that the stock has risen 15% since my first article, without much noticeable improvement in the macroeconomic situation, I will discuss whether it makes sense to sell the stock ahead into earnings. The article also provides a brief overview of Adobe’s fiscal 2022 results, discussing the impact of high inflation and key earnings adjustments. I will also explain my expectations for fiscal 2023, my long-term view of the company, and whether I am currently considering building a position in ADBE stock, also in light of the skewed valuation.

How Did Adobe Perform In Fiscal 2022?

The company beat fiscal 2022 earnings per share (EPS) estimates by a small margin. Given that earnings are fairly easy to manage, especially on a per-share basis, and considering that Adobe has a strong tendency to beat earnings estimates (Figure 1), the positive surprise for fiscal 2022 was not a big surprise.

For the fourth quarter of 2022, the company delivered EPS of $3.60 on a non-GAAP basis and $2.53 on a GAAP basis. Stock-based and deferred compensation (SBC) expense was again the primary driver of the adjustments ($0.84, 23% of adjusted EPS). For the full year, Adobe reported diluted EPS of $10.10 (non-GAAP) and $13.71 (GAAP), representing year-over-year ((YoY)) growth of 0.8% and 9.9%, respectively. Operating cash flow reached a record $7.84 billion (up 8.4% YoY), and GAAP operating income was $6.10 billion. Revenues were $17.6 billion, up 11.5% YoY. Excluding the 53^rd week’s contribution in fiscal 2021, revenue growth would have been slightly higher. Adobe also faced significant headwinds from the strong dollar, but as an international company, I don’t see the point of factoring in such effects. They are simply a cost of doing business.

Compared to fiscal 2021, growth slowed significantly (Figure 2), but this was largely expected given the difficult comparison, as fiscal 2021 benefited from the pandemic-related surge in demand. Digital Media revenue was $12.84 billion, up 11% YoY, with net new annual recurring revenue of $1.91 billion. Digital Experience revenues were up 14% year-over-year to $4.42 billion, with a strong subscription revenue contribution of $3.88 billion, up 15% year-over-year. Document Cloud saw revenue growth of 21% YoY to $2.38 billion. The majority of Adobe’s revenue (93% of total revenue) is subscription-based, which is an important part of the investment thesis:

Another important pillar of the long thesis for ADBE stock is the spectacular margin profile. For example, the company has a gross margin in the high 80% range. But it gets better: Adobe has actually been able to increase its gross margin slightly over the past few years, and the fact that it saw only a 50 basis point decline in fiscal 2022 confirms Adobe’s unwavering pricing power (Figure 3). Importantly, subscription gross margin is extremely stable, with a seven-year average of 90.1% and a standard deviation of only 0.3%.

Adobe’s strong position can also be noticed from the company’s operating margin (Figure 4, blue), which has increased significantly in recent years thanks to rigorous management of general and administrative costs – without compromising on research and development (R&D). On average over the last seven fiscal years, Adobe spent 16.8% of its revenue on R&D, with a standard deviation of only 0.4%.

However, looking at free cash flow (FCF), things don’t look so good. While revenues grew at a compound annual growth rate (CAGR) of 20.1% since fiscal 2016, FCF growth was slightly slower at a CAGR of 17.2%, when taking working capital movements into account via a three-year rolling average. However, when stock-based compensation is also considered, growth was even slower at 15.5% (Figure 4, gray). Accordingly, Adobe’s free cash flow margin declined over the years, primarily due to the relative increase in SBC. Fiscal 2022 stands out in this regard, with Adobe’s cash flow statement showing $1.44 billion in such compensation, or about 23% of operating cash flow after normalizing for working capital movements.

Can We Expect Adobe To Beat Earnings On Wednesday?

Before assessing whether investors can expect Adobe to beat earnings Wednesday, it’s important to take a look at the company’s fiscal 2023 guidance. When assessing the odds of an earnings beat, I like to look at revenue guidance, analyst estimates and recent revisions. Revenue is much harder to manage than earnings – especially at the per share level – so if trends have been positive, the odds of an earnings beat are elevated.

For fiscal 2023, management expects revenue growth of 9% on a reported basis. For the first quarter, the company expects revenue of $4.62 billion, slightly below earlier analyst estimates (Figure 5). Adobe had reported slightly negative revenue surprises in the third and fourth quarters of fiscal 2022 (Figure 6), which likely made management a bit more cautious. A mild recession seems to be the consensus for 2023, and computer hardware giants HP Inc. (HPQ) and Dell Technologies Inc. (DELL) (see my recent update) expect a rather weak performance in 2023, albeit with an improvement in the second half of the year. I think it’s reasonable to expect the same trend for Adobe, also given management’s near-term projections. I doubt there is much room for a negative surprise – also from a currency perspective. The U.S. dollar has weakened since Adobe’s FQ4 2022 earnings call (improving international earnings), but has rebounded to mid-December levels earlier this year.

For these reasons, I would not sell ADBE stock ahead of the earnings announcement – even though market sentiment is quite weak, I doubt there will be a negative surprise. In addition, traders are weighing the possibility that the Federal Reserve will at least pause on rate hikes in light of recent events. This should support equity valuations, at least in the short term.

What Is The Long-Term Outlook For ADBE Stock?

In my first article about the company, I expressed concerns about Adobe’s basically very solid economic moat. I explained the lock-in and network effects from which Adobe benefits greatly, and there is no denying that the company is in many ways a monopoly. However, the fact that the Figma acquisition proves Adobe XD’s inability of becoming the market leader in UX/UI was somewhat sobering. I think my original argument still has merit today.

Adobe’s previous acquisitions have all been rather small compared to the $20 billion the company plans to spend on Figma. I think it’s concerning that a relatively new software product (Figma was only introduced in 2016) can evolve so quickly and become the market leader. Perhaps, Adobe needs to increase its R&D spending? 17% of revenue or $3.0 billion in fiscal 2022 is certainly not peanuts, but probably not enough given the rather poor acceptance of Adobe’s own UX/UI solution. Of course, it’s also possible that Adobe’s management opted for the quick-‘n easy fix – but a price-to-sales ratio ((P/S)) of 50 (Adobe currently trades at a P/S ratio of less than 8) doesn’t exactly represent what I consider to be a financially prudent use of resources. With that in mind, and at the risk of sounding a bit presumptuous here, I can’t understand Morningstar’s assessment of Adobe’s capital allocation:

We assign Adobe an Exemplary capital allocation rating. The rating reflects our assessments of sound balance sheet, exceptional investment, and appropriate shareholder distributions.

Granted, Adobe’s balance sheet is indeed in great shape, as I pointed out in my previous article, but I find it very difficult to consider the proposed Figma transaction (by far Adobe’s largest acquisition in quite some time) as an exceptional investment. The valuation just seems completely out of proportion, even if synergies turn out to be strong. I also have to say that I can’t understand how the analyst concludes that the distributions to Adobe shareholders are appropriate. Granted, the company spends a significant percentage of its free cash flow on share repurchases (Figure 7) – $20.5 billion since fiscal 2016, to be exact.

Dividing the annual dollar amount spent on buybacks by the average share price for each fiscal year gives a reasonable proxy for the number of shares bought back: 68 million, or about 14% of the diluted weighted average shares Adobe had outstanding in fiscal 2016 (see also Figure 8). In stark contrast, the number of Adobe shares has declined by less than 7% during this period, confirming that, as with so many technology companies, stock-based compensation is rather disproportionate (see my article on the topic). At least, Adobe’s management is not among those who claim to have “returned” a certain amount of cash to shareholders through buybacks. That said, Adobe does adjust its non-GAAP earnings numbers for SBC, so I would be very cautious about taking them at face value (see below).

Coming back to the long-term outlook: I don’t think the Figma acquisition should be extrapolated to other parts of Adobe’s business. Granted, Adobe’s moat may not be as wide as initially thought, but I think its ecosystem is nevertheless very strong and robust – anyone who uses Photoshop, Illustrator, InDesign and others professionally knows what I mean.

The decline in share price since 2021 is a fair reflection of the increase in risk premium due to rising interest rates and management’s challenges implied through the Figma acquisition. Of course, a deep and prolonged recession – which is definitely not the consensus at present – would put further pressure on the valuation of ADBE shares. Another, often overlooked aspect relevant to platform economy companies such as Microsoft (MSFT) or Adobe should also be considered. The more unprofitable startup or outright zombie companies disappear from the economy due to increasingly difficult financing conditions – a “cleansing process” that now seems to be underway due to higher interest rates – the more Adobe will also feel this through a slower growth in subscriber numbers, or a temporary decline. I have discussed this aspect in detail from a broader perspective in another article.

ADBE stock is currently trading at a normalized free cash flow yield of nearly 4%, so not uber-expensive for a growth stock. Also, a blended price-to-earnings ((P/E)) ratio of 23 (Figure 9) is not overly demanding for a company with such high profitability and earnings growth, but it is important to understand that SBC accounts for a significant portion of the earnings adjustments. The FAST Graphs chart, based on unadjusted diluted earnings per share, paints a much less rosy picture, with ADBE stock currently trading at a P/E of nearly 32 (Figure 10).

Summary And Conclusion

My view of the company hasn’t really changed since my first article. Adobe is a very strong company that has always appealed to me because of the lock-in and network effects of its various Creative Cloud software products. Adobe has done a great job of transitioning its licensing model from perpetual to subscription. The company’s profitability remains excellent, even against the backdrop of a pretty inflationary environment and a clouded macroeconomic outlook. Granted, the moat may not be as wide as initially thought, but I don’t think it’s justified to extrapolate Adobe’s weakness in UX/UI to other areas, and the Figma acquisition certainly has its appeal due to the likely very high synergy potential. In this context, I would like to see Adobe increase its R&D spending from the already substantial 17%, resulting in a stream of productivity innovations that result in network and cross-selling effects and also bolster the addressable market of its Creative Cloud programs.

Of course, it is reasonable to assume that Adobe will continue to grow through acquisitions, which will eventually put a strain on Adobe’s balance sheet. However, I would not overstate this aspect, as Adobe intends to finance the Figma acquisition in part through a capital increase – and this might as well be the case with future acquisitions. In turn, shareholder dilution through such partially equity-financed acquisitions should be kept in mind, as they work in the same direction as the rather disproportionate stock-based compensation. As an investor, I would keep a close eye on the company’s financial management, the quality of which will probably only become apparent after some time. Finally, Adobe’s very significant goodwill position (47% of total assets at the end of fiscal 2022) should also be considered. If the growth expectations of the acquired business units are not met, associated goodwill must be written down, which can put additional pressure on the share price. Of course, a recession likely triggered or fueled by mass bankruptcies of unprofitable startups (some of which are outright zombie companies) and a decline in ad spending should be seen as a catalyst in this regard.

The “risk” of further potentially overly expensive acquisitions, the price tag of Figma, and the disproportionate SBC – including management’s decision to adjust earnings for these expenses – are the main reasons why I am not a buyer of Adobe. Realizing that the company generates solid free cash flow is one thing, but seeing it used for buybacks that are only 50% effective due to SBC is the other side of the coin. Who knows, maybe Adobe will announce a change of course at some point by starting to pay a small but growing dividend and reducing the relative size of its SBC? That would certainly set Adobe apart from other technology companies that are notorious for funneling significant amounts of reported cash flow and earnings into the pockets of management and employees.

I don’t expect any negative surprise for the upcoming results tomorrow. Revenue guidance is skewed towards the later part of the year, and taking into account the currency fluctuations since the last call, I can even imagine that the movement of the U.S. dollar will be a small tailwind for Adobe’s top-line. Analysts are quite modest, and 9% year-over-year revenue growth is not an overly challenging guidance. For these reasons, I expect the company to beat expectations on earnings as well, which we all know are pretty easy to manage. Adobe is projecting mid-point non-GAAP EPS of $3.68 and $15.30 for FQ1 and fiscal 2023, respectively, the latter translating to a forward P/E of 21.5. This, of course, includes significant adjustments for SBC.

SBC adjustments aside, Adobe Inc. stock is not overly expensive, but for the reasons stated above, I am not interested in buying. If the SBC-adjusted valuation drops to 20 times earnings, I might reconsider, but otherwise I prefer to stick with companies with more reasonable compensation plans, higher current cash flows (i.e., lower duration stocks), and shareholder returns through reliable dividend payments.

Thank you for taking the time to read my article. Regardless of whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments section below. And if there is anything you would like me to improve or expand upon in future articles, drop me a line as well.

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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.

Additional disclosure: The contents of this article and my comments are for informational purposes only and may not be considered investment and/or tax advice. I am neither a licensed investment advisor nor a licensed tax advisor. Furthermore, I am not an expert on taxes and related laws – neither in relation to the U.S. nor other geographies/jurisdictions. It is not my intention to give financial and/or tax advice and I am in no way qualified to do so. I cannot be held responsible and accept no liability whatsoever for any errors, omissions, or for consequences resulting from the enclosed information. The writing reflects my personal opinion at the time of writing. If you intend to invest in the stocks or other investment vehicles mentioned in this article – or in any form of investment vehicle generally – please consult your licensed investment advisor. If uncertain about tax-related implications, please consult your licensed tax advisor.

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