Adobe: Q2 Showed The Monetization Power Of Company’s AI Tools
Contributor since 2021 / 562 Followers
Summary:
- ADBE’s second-quarter performance exceeded expectations with impressive revenue and EPS growth, leading to raised guidance for FY24.
- The company’s AI tools, including Firefly and Adobe Express, are driving growth in Document Cloud and setting the foundation for AI-driven marketing.
- Despite regulatory challenges and competition, ADBE’s strong performance and demand for AI tools support a bullish outlook, with a price target upgrade.
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Investment Thesis
The last time I wrote about Adobe Inc. (NASDAQ:ADBE), I talked about the company’s first quarter results and argued that the company’s AI roadmap was on track, and as such, investors should be patient when it comes to its monetization.
In this article, I dissect the company’s second-quarter performance and argue why the patience, that I requested from investors when it comes to AI monetization, is finally starting to pay off thanks to the company’s strong AI-driven top- and bottom-line growth. I also lay out my reasons for why the AI party may only be beginning for the company.
Second Quarter Highlights
It was yet another impressive quarterly performance from ADBE. Q2 revenues came in at $5.31 billion, up 10.2% y/y and beating analyst estimates by $15.7 million. Non-GAAP diluted EPS came in at $4.48 jumped 15% y/y and beat analyst estimates by $0.08. The company’s remaining performance obligations (RPOs) came in at $17.9 billion, growing at an impressive rate of 17% y/y. Both the Creative Cloud and the Document Cloud segments registered impressive growth, both on a sequential and on a y/y basis, with the latter generating a double-digit growth of 19% y/y.
The company, thanks to these impressive figures, raised its FY24 guidance. Total revenues are now expected to come in between $21.4 and $21.5 billion (vs. previous guidance of a range between $21.3 and $21.5 billion and analyst consensus of $21.46 billion). Net new ARR of the Digital Segment is now expected to come in at $1.95 billion (vs. previous guidance of $1.9 billion), and non-GAAP EPS is expected to be between $18 and $18.2 (vs. previous guidance of between $17.6 and $18 and analyst consensus of $18.01). The company’s guidance for the third quarter also surpassed analyst expectations. The raised guidance together with an impressive quarterly performance boosted the company’s shares by 14.5% following the earnings release.
AI Monetization Required Patience and that Patience is Already Paying Off
In my last article on ADBE, I called for patience when it came to the monetization of ADBE’s AI tools. Based on the company’s Q2 performance and the demand for the company’s products that incorporate AI, it appears that the patience is already paying off. Unlike other enterprise companies, such as CRM, ADBE has been largely immune to the slowdown in enterprise spending.
For instance, the company introduced the Acrobat AI Assistant, which is now available through an add-on subscription to both enterprise and individual users of Adobe Reader and Acrobat. Moreover, the feature is available across desktop, web, and mobile. Both Reader and Acrobat, armed with AI assistant, have seen tremendous demand, as evidenced by the 19% y/y growth in the Document Cloud revenues. Net new Document Cloud ARR came in at a record $165 million during the second quarter, registering a y/y growth of 24%.
More recently, the company has upgraded the AI assistant, which enables it to provide detailed insights into different themes and trends across a variety of documents. In addition, the company also announced that it was bringing Firefly into Acrobat, which would allow users to “create and edit images in PDFs via text prompts.” These features, in my opinion, should allow more free-to-paid conversions of Acrobat in the coming quarters. The company has already seen strength in such conversions during Q2 and given that it also saw free monthly active users of Acrobat Web grow over 60% y/y, the company now has a much higher customer base to try and convert into paid subscriptions.
Then there’s Firefly, whose popularity is growing more and more with each passing quarter. The company saw an increase in renewals and also saw a higher rate of migration to the higher-ARPU Creative Cloud plans thanks to the popularity of Firefly, which translated to a net new Creative ARR of $322 million during the quarter and total Creative revenue of $3.13 billion, which represents a growth of 10% y/y. The company, during the quarter, also introduced Firefly into Lightroom and also launched Firefly services for enterprises, both of which are likely to drive both top-and bottom-line growth in the coming quarters, if the company can maintain the popularity of the AI tool.
Taken together, this has been a quarter where one can say that the company’s AI tools have reached an inflection point. The company took its time to monetize its AI tools, and it has now firmly laid the foundation to monetize them. The evidence can be seen through the aforementioned developments. In addition, higher user retention and deals signed with major enterprises courtesy of its AI tools, all contribute to the company’s growth and is also providing concrete evidence that the company can be a major AI beneficiary.
Popularity of Express Demonstrates How Adobe Can Gain in AI-Driven Marketing
Yet another major takeaway from the quarter was the popularity of Adobe Express, the all-in-one content creation app with generative AI features. The company launched an Express app on both iOS and Android earlier in the quarter and saw its monthly active users ((MAUs)) double on a sequential basis. The app, which offers a 30-day free trial, provides an ideal ground for the company to acquire more users, thereby increasing the outreach of its AI tools. This should set the foundation for the company to then attract these users to the company’s other products, which allows it to further monetize its AI tools.
In addition to the Express mobile app, the company also launched Express for Business during the quarter, which should attract enterprises who are interested in AI-driven marketing. While it’s too early to predict the success of Express for Business, since the company had some major enterprise customer wins during the quarter and given the ease with which, companies can produce marketing content through ADBE’s AI tools, there is cause for optimism about its growth potential. Furthermore, earlier this week, at the Cannes Lions International Festival for Creativity, the company announced a partnership with TikTok that would see the social media company’s music library integrate into Express.
So, the company’s AI tools are not only driving the growth of the Document Cloud but are also allowing the company to set the foundation to be a leader in AI-driven marketing through Express.
Valuation
|
Forward P/E Approach |
|
|
Price Target |
$656.00 |
|
Projected Forward P/E Multiple |
31.3x |
|
PEG Ratio (NTM) |
2.06 |
|
Projected Earnings Growth |
15.2% |
|
Projected FY25 EPS |
$20.97 |
Sources: Company’s Q2 Earnings Release, Refinitiv, Seeking Alpha, and Author’s Calculations
As mentioned earlier, ADBE management, during the earnings call, raised their FY24 EPS guidance to between $18 and $18.2. Given that the company has not experienced the kind of slowdown experienced by other software companies, I have assumed the higher end of the EPS guidance range, which is $18.20, for my calculations. This is significantly higher than my previous estimate of $17.80 and reflects the tremendous demand for the company’s products.
ADBE currently trades at a forward P/E multiple of 26.7x. While this makes it more expensive than CRM (22.4x) and ORCL (22.8x), it trades cheaper than its other peers such as Autodesk (28.7) and SAP (33.5). The company also trades cheaper compared to its historical multiples of 32.4x (5-year median forward P/E multiple) and 31.3x (10-year median forward P/E multiple). Last time, I used a 27.5x multiple for the company, which is what it was trading at during the time. In my opinion, the company’s future potential has significantly improved since then and its AI tools are seeing incredible demand, which sets it apart from some of its software peers. As such, I have used the company’s 10-year median forward P/E multiple of 31.3x for my calculations.
According to Seeking Alpha, the company’s PEG ratio stands at 1.67, lower than the industry median of 2.06 and its 5-year historical average of 2.23. At a forward PEG ratio of 1.67 and a forward P/E of 31.3x, the earnings growth would be 18.74%, which is too optimistic in my opinion, especially since we still don’t know the full extent of growth that the company will see in products such as Express for Business and Express Mobile app. At a forward PEG ratio of 2.06, the earnings growth would be 15.2%, which is more reasonable in my opinion, especially given that the company’s trailing 5-year CAGR of its EPS has been 16.22%, according to LSEG Workspace. As such, I have assumed an earnings growth of 15.2% for my calculations, and at this growth rate, FY25 EPS is projected to come in at $20.97.
A forward P/E multiple of 31.3x and an FY25 EPS of $20.97 results in a price target of $656, which represents an upside of about 26% from current levels. This is a significant jump from my previous target of $561. However, as mentioned earlier, given that the company has not faced any of the macroeconomic challenges encountered by its peers and given that its AI tools have seen tremendous demand, the ADBE story, in my opinion, has changed. As such, the company deserves a premium multiple, in my opinion, which has subsequently led to a higher PT. Given the considerable upside from current levels, I am also upgrading my rating on the stock from a BUY to a STRONG BUY.
Risk Factors
The major risk factor that would adversely impact my thesis is the regulatory headwind that the company is currently facing. Earlier this week, the FTC filed a lawsuit against the company and two of its executives over the way the company had priced its subscription plans. More specifically, the regulator argued that the company hid the early termination fee for its most popular subscription plan and has made it difficult for the company’s customers to cancel their subscriptions. Furthermore, it alleged that the company is in violation of the “Restore Online Shoppers’ Confidence Act.” This is a major concern for investors, especially for those like me who are incredibly bullish on the company’s prospects, as this segment is how the company can capitalize on the growing popularity of its AI tools.
The other risk factor remains the same as last time, which is the rising competition such as OpenAI’s video generator Sora, and Runway’s new Gen-3 Alpha model, which has received some glowing reviews. Whether the company can outperform these competitors and continue to attract new customers as these companies become more mainstream will also affect the company’s long-term growth prospects, and subsequently the stock’s path to my PT.
Concluding Thoughts
It was yet another incredible quarter for ADBE, as it once again delivered a top- and bottom-line beat. There were question marks surrounding the company’s ability to monetize its AI tools, which were emphatically answered by the company during the quarter. There was not only strong demand for the company’s AI tools, but the company was also able to monetize the demand, as evidenced by the strong growth seen in its Document Cloud segment. Adobe’s decision to launch the Express Mobile app as well as Express for Business is a smart one as it sets the foundation to not only attract new users but also for the company to be a leader in AI-driven marketing. Unlike its peers, the company was also largely immune from the slowdown in enterprise spending. One only needs to look at the popularity of Express to see that the AI party for this company is only getting started.
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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