Adobe: AI Story Is On Right Track, Time To Be Patient (Rating Upgrade)
Contributor since 2021 / 450 Followers
Summary:
- Adobe had an impressive Q1 performance, beating revenue and EPS estimates, but stock stumbled due to concerns about AI monetization efforts.
- Despite no current revenues from AI, Adobe’s underlying business remains strong, with record revenues and strong growth in remaining performance obligations.
- Adobe’s AI roadmap is on track, with popular AI tools and plans for expanded offerings, but investors need to be patient when it comes to monetization.
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Investment Thesis
Adobe Inc. (NASDAQ:ADBE) had an impressive first quarter, yet the stock stumbled as investors lost patience with the company’s monetization efforts of its AI offerings. In this article, I argue why the company’s AI roadmap remains on track and why investors should be patient with a company, which is still likely to be a major beneficiary of the AI revolution. I previously covered ADBE in June 2023 and gave it a Hold rating.
A Snapshot of Adobe’s Q1 Performance
The company’s Q1 performance was impressive, with ADBE generating record revenues of $5.1 billion, up 11.3% y/y and beating analyst estimates by $36.6 million. Non-GAAP EPS came in at $4.48, beating analyst estimates by $0.10. The company’s remaining performance obligations also registered an impressive 16% y/y growth, as there was strong momentum experienced across Creative Cloud, Document Cloud, and Experience Cloud divisions.
The company, more or less, reiterated the guidance for FY24. Furthermore, for Q2, the company now expects total revenues between $5 and $5.3 billion and non-GAAP EPS to come in between $4.35 and $4.40. The guidance fell shy of analyst expectations, which called for revenues of $5.31 billion and EPS to come in around $4.38. During the quarter, the board also authorized a fresh $25 billion share buyback. The lighter-than-expected guidance along with concerns about the timeline of AI monetization resulted in shares falling nearly 14%.
Adobe is on the Right Path When It Comes to AI, Investors Need to be Patient
While the AI revolution has led to massive creation of shareholder wealth, it has also made investors extremely impatient. ADBE became a victim of this impatience when it announced that it would take some time before it ramps up its AI monetization efforts.
Although this extreme impatience should come as no surprise, given that it is irrational exuberance that led investors to boost ADBE’s stock in the first place, when one analyses the company from a long-term perspective, with patience, then I am of the opinion that there is no reason for the alarm bells to go off.
First, even without any revenues from Firefly, ADBE’s AI offering, the company managed to comfortably beat its own Q1 guidance, which the management outlined during Q4 of last year, and as I mentioned earlier, the company also generated record revenues. Second, remaining performance obligations (RPOs) surged to 16% growth on a y/y basis and there was strong adoption of the company’s Creative Cloud apps across “geographies and customer segments.” This suggests that the company’s underlying business, even without AI, remains strong and intact.
Furthermore, although Firefly does not generate any revenues today, the AI tool continues to be extremely popular. According to the earnings call, “Q1 saw the highest adoption of Firefly powered tools in Photoshop”, with the features being adopted across a range of devices including desktop, web, and more recently, on iPad. ADBE’s AI products also led to record new commercial subscriptions in Creative Cloud during the first quarter. Strong growth was also seen in Document Cloud during the quarter.
The management now expects Firefly services and AI assistant in Acrobat to generate strong growth in ARRs in the second half of FY24. To date, more than $6.5 billion assets have been generated using Firefly. Moreover, Firefly also offers customers to create their own custom models using their own proprietary datasets, which puts it in the same category as CRM’s Einstein Copilot and Oracle’s AI services. And with the company set to launch expanded Firefly Services offerings and a new AI Assistant in ADBE Experience Platform, during the Adobe Summit later this month, the AI products, which can be monetized for the company, are only set to grow.
ADBE is taking its time when it comes to ramping up monetization of its AI products. For investors who are short-term focused, this could be a painful affair, especially for those who drove the stock up when the company first rolled out Firefly. But if you take a more holistic, long-term perspective, then one can clearly see that despite no revenues coming from AI, the company’s business remains strong across all segments. Moreover, as I mentioned last time I wrote about ADBE, an analysis by Market.us found that generative AI in the fashion space is forecast to grow at a CAGR of 36.9% for the next eight years. That’s a long-term forecast and not a short-term one, which makes the impatience surrounding ADBE’s AI efforts all the more strange in my opinion.
Furthermore, it is not as if the company is simply biding its time and doing nothing. Behind the scenes, there is a lot of innovation going on. The added benefit of increased privacy and trust in Firefly also suggests that when it is ready to monetize the product, there will be demand. Adobe’s AI story has only finished the first few chapters, the best part is yet to come in my opinion. As such, patience is warranted.
Figma Deal Termination Unlikely to Cause Any Long-Term Issues
As mentioned earlier, one of the main reasons why the company’s EPS, in Q1, took a hit was because of the $1 billion termination fee arising due to the company’s failure to close the acquisition of Figma.
In December of 2023, ADBE finally called off its planned $20 billion acquisition of Figma after European regulators blocked the deal. Figma’s design software had already become more popular than ADBE’s XD application and an acquisition was considered the right move for the company to wrest control of this space again. However, regulators, who have become even more stricter these days and have increased their scrutiny more than ever before, out of fear of mergers causing a monopoly (just ask Microsoft and Activision), the acquisition was seen as a tactic to kill competition rather than innovation.
In a way, this termination has come a blessing in disguise. For a company that generated $6.9 billion in FY23 and has cash & cash equivalents of $7.84 billion, the decision to pay up $20 billion for an acquisition was strange in my opinion. Furthermore, ADBE had planned to fund 50% of the acquisition by cash, which meant that it would have had to take on more debt. ADBE’s long-term debt currently stands at $3.65 billion, according to LSEG Workspace (formerly Refinitiv), which is reasonable. Acquiring Figma would have increased these debt levels. Moreover, the company, during the earnings call, announced a fresh $25 billion buyback program. Acquiring Figma would have considerably made future buybacks, such as the recent one, difficult for the company.
ADBE does not need Figma for its long-term growth, especially since its AI roadmap is on the right path. Moreover, while Figma generated nearly $600 million in ARR in FY23, ADBE’s Digital Media segment, for the same period, generated ARRs of $1.91 billion, so it’s not like ADBE needed Figma desperately. All things considered, therefore, the $1 billion termination fee seems to be a short-term blip, one that is unlikely to cause ADBE any headaches, compared to if it had paid up $20 billion.
Valuation
|
Forward P/E Approach |
|
|
Price Target |
$561.00 |
|
Projected Forward P/E Multiple |
$27.5x |
|
PEG Ratio (NTM) |
1.89 |
|
Projected Earnings Growth |
14.5% |
|
Projected FY25 EPS |
$20.38 |
Source: Company’s Q1 Earnings Release, Refinitiv, Seeking Alpha, and Author’s Calculations
Management, during the earnings call, more or less reiterated the FY24 EPS target range of between $17.6 and $18.00. Although the company surpassed the Q1 EPS target, the termination fee paid for canceling the Figma acquisition had a negative impact on the EPS by $2.19. The management, as a result, sees this impact of termination fee on the full-year EPS as well. As such, factoring in all these figures, I have assumed the FY24 EPS as $17.8, the midpoint of the management’s guidance.
The company, according to LSEG workspace (formerly Refinitiv) currently trades at a forward P/E of 27.5x, which is cheaper compared to some of its peers such as Autodesk (30.95x) and Salesforce (30x). Moreover, even relative to its historical multiple of 32x, the stock is cheap. As such, I have assumed the company’s forward P/E of 27.5x for my calculations. This estimate is slightly lower than the estimate I used last time I wrote about ADBE (28.2x). Given that the monetization of AI is expected to ramp up only in the second half of the year, the reduced multiple is a reasonable estimate in my opinion.
The company currently trades at a forward PEG ratio of 1.89x, according to Seeking Alpha, which is lower than its 5-year average of 2.27. Despite the company’s AI offerings still taking time to have an impact on the bottom line, I still believe that the company is likely to be a major AI beneficiary. As such, I have assumed the current PEG ratio of 1.89 since I do believe the company to deliver strong earnings growth. A forward P/E of 27.5x and a PEG ratio of 1.89 would result in an EPS growth rate of 14.5%. This results in an FY25 EPS of $20.38.
A forward P/E of 27.5x and an EPS of $20.38 translates to a price target of $561, which suggests an upside of about 12% from current levels.
In addition, the stock has some short-term catalysts that could drive the price higher. Later this week, the company is hosting its Adobe Summit, which will also include an Investor meeting. Any positive developments from the Summit are likely to drive the price higher.
Risk Factors
One of the major risk factors to ADBE has been OpenAI’s video generator Sora. Despite its limitations and its ethical issues, and despite the fact that it is only set to be launched later this year, the reviews of the tool have been raving, with TechRadar arguing that it has serious sci-fi potential. When asked, ADBE’s management was quick to dismiss Sora as a major threat, with CEO Shantanu Narayen arguing that “net-net video is going to be even more of a need for editing applications in order to truly take advantage of generative AI.” Whether he is right or wrong, only time will tell, but the launch of Sora is truly a risk that investors should consider.
Then there’s always the risk that the monetization of the company’s AI offerings may not go as planned. This would be a significant blow to the company’s future growth, and despite my bullishness on ADBE’s AI roadmap, it’s definitely a risk that investors need to consider.
Concluding Thoughts
ADBE’s stock lost nearly 14% as investors lost their patience as a consequence of the slower-than-expected efforts by the company to monetize its AI offerings. I am extremely confused by this reaction since, in my opinion, if one takes a long-term perspective, one would see that this is a company whose underlying business remains strong and the AI roadmap is actually on the right path, with the increased privacy associated with the company’s AI tools expected to boost demand once the company is ready to monetize.
Moreover, the termination of the Figma acquisition can actually turn out to be a blessing in the long term. ADBE doesn’t need Figma to grow and the fact that investors avoided a $20 billion hit, which would have raised the company’s debt levels and stunted the buyback strategy, deserves some cheer. From a valuation perspective, the company finally looks attractive and the recent weakness in the stock presents a wonderful buying opportunity in my opinion. ADBE’s AI story is only getting started, and as such, it is time to be patient, not panic.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in ADBE over 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.
I also have a beneficial Long position in the shares of MSFT either through stock ownership, options, or other derivatives.
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