Today, I would like to publish my first article about another of my favorite tech stocks named Adobe (ADBE), which is unfortunately still missing in my article collection on Seeking Alpha, among a few others.
To be honest, I am a bit surprised that Adobe enjoys so little attention from investors. In my opinion, Adobe is an absolute necessity in an increasingly digital world, not only for businesses and creative individuals, but also for far-sighted and long-term oriented investors. At the same time we are consciously or unconsciously in daily contact with Adobe’s products through its Acrobat Reader, Photoshop and PDF-documents.
While the stock tends to enjoy less public attention, Wall Street seems to agree with me. The following chart compares Adobe’s performance against the S&P 500 and Nasdaq 100 index over the last five years. As you can see, Adobe has achieved an impressive performance of around 541%, outperforming the two major indices by far.
(Adobe’s performance vs. S&P 500 and Nasdaq 100. Source: YCharts)
Even in a comparison with the tech mega-caps, Adobe has no need to hide itself, as the following chart shows. Adobe follows closely behind Amazon (NASDAQ:AMZN) in the rankings, which has delivered an impressive performance of over 600% over the last five years (see following figure).
(Adobe’s performance vs. tech mega-caps. Source: YCharts)
Going forward, what can be expected from Adobe stock and what are the reasons that could lead to a further upside in Adobe’s share price? Considering the recent run-up despite a challenging environment due to the pandemic, is the stock worth an investment right now? What are potential catalysts and obstacles? What is Adobe’s fair value?
These are the questions I would like to address in the context of this article.
(Adobe analyst meeting slide. Source: Adobe)
2. Which reasons could lead to a further rise in Adobe’s share price?
First, Adobe offers a wide range of software solutions in the areas of design, marketing and entertainment (e.g. photo, audio, video, augmented/virtual reality, 3D, document editing and processing, analytics and customer insights, e-commerce, advertising, e-learning) and addresses nearly the complete range of potential target groups (e.g. individuals, freelancers, small-, medium- and large enterprises, educational, public and private institutions, consumers, students).
The following figure illustrates Adobe’s whole range of product offerings and software solutions.
(Display of Adobe’s whole range of software solutions and product offerings. Source: Adobe Financial Analyst Meeting, November 4, 2019)
Second, with regard to competition, it is hard to name a direct major competitor to Adobe’s offerings. This demonstrates the company’s unique market position, huge economic moat and global leadership in its own niche.
For instance, the following graph illustrates Adobe’s peers according to Seeking Alpha. But none of them is a direct competitor to Adobe in the areas of creativity, design and document processing. You will see similar results on other platforms.
Additionally, the recent acquisitions of Magento and Marketo will enable expansion of Adobe’s ecosystem by further integration of solutions in the areas of e-commerce, marketing, artificial intelligence and machine learning.
Furthermore, by using Adobe’s services, you will experience that Adobe’s company policy is designed to monetize all of its software and product offerings as soon as possible. On the other hand, customers are willing to pay due to the provided value of these offerings.
Third, Adobe has a huge total addressable market (TAM) with regard to its software solutions and product offerings. According to the company’s financial analyst presentation in 2019, the projected TAM for Adobe’s main segments is amounting to $128B in 2022.
In this context, it is noteworthy that Adobe’s business consists of the two main segments called Digital Media and Digital Experience. Digital Media comprises the business areas of Creative Cloud and Document Cloud.
Digital Media appeals to all target groups and includes software solutions for content creation, photo, video, graphic, movie design as well as designing e-learning, training and social media content. Document Cloud focuses on Acrobat, PDF mobile and web services (such as create, sign, edit, share, compress).
According to the company’s presentation in 2019, the Digital Media segment has a projected TAM amounting to $31B in 2022.
Digital Experience, on the other hand, focuses on corporate clients and offers product solutions and software offerings in the areas of advertising, marketing, analytics, e-commerce as well as data insights, customer journey and content management.
The Digital Experience segment has a projected TAM of $84B in 2022 according to the company’s presentation in 2019.
The following figure illustrates a detailed breakdown of Adobe’s TAM in the different segments.
Fourth, Adobe has demonstrated double-digit revenue and profit growth for years. For the past five years, the average revenue growth rate was 22% and the average net income as well as EPS growth rate was 62% for the past five years.
At the same time, the company had a very strong net margin and net income expansion during the past five years. While revenues more than doubled since FY 2015, net income has almost grown fivefold during the same time period (see following figure).
(Net margin breakdown for FY 2019. Source: Adobe 10K FY 2019)
While, according to the company’s financial analyst meeting in 2019, Digital Experience has an about twice as high projected TAM, revenues for FY 2019 in the Digital Media segment were more than twice as high as in the Digital Experience segment.
Consequently, based on the company’s TAM projections for both segments amounting to $128B for 2022, there is still an enormous growth potential from an operational point of view (see following figure).
(Adobe’s revenues by segment. Source: Adobe 10K FY 2019)
Additionally, as can be seen from the figures for 2019, around 90% of Adobe’s revenues consist of subscriptions, i.e. recurring revenues with high customer loyalty and stickiness.
Moreover, the company has exceptional gross margins with 85% in total which is also a result of its recurring revenue model and customer loyalty (see following figure).
Fifth, turning to Q2 2020 results, Adobe reported double-digit growth rates despite a very challenging market environment due to the global pandemic:
The following figure summarizes the year-over-year growth rates of the different segments.
(Revenue growth by segment Q2 2020. Source: Adobe Q2 2020 results)
Sixth, turning to guidance, the company expects $3.15B in revenue, representing a probably conservative double-digit year-over-year growth rate of 11%. Digital Media is expected to grow by 16%, whereas Digital Experience is expected to be flat.
The growth slowdown in the Digital Experience segment is a result of two main factors: 1) delays in general enterprise spending and the significant global decrease in advertising spending due to the pandemic, which impacted especially the Advertising Cloud revenue; 2) according to the management’s statements during the earnings call, Advertising Cloud offerings consist of subscription-based as well as transaction-based solutions. Transaction-based solutions will be eliminated going forward, which will negatively impact revenues. Consequently, Advertising Cloud will not be an area of growth for now. While the elimination of these offerings will negatively impact revenue, it will improve overall margins.
(Adobe Q3 2020 financial targets. Source: Adobe Q2 2020 earnings release)
Seventh, besides double-digit growth rates, a very loyal customer base and a high-margin business, the company also has a very healthy balance sheet with $4.1B in (long-term) debt against $4.35B in cash, cash equivalents and short-term investments as of Q2 2020.
3. Valuation compared to a potential peer group indicates potential overvaluation on a P/S ratio basis
With regard to the company’s valuation, let us begin with the market cap and a comparison with a potential peer group. Since it is really hard to name a direct competitor to Adobe, considering its market leadership and unique positioning, I have chosen some major players from the media, entertainment and advertising sector as comparison, which also have dominant market positions in their own sectors. As can be seen in the following chart, Adobe currently has a market cap of $229B.
(Adobe’s market cap compared to major players. Source: YCharts)
While Adobe has a relatively low market capitalization in comparison to major players, its market cap is relatively high if revenues are included (see following figure).
(Adobe’s revenue compared to major players. Source: YCharts)
Despite its relatively high valuation, Adobe’s revenue growth in the most recent quarter is not significantly higher compared to the peer group (see following figure).
(Adobe’s revenue growth compared to peer group. Source: YCharts)
The discrepancy between valuation, growth and revenues becomes clearer when the forward EV to revenues multiple is included. As can be seen in the following graph, Adobe has by far the highest multiple. Now one could argue that Adobe deserves a higher valuation because of its Software-as-a-Service (SaaS) business model and is in line with smaller SaaS companies. Nevertheless, in this context it is noteworthy that Salesforce (NYSE:CRM), another major SaaS player, has a valuation only half as high with a forward EV/S multiple of 9.
(Adobe EV to revenues (forward) multiple vs. peers. Source: YCharts)
Additionally, as you can see in the following graph, Adobe’s current P/S ratio is approximately 50% higher than its average for the past five years.
(Adobe’s P/S ratio over time. Source: Morningstar)
Since the comparison with a potential peer group may be misleading, it makes sense to additionally conduct a valuation using the DCF method.
4. Valuation based on DCF method indicates an upside potential of at least 35%
In order to choose a conservative approach, I have chosen a growth rate of 15% per year in terms of the free cash flow, which is largely in line with analysts’ estimates for the next few years provided by MarketScreener.
Furthermore, I have chosen a multiple of 32 for the last FCF, which corresponds to the five year average of Adobe’s Price/Cash Flow multiple and is 33% lower compared to its current multiple (48.36), according to Morningstar.
Additionally, I have used a discount rate of 6% considering the following factors: a) the dominant market position on a global scale and the current “crisis-resistant” business model in view of the increasing digitization trend; b) the company’s current and future double-digit growth rate estimates despite a challenging environment; c) negative, zero or nearly zero interest rates on a global level including massive quantitative easing provided by central banks; d) not even a minimal interest rate increase in sight from the central banks. Nevertheless, I would only apply this discount rate to fundamentally very solid companies as it is the case with Adobe.
Considering all these factors, and based on my valuation method, the fair value is $808.45, which corresponds to an undervaluation of the stock of 70% (see calculation below on the left side).
Since I used a discount rate of 6% and was often asked by readers what the fair value would be by applying a discount rate of 8%, I also calculated the corresponding fair value.
The fair value with a discount rate of 8% is $679.95, which corresponds to an undervaluation of 43% (see calculation below on the right side).
The calculation does not include the impact of the ongoing and potential buyback programs. Further share buyback programs are likely to provide a further boost to the share price. The current share buyback program of the company has $3.4B available for share repurchases.
On the one hand, Adobe is a clear beneficiary of the increasing digitization of private, public and business environment which was also fueled by the global pandemic.
On the other hand, Adobe enables individuals, companies, educational & public institutions to continue business or even increase sales despite a challenging market environment.
Adobe has a unique market position, a huge economic moat and a strong niche as a SaaS company serving the digital areas of design, advertising, commerce, entertainment and analytics. Additionally, Adobe covers the whole range of target groups and sectors and is an absolute necessity in all areas of creativity.
Additionally, Adobe’s strong market position is highlighted by the double-digit growth rates it has achieved over the past years and is projected for the future.
In general, Adobe sees a TAM of $128B in 2022 for its software offerings with a trailing twelve months revenue of $12B per Q2 2020, which represents an immense growth opportunity going forward.
However, Adobe is also confronted with short-term headwinds. The Advertising Cloud in particular – as a part of the Digital Experience segment – is struggling with stagnating growth due to the reduction in advertising expenditures and the cost-cutting measures of corporate clients. Yet, with economic recovery as well as rising advertising and corporate spending, this area could grow disproportionately.
Based on my fair value calculation, the stock has an upside potential of 70% and could be worth $808 per share. Which means that the stock still has upside potential left despite its recent rally.
If you already own the stock, you may not want to chase the recent rally.
If you do not own Adobe yet, it should be at the top of your watchlist for the next market pullback.
Nevertheless, even if the shares appear fundamentally undervalued, unexpected events are always to be expected on the stock market and there is no guarantee of rising share prices. Investors should always bear in mind that stock prices are volatile and should not be influenced by price movements alone, but rather should pay attention to the underlying fundamentals. In this respect, investors should always pay attention to their individual risk tolerance.
PS: If you liked my article and you want me to write more articles of this kind in the future, then like, comment and share this article. I intend to publish more about tech stocks in future. If you are interested in finding out my favorite technology stocks, follow me on Seeking Alpha. Thank you for reading!
Disclosure: I am/we are long ADBE. 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.