Adobe Stock: Time To Be Greedy (NASDAQ:ADBE)

Adobe Headquarters

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From being one of the top computer software companies in 2021, in the span of just under a year investors have a totally different perception of Adobe (NASDAQ:ADBE). Sixty percent far from its all-time high, with limited operating income growth in Q3, and after a $20 billion acquisition for a company with a Price/Sales of 50x, shareholder confidence is waning. These are the main themes of bearish investors on Adobe, and in this article I will comment on them individually based on my opinion. I could be wrong, but I think the market is punishing this company too much.

Never try to catch a falling knife

Adobe’s price per share is objectively in free fall, and this represents the first criticism of this company. What solid company collapses this much? Since November 2021, the price has collapsed by 60%, including almost 30% in this month alone. Undoubtedly, volatility is currently one of the biggest risks as it can lead the price to completely unexpected declines; however, all that does not scare me this time. As long as the falling knife is a leading company in its industry and with a free cash flow margin stably above 40%, catching it may not be all that painful. The risk of overpaying obviously remains, but from a long-term perspective if the company is solid, having taken advantage of short-term volatility may have been the biggest plus. The reasons why I disagree with the motto “never try to catch a falling knife” are attributable to Adobe’s current financial and economic condition: analyzing its financial statements I think it is very difficult to be able to find a weakness.

Ability to generate income and free cash flow

On future growth expectations I will talk about that later, for now let’s focus on what Adobe has been up to now. I think it is important to put the big picture in context and understand what kind of company we are talking about.

Income Statement

TIKR Terminal

From an income standpoint, the graph speaks for itself.

  • Revenues up every single year as well as gross profit.
  • Operating income up every single year since 2014. Its margin has more than tripled since 2013.
  • Net income growing strongly over the long term. LTM and 2021 results are lower than 2020 due to higher-than-average taxation. In fact, considering pre-tax income, in LTM Adobe generated $5.95 billion versus $4.17 billion in 2020. This has similarly affected the net income margin as well.

Cash flows

TIKR Terminal

In terms of cash flow, the situation becomes even more interesting. Adobe’s subscription-based business model allows for stable and predictable operating cash flow. In addition, since the company does not have high capex, the free cash flow margin is huge: out of $100 in revenue Adobe gets $41.50 in free cash flow. As if that were not enough, free cash flow has increased every single year since 2013, and its margin has also gotten progressively better. Adobe’s ability to generate so much cash is in my opinion its greatest strength, and it is what makes me confident despite the fact that the market is not of the same opinion.

To conclude the aspect related to the profitability results achieved, let’s take a look at the key profitability ratios to understand how efficient Adobe has been in allocating its resources so far.

Profitability ratios

TIKR Terminal

Once again the results were excellent. Not only because all these values are quite high, but because they tend to have an upward trend. A return on capital of 32% is very close to Microsoft’s 34% to give an idea of how profitable this company is. The drop in ROE compared to 2020 is purely technical since the numerator of this ratio is net income: as previously announced high taxation has negatively affected it.

Flawless balance sheet

The ability to generate a huge amount of free cash flow has spilled over the years within the balance sheet.

Balance sheet

TIKR Terminal

Adobe has total debt of only $4.64 billion, payable entirely from total cash and short-term investments, so net debt is negative. Despite the buyback plans that began in 2015, total equity has increased year after year due to growing retained earnings. Overall, we are facing an optimal situation where the company has no difficulty in dealing with debt and continuing its buyback plan. In Q3, 5.1 million shares were purchased at a cost of $1.80 billion, but $8.3 billion of the $15 billion authorized through 2024 still remains. After a collapse of such a magnitude in market capitalization, I would not be surprised if Adobe accentuates its share buyback in the coming quarters.

In light of these economic-financial considerations, I think it is hard not to say that Adobe is a top-tier company. It is important to point this out because I believe that a 60% drop has a different meaning depending on the company that experiences it, which is why I feel confident about a recovery of Adobe. Past performance does not guarantee future performance, but it does help.

Adobe shows limited growth

This is the second criticism leveled against the company. We have seen previously how Adobe’s past has been glorious, but according to bearish investors something is changing and we can already see it from the latest quarterly report. Let’s take a look at what it is all about.

  • Operating income Q3 2022 was $1.48 billion, a growth of only 3% compared to $1.44 billion in Q3 2021.
  • Q3 2022 net income was $1.13 billion, a 6.20% decrease from $1.21 in Q3 2022.

These results are certainly not positive, but before we panic, I think it is important to understand the causes of this stall. There are two main reasons.

  • Adobe is an international company that operates in multiple geographic areas; therefore, it is subject to foreign exchange risk.

Revenue by geography

Adobe Q3 FY2022 Earnings Call Script

With the recent strengthening of the dollar against major world currencies, all U.S. companies selling abroad have been negatively affected, not just Adobe. It is very complex to operate in the current macroeconomic environment, but I think this is a temporary situation. It is hard to imagine a dollar below parity with the euro as being a permanent situation, but I could be wrong.

  • Adobe in Q3 2022 increased both R&D costs and sales and marketing costs. The former increased by $124 million over Q3 2021 and the latter by $198 million. These are variable costs but still negatively affect short-term profitability, which is why profit is down.

Overall, excluding variable costs, it is true that profit margins have narrowed, but it is mainly due to exogenous factors related to the current economic slowdown. Also, in terms of revenue growth Adobe achieved the best Q3 2022 in its history.

Income statement

Adobe Q3 FY2022

Revenues for Q3 2022 were up 13% over Q3 2021, a growth not at all obvious during a recession. In particular, it was subscriptions that drove the growth, showing how much Adobe’s products are still in demand. All this, considering that the company managed to keep its gross margin stable (87.7%).

As for the revenue growth of the different market segments, all of them experienced double-digit growth.

Growth rates

Adobe Q3 FY2022 Earnings Call Script

There has not been a single segment that has struggled to grow, and if it were not for the superdollar, we would now be talking about revenue growth of at least 15 % YoY. As for Q4 2022 guidance, however, the results are not that different from Q3.

Q4 targets

Adobe Q3 FY2022 Earnings Call Script

Double-digit growth is expected for each segment, and the superdollar will still negatively impact, especially the Digital Media segment. These growth rates may be lower than those seen in the past, but one must also put into context how many problems have arisen compared to 1 year ago. In 2021, the major central banks were not adopting restrictive monetary policy, Europe did not have gas supply problems, inflation was not as high, and the Dollar Index was not at a 20-year high. In addition, the size of Adobe has increased from years past; therefore, it is not reasonable to expect the same growth rates. Double-digit growth is still a very good result for such an established company in my opinion. Sometimes focusing too much on the short term clouds the long-term view.

To conclude the topic related to growth, I will now show you the long-term estimates according to analysts from several Web sites.

Revenue forecast

stockforecast.com

Analysts at stockforecast.com estimate that Adobe’s revenues may grow 11.39% CAGR through 2030. However, in this case we are assuming that FY2022 revenues will be $17.85 billion, which is not yet certain. Also, the CAGR through 2026 is 12.24%.

Revenue forecast

TIKR Terminal

TIKR Terminal analysts instead estimate revenues through 2026 will grow at a CAGR of 12.09%, thus slightly lower. These forecasts may turn out to be wrong, but I personally would be surprised if growth fell below double digits. All in all, I do not see Adobe as having no growth prospects, and the recent acquisition of Figma may revise these estimates upward.

Figma has been overpaid

For those presenting a bearish thesis, this is one of the main issues, perhaps the most important. Since the announcement of the acquisition of Figma for $20 billion, Adobe has plummeted by 25% because according to the market it was overpriced. Several criticisms have also been inflicted on Adobe’s business model: if its competitive advantage is so strong why does it need to buy a small company for $20 billion? All these doubts are absolutely legitimate, but I think the market reacted too much on impulse without analyzing with a cool head what is going on. Here are the main reasons behind my reasoning.

Unwarranted panic

To explain why I think the market has been too impulsive I think it is enough to look at the collapse of Adobe’s market cap. From the time of the Figma acquisition announcement to the present (I am considering a price of $280 per share), Adobe has lost about $43 billion in market cap. Even assuming that the Figma acquisition was completely worthless (which it wasn’t), I don’t think a further $23 billion market cap collapse is entirely reasonable. Certainly, the current bearish market is not helping, but I think it is just pure bearish speculation at this point.

Figma acquisition will not dilute shareholders

Although Adobe does not currently have $20 billion cash the acquisition of Figma will not dilute its shareholders in the medium term. The deal was reached by paying half cash and half in stock. If the cash is not enough, then Adobe will temporarily increase its debt. The reason why there will be no dilution was clarified by CFO Dan Durn:

While the transaction is pending, at a minimum we expect to maintain share repurchases sufficient to offset the dilution of equity issuances to Adobe employees.

In addition, if the company were to opt to increase its debt, it would provide to repay it as soon as possible and then resume the share buyback. In any case, this talk is postponed until 2023, as the acquisition will be subject to regulatory approvals in these months.

Figma is not a small company

My impression is that the market is underestimating Figma; therefore, I would like to point out some aspects why I believe this company is better than expected.

  • Figma was created in 2012 and already has 850 employees.
  • Its gross profit is 90% (higher than Adobe) and it is a company that already creates money since its operating cash flow is positive.
  • Expected revenues for 2022 are $400 million and it has a net dollar retention rate of 150%. This company is growing fast.
  • Figma currently owns the leadership of the collaborative design and prototyping market: its market share is 31.41% while Adobe XD is about 15%. With this acquisition Adobe is securing about 46% of this market.
  • According to Adobe’s statements, Figma is just getting started. The total addressable market is about $16.5 billion by 2025, and if Figma maintains its current market share it could already generate $5.18 billion in revenues in 2025. Considering these forecasts, it is not that much $20 billion.

Figma’s technologies improve Adobe as a whole

Adobe not only shelled out $20 billion to benefit from Figma’s revenues but also to improve the products it already offered previously. In the last few days I have heard about “diworsification” but this is not the case at all, as this acquisition not only provides new market opportunities but also makes the content creation product offerings more complete. Adobe is a more efficient company if it leverages Figma’s technologies, and all of this was discussed at length in the earnings call. Here is an excerpt:

Adobe and Figma now have a new opportunity to make content creation more efficient, collaborative and fun by bringing together Adobe Express, Acrobat and FigJam, an online whiteboarding solution for teams. With the combination of these products, we can offer tremendous value to hundreds of millions of customers.

As far as I am concerned, the acquisition of Figma for $20 billion is not wrong, since we are talking about a fast-growing company, a leader in a growing market, and which will bring overall improvement to Adobe’s products through its technologies. Nevertheless, I still respect the opinion of those who are against this acquisition and believe that Adobe should have developed these technologies on its own instead of buying them for $20 billion from Figma. On the other hand, I disagree with those who believe that the Figma acquisition is the beginning of the end of Adobe, this seems to me pure speculation now since it is not supported by the numbers. Large acquisitions are often viewed with skepticism since they tend to shake up the company’s balance, both for the bad and the good.

How much is Adobe worth?

Each investment is represented by the present value of future cash flows; therefore, I will use a discounted cash flow to calculate the Adobe’s fair value. To make the valuation more objective, I will construct three models each representing a different scenario. Once the fair value of each scenario is calculated, I will extrapolate the final fair value through a probability-weighted average.

  • The first is the best-case scenario, since the free cash flow estimates by stockforecast.com analysts are met.
  • The second is the normal-case scenario, and considers analysts’ estimates written down by 15% for each year.
  • The third is the worst-case scenario, and considers analysts’ estimates written down by 30% for each year.

The three models differ in free cash flow, but have some similar characteristics:

  • The cost of equity will be 10% and includes a beta of 1.13, a country market risk premium of 4.20%, a risk-free rate of 3.75%, and additional risks of 1.50%. The latter were included for the purpose of discounting any problems related to Figma’s operations. As Adobe is a company with negative net debt, the WACC corresponds to the cost of equity.
  • The source of outstanding shares and net debt is TIKR Terminal.
  • The perpetual growth rate will be 2.5%.

Best-case scenario

Discounted cash flow

Discounted cash flow

In the best-case scenario Adobe is very undervalued as it has a fair value of $428 per share. In probabilistic terms, I consider this scenario the least likely, therefore, I would give it a 20% probability: I want to be conservative. In this scenario we are assuming that Adobe’s growth will not stop even during the recession.

Normal-case scenario

Discounted cash flow

Discounted cash flow (-15%)

This is the scenario I consider most likely as we have a 15% margin of error for analysts: neither too high nor too low. Again, Adobe is undervalued as it has a fair value of $364 per share. In addition to the margin of error on estimates, at the current price we also fit within a 20% margin of safety. This is an optimal situation in my view. I consider this scenario to be 50% likely.

Worst-case scenario

Discounted cash flow

Discounted cash flow (-30%)

In the worst-case scenario Adobe is always undervalued but the current price does not fit within the margin of safety. This is an extreme situation in my opinion since it would mean that analysts’ estimates will be defeated by 30% every single year, including 2022 which is now only 1 quarter left. Since caution is never too much in financial markets, I wanted to consider this 30% likely scenario anyway.

Making a probability-weighted average across scenarios, Adobe’s fair value is $358, much higher than the current $284 per share. Overall, I may have been even too conservative in these models, yet Adobe remains a buy. To start building a position at this price I consider it a reasonable choice, but that does not take away from the fact that the risk on this investment is high. I conclude this article with a famous quote from Warren Buffett:

Be fearful when others are greedy and greedy when others are fearful.

There is no doubt that the market is currently fearful about Adobe, but how many will be truly greedy?

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