Introduction
Adobe Inc. is a well know American multinational computer software company headquartered in San Jose, California, and incorporated in Delaware. The company has specialized in producing software that facilitates the creation and publication of various types of content for graphics, photography, illustration, animation, multimedia/video, motion pictures, and print. Some of its prominent offers are – Adobe Photoshop, Adobe Illustrator, Adobe Acrobat Reader, and the Portable Document Format (PDF), along with an array of tools helping with creation, editing, and publication of audio-visual content.
Adobe’s product lineup evolved over time, initially presenting a bundled solution named Adobe Creative Suite. This suite later transformed into a subscription-based software-as-a-service (SAAS) model, now known as Adobe Creative Cloud. In addition to these foundational products, Adobe has also ventured into digital marketing software and is now a prominent global leader in Customer Experience Management (CXM).
Adobe offers its various products under Software as a service (SAAS) subscription model. Its offerings are categorized into two primary divisions: Digital Media and Digital Experience.
Within Digital Media, there are two sub-divisions: Creative Cloud and Document Cloud. Adobe Creative Cloud consists of a suite of applications and services that provides subscribers access to an array of software utilized for tasks such as graphic design, video editing, web development, and photography. This suite is complemented by a collection of mobile applications that enhance accessibility and usability. Conversely, Adobe Document Cloud comprises a suite of cloud-based applications tailored for the management, editing, and exchange of PDF documents.
The Digital Experience segment offers Adobe Experience Cloud applications, designed to oversee customer journeys by providing tools for data analytics, content delivery management, and workflow streamlining. This area is a fast-growing segment for Adobe, geared towards offering supplementary value-added services to its existing users, thereby generating increased revenue from existing customer bases.
According to latest quarterly report from Adobe:
Creative revenue in the second quarter of fiscal 2023 was $2.85 billion, up from $2.61 billion in the second quarter of fiscal 2022, representing 9% year-over-year growth. Document Cloud revenue in the second quarter of fiscal 2023 was $659 million, up from $595 million in the second quarter of fiscal 2022, representing 11% year-over-year growth. Total Digital Media segment revenue grew to $3.51 billion in the second quarter of fiscal 2023, up from $3.20 billion in the second quarter of fiscal 2022, representing 10% year-over-year growth driven by strong net new user growth.
Digital Experience revenue was $1.22 billion in the second quarter of fiscal 2023, up from $1.10 billion in the second quarter of fiscal 2022, representing 12% year-over-year growth. Driving this increase was the increase in subscription revenue, which grew to $1.07 billion in the second quarter of fiscal 2023 from $961 million in the second quarter of fiscal 2022, representing 11% year-over-year growth.
Adobe quarterly report
Segment Landscape
Let’s dive into the market landscape in which Adobe operates and understand its potential growth trajectory.
The Creative segment significantly drives Adobe’s revenue, contributing approximately 70-75% of its total earnings. While specific subscriber figures aren’t disclosed by Adobe, estimates suggest a substantial increase from 12 million in 2017 to around 20 million by 2024, representing a compound annual growth rate (CAGR) of roughly 8-9%. Globally, there are approximately 50 million content creators (as per Forbes), of which 96% are categorized as amateurs who may not generate substantial income through their content. Nonetheless, they are highly inclined to utilize Adobe’s product suite. Notably, Adobe’s specialized offerings, such as Adobe Express, cater to novice creators, empowering them to generate content swiftly and effortlessly, with a minimal learning curve.
Considering the current subscriber count of around 20 million, Adobe possesses considerable room for expanding its subscriber base. Based on historical subscriber growth rate at Adobe, I am estimating that Adobe could increase their number of subscribers to 30 million in next 5 years.
The Digital Experience segment constitutes the remaining 25% of Adobe’s revenue. As previously mentioned, this segment provides content management software services (CMS). This domain is marked by strong competition, from industry giants like Oracle, Salesforce, and HubSpot. The CMS services market is assessed at approximately $48.3 billion, and its growth has maintained a modest 1.1% CAGR, a trend expected to persist over the coming years. Notably, Adobe, Oracle, and Salesforce, hold a comparable market share. Despite the gradual growth of the CMS market, Adobe’s Experience Cloud segment has demonstrated a markedly higher growth rate of around 15% – a testament to the advantages inherent in utilizing Adobe’s products over those of other players in this sector. This advantage appears to stem from the seamless integration of Adobe Experience with Adobe’s cloud services.
Growth projections
Given the factors outlined above, it is projected that Adobe could sustain a revenue growth rate ranging from 10% to 12%. This estimation aligns with revenue growth projections provided by Seeking Alpha. While a growth rate of 10%-12% might appear conservative, especially considering Adobe’s historically high revenue growth, it’s important to note that Adobe already occupies a dominant position within its operating domains. A substantial 40% of content creators are already using its services, and Adobe’s CMS market share mirrors that of its competitors. Hence, projecting a relatively moderate growth rate moving forward is both reasonable and anticipated.
Fundamentals
Over the past decade, Adobe has shown a robust revenue growth of 17.72% CAGR, coupled with consistent operating margins ranging from the lower to mid-30% range. This has been complemented by a strong balance sheet, and controlled debt level considering numerous acquisitions. The interest rate required to service the existing debt is quite lower than the company’s operating income, and its A+ S&P rating indicates that any future borrowing needs can be met at a minimal borrowing cost.
Furthermore, Adobe also has a robust free cash flow, which expanded by 11.4% last year and averaged 24% over the past three years. This growth in free cash flow has facilitated continuous share buybacks, resulting in the removal of approximately 40 million shares from circulation over the past decade. This strategic move has further increased shareholder value.
Valuation
For the valuation of Adobe, I will be using a discounted cash flow model. Based on the previously mentioned points, my estimations are as follows: a growth rate of 10-12% for the upcoming five years, gradually tapering to reach a target revenue of $41 billion. A perpetual growth rate of 4% (equivalent to the current 10-year treasury yield) and operating margins stabilizing at 30%.
Calculation of re-investment involves standard assessment of capital expenditure, depreciation, and changes in working capital. In addition to these, I am also including acquisitions in the re-investment calculation as I believe it provides a complete view of Adobe’s re-investment necessities, given the significant role acquisitions play in their growth strategy. Notably, Adobe has consistently pursued one or more acquisitions each year since 2001. Excluding potential capital requirements for future acquisitions would lead to an incomplete evaluation of their re-investment rates. The efficacy of Adobe’s re-investment is gauged through the sales-to-capital ratio.
| (in millionsexcept Sales-to-Capital ratio) | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 |
| Acquisitions | -704.6 | -29.8 | -826 | -48.4 | -459.6 | -6,314 | -101 | – | -2,682 | -126 |
| Acquisitions avg | -1254 | -1254 | -1254 | -1254 | -1254 | -1254 | -1254 | -1254 | -1254 | -1254 |
| Capital expenditure | -188 | -148 | -185 | -204 | -178 | -267 | -395 | -419 | -348 | -442 |
| Depreciation and Amortization | 321 | 314 | 340 | 332 | 326 | 346 | 757 | 571 | 576 | 618 |
| Change in Working Capital | 163 | 396 | 332 | 396 | 388 | 464 | -43 | 186 | 292 | 336 |
| Reinvestment | -959 | -693 | -768 | -731 | -719 | -711 | -935 | -916 | -734 | -742 |
| Sales to Capital ratio | -0.10 | -0.94 | -1.38 | -1.98 | -2.41 | -3.01 | -1.81 | -3.18 | -2.48 | -1.11 |
Over the past decade, Adobe has spent an average of $1.25 billion on acquisitions every year. With this, Adobe has a median sales-to-capital ratio of 2.20 or in other words, for every dollar invested, Adobe makes $2.2 in additional revenue. Utilizing this ratio, I will compute future re-investment prior to determining the free cash flow.
Considering these parameters and employing a discount rate of 10.80%, the derived discounted cash flow (DCF) valuation for Adobe amounts to $213.32.
| (in millionsexcept Sales-to-Capital ratio) | TTM | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | Terminal |
| Revenue | 18429 | 19367 | 21691 | 23860 | 26246 | 28870 | 31180 | 33674 | 36031 | 38193 | 40103 | 41731 |
| Operating Income | 6199 | 6585 | 7158 | 7635 | 8136 | 8661 | 9354 | 10102 | 10809 | 11458 | 12031 | 12519 |
| Income after Tax | 4832 | 5202 | 5655 | 6032 | 6428 | 6842 | 7390 | 7981 | 8539 | 9052 | 9504 | 9890 |
| Sales to Capital ratio | 2.20 | 2.20 | 2.20 | 2.20 | 2.20 | 2.20 | 2.20 | 2.20 | 2.20 | 2.20 | ||
| Re-investment | 1056 | 986 | 1085 | 1193 | 1050 | 1134 | 1071 | 983 | 868 | 740 | 2302 | |
| FCFF | 4146 | 4669 | 4947 | 5235 | 5792 | 6256 | 6909 | 7557 | 8184 | 8764 | 7589 | |
| Terminal value | 173030 | |||||||||||
| Present Value | 3741 | 3803 | 3637 | 3473 | 3468 | 3380 | 3370 | 3326 | 3251 | 3142 | 62030 |
| (in millions except value per share) | |
| Present Value of Total CF | $ 96,620 |
| Cash, Cash Equivalent, Marketable securities | $ 6,096 |
| Long term Debt obligations | $ 3,631 |
| lease obligation | $ 408 |
| Equity Value | $ 98,677 |
| Total shares outstanding | 462.6 |
| Equity value per share | $ 213.31 |
According to my assessment, Adobe appears to be considerably overvalued at its current stock price. To validate the existing stock price, Adobe would need to achieve a remarkable 24% compound annual growth rate (CAGR) over a span of 10 years, reaching a target revenue of approximately $130 billion. Such a level of growth demands a substantial and sustained increase in the number of subscribers, surpassing the present levels. However, considering the market statistics we’ve previously discussed, this elevated growth scenario seems highly implausible.
Let’s also take a quick look at the impact of Figma acquisition on Adobe’s price. Here is what Adobe’s latest quarterly report mentioned about the acquisition:
On September 15, 2022, we entered into a definitive agreement under which we intend to acquire Figma, Inc. (“Figma”) for approximately $20 billion, comprised of approximately half cash and half stock, subject to customary purchase price adjustments. Approximately 6 million additional restricted stock units will be granted.
Considering the above factors, the re-evaluated value of Adobe adjusts to $189.24. This adjustment is due to reduced cash reserves, likely higher debt level (factoring in a presumed 50% cash and 50% debt financing for the Figma deal), and stock dilution of around 6 million shares.
Nonetheless, this revised value doesn’t factor in the potential future revenue growth stemming from the web-design market where Figma operates. However, please note that it is premature to estimate Figma’s impact on Adobe’s revenue growth, given that Figma’s most recent revenue figures stood at $400 million. I do believe that the acquisition of Figma is a positive addition to Adobe’s portfolio, with substantial potential for future growth.
Adobe’s revenue expansion is intricately linked to expansion of its subscriber base and its ability to offer more services. While the business of content creation is often presented as highly profitable, a substantial portion of content creators and influencers do not generate any significant income. Consequently, this financial limitation acts as a deterrent to their adoption of Adobe’s relatively expensive services, which can cost novice users from several hundred to a thousand dollars annually. The affordability factor I believe is a big challenge to Adobe’s growth.
In addition, any business is influenced by macro-economic elements such as economic recessions, which can contribute to a slowdown in Adobe’s expansion efforts.
Conclusion
In conclusion, while the recent surge in stock price has benefitted current shareholders, I do not advise taking new positions in the stock. Presently, the stock lacks any margin of safety, and Adobe’s recent communications have not disclosed any information that would substantiate its elevated valuation.
Disclaimer
The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice.