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Creative software market leader has growth and quality credentials and trades at a discount to its usual rating
Thursday 12 May 2022 Author: Steven Frazer

Betting against the market is always risky and it may feel contrarian to be thinking about buying anything technology-related. But we think Adobe (ADBE:NASDAQ) stands out for three clear reasons: its consistently strong financial performance; its exposure to structurally growing markets; and its powerful balance sheet.

This is a high-quality business getting very short shrift from the markets right now. Despite beating analyst forecasts in the first-quarter, its shares still slumped 9% (22 Mar), and they have continued to fall. Year-to-date, the stock has lost 33%, or 45% from its one-year peak in November.

Adobe’s 2022 price to earnings multiple is now 27.5, falling to 20 next year. That might not look especially cheap, but it is historically low for a business consistently growing in the mid-teens and delivering 35% and 25% returns on equity and investment, respectively.




 

A DOMINANT FORCE IN DIGITAL CONTENT

Adobe is a dominant force in the creative digital content industry, with more than 50% of the creative software market, according to analysts.

We’re all familiar with PDF documents and many readers will know its Photoshop image editing product, but the company’s suite extends far deeper with professional Creative Cloud products like InDesign, Illustrator and Premiere Pro, among others.

Effectively, whenever you view an image, video, website, magazine, or even an app, there is a good chance it was created using Adobe software.

We see the company as a major beneficiary of continued explosive growth in this market as ever-richer digital content is consumed across multiple devices.

A ROLE IN THE METAVERSE

It could also become a key creative force in building the metaverse if people like Facebook’s Mark Zuckerberg and Microsoft’s (MSFT:NASDAQ) boss Satya Nadella, who have bet big on the virtual vision of the future internet, are right.

Since 2018, Adobe’s sales have grown from $9 billion to $15.8 billion in fiscal 2021 (to 3 December), with 92% of that coming from annually renewing subscriptions, up from 86% in 2019. Recurring subscription revenue is important.

Subscriptions come at a low marginal cost to the company, which gives Adobe control over its own operating expenses, which is good news in the current inflationary environment.

This is illustrated by the firm’s gross margins, up from 85% in 2019 to 88% last year. The subscription model is unlocking international growth opportunities and helping to combat software piracy,
while drawing users into an ecosystem from which it is difficult to break free.

That past success means that investors can have reasonable confidence in the company’s execution and ability to keep on tapping opportunities.

Adobe thinks there’s plenty of room to grow, with a total addressable market for its Creative Cloud products of $63 billion.

For reference, Creative Cloud revenue for 2021 was $9.6 billion. Similarly, management claims the addressable market for its Document Cloud products (electronic signatures and more) is $32 billion. In 2021, Adobe reported $2 billion in Document Cloud revenue.

Even if these projections turn out to be overly optimistic, it is still reasonable to assume there’s plenty of space for Adobe to continue to take market share and expand its ecosystem, selling a wider variety of products to users, with the cloud at its heart.

ALL ABOUT COLLABORATION

Enabling users to collaborate from anywhere in the world is key for the creative industry, and Adobe made an important acquisition in this space when it agreed to purchase cloud-based video collaboration company Frame.io in October 2021.

Another project it has launched is a ‘lite’ version of its suite, a stripped back set of tools for new users or those that don’t need the full bells and whistles. This could be a great way to seed new users to fully priced tools as their needs change.

An Adobe ‘lite’ version is also being used to head off competition. Privately-owned Australian start-up Canva has been making ground with low-cost tools offered to users to which it then tries to upsell.

Making strategic acquisitions like Frame.io and launching new products requires deep pockets, which is where Adobe’s balance sheet muscle comes in. At the end of last year, it had more than $1.1 billion of net cash on its books, having thrown off $6.88 billion of free cash flow during
the 12 months.

While there is no dividend, surplus cash doesn’t get wasted. Adobe has bought back approximately $12 billion of its own shares since 2018, with scope to repurchase up to another $13.1 billion of stock under its current buyback agreement.

There has also been progress in streamlining its business. Operating expenses as a percentage of overall revenue have decreased in each of the past two years, falling from 56% in 2019 to 51% in 2021.

As it grows revenue, Adobe is showing its ability to keep costs in line, benefiting from its ever-increasing scale.

We cannot guarantee that Adobe shares won’t fall further in the coming weeks; there are just too many uncertainties right now.

But we do believe that once the global economy and markets are able to find some stability, Adobe will once again win the recognition the business richly deserves.



 

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