It is no secret that I prefer companies with a significant competitive advantage. I also like companies with significant growth potential. I prefer companies with a high Return on Invested Capital (ROIC), a gross profit margin exceeding 85%, and an operating margin surpassing 30%. Adobe has all the aforementioned features and has been on my watch list for a long time. In this analysis, I will investigate whether now is the time to buy Adobe.
This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and briefly go through why the company has meaning to me. I have changed the format of the analysis a bit to try to make it shorter and with less numbers. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.
For full disclosure, I should mention that at the time of writing this analysis, I do not own any shares in Adobe. If you would like to copy my portfolio or view the stocks in my portfolio, you can find instructions on how to do so here. Adobe has been on my watch list for years, but I have never pulled the trigger. If you want to purchase share or fractional shares in Adobe, you can do so through eToro. eToro is a highly user-friendly platform that allows you to get started on investing with as little as $100.
The Business
Adobe was founded in 1982 and describes itself as one of the largest and most diversified software companies in the world. Adobe has divided its business into three different segments: Digital Media, Digital Experience, and Publishing and Advertising. Digital media is their largest segment, contributing 73% of the revenue. Digital Media revolves around Adobe Creative Cloud and Adobe Document Cloud, which include Creative Cloud Express, Photoshop, Illustrator, Lightroom, Premiere Pro, and Acrobat. Digital Experience is the second-largest segment and contributes 25% of the revenue. It is an integrated platform and set of applications within the Adobe Experience Cloud that enable businesses to create, manage, execute, measure, monetize, and optimize customer experiences across various domains, including analytics and commerce. Publishing and advertising is a small segment that contributes 2% of the revenue. It includes e-learning solutions, technical document publishing, and web conferencing. Adobe generates 94% of its revenue from subscriptions, which I appreciate because it is recurring revenue. I believe that Adobe has both a brand moat and a switching moat. To Photoshop is now a verb, indicating a strong brand moat. Besides that, Adobe is listed as the 17th most valuable brand in the world by Interbrand. They have a switching moat because it is difficult for customers to switch to a competitor once they have mastered Photoshop.
Management
The CEO is Shantanu Narayen. He joined Adobe in 1998 as the Vice President and General Manager of Adobe's Engineering Technology Group. He became President and COO in 2005 before assuming the role of CEO in 2007. He became the chairman of the board in 2017. He has a bachelor's degree in engineering from Osmania University in India, a master's degree in computer science from Bowling Green State University in Ohio, and an MBA from the University of California, Berkeley. He has been named to Barron's list of The World's Best CEOs several times and has also been ranked fifth on Glassdoor's Top 100 CEOs list. According to Comparably, he is listed in the top 5% of CEOs in companies of similar size, with an employee rating of 94/100. Shantanu Narayen is also responsible for the decision to transform Adobe's Creative Suite business from a boxed-licensed software model to a monthly cloud-based subscription model, culminating in the launch of Adobe Creative Cloud in 2013. Despite the mainstream nature of subscription models today, at the time, Adobe was among a small group of industry leaders who saw the value in transitioning from one-time software purchases to a business model with predictable revenue, increased technology innovation, and the ability to utilize data for enhancing customer understanding and interactions. Thus, Shantanu Narayen made a wise decision that has led Adobe to become the successful business it is today. Based on his results, extensive experience, and excellent ratings, I believe that Shantanu Narayan is a great CEO and the ideal person to lead Adobe's growth in the future.
The Numbers
The first number I will investigate is the return on invested capital, also known as ROIC. Ideally, you would like to see a Return on Invested Capital (ROIC) above 10% in all years. In the past decade, Adobe delivered an underwhelming Return on Invested Capital (ROIC) in its early years. It isn't surprising that Adobe didn't launch its subscription model until 2013, and it took some years for it to affect the numbers. Adobe has consistently delivered double-digit Return on Invested Capital (ROIC) since 2016, and above 25% since 2019, which are very encouraging figures. ROIC has decreased slightly since the peak of the pandemic, but I am not concerned about it as Adobe has consistently maintained a ROIC above 25% since 2019.
The following numbers represent the sum of the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. I believe that the numbers are very encouraging, as Adobe has managed to grow their equity every year in the last 10 years, except for 2022, which was a challenging year for most companies due to macroeconomic factors. The equity increased again in 2023, reaching a new all-time high, which is very encouraging to see. Furthermore, it is also noteworthy that equity has grown by more than 10% annually since 2017, with the exception of 2022.
Finally, we will analyze the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. Levered free cash flow margin is used because I believe that margins provide a better understanding. Free cash flow yield refers to the amount of free cash flow per share that a company is expected to generate in relation to its market value per share. It is not surprising to see that Adobe has consistently generated a positive free cash flow in each year over the past decade. Free cash flow decreased slightly in 2023, but it is still the second-best year in Adobe's history. Hopefully, free cash flow will grow again in 2024. It is more concerning that the levered free cash flow margin reached the lowest level since 2016 in 2023, and I would like to see it increase in 2024. Levered free cash flow margin is still very high, but I don't like to see it decreasing. Free cash flow yield is slightly below the ten-year average, which indicates that Adobe is not trading at a favorable valuation. However, we will revisit this point later in the analysis.
Debt
Another important aspect to investigate is debt. It is crucial to determine if a business has a manageable level of debt that can be repaid within 3 years. This can be calculated by assessing the long-term debt to earnings ratio. Upon calculating using Adobe's data, I can see that Adobe has 0,67 years of earnings in debt, which is great. Therefore, debt is certainly not a concern for Adobe.
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Risks
Like any other investment, there are risks associated with investing in Adobe. One risk for most companies now, including Adobe, is macroeconomics. Adobe has a wide range of customers, including large corporations, smaller businesses, and individuals. If there is an economic slowdown, Adobe, like other companies, could experience a decrease in the high growth it has enjoyed over the past decade or so. Management has mentioned that they are observing macroeconomic impacts on their business, similar to what other enterprise software companies are experiencing. Management also mentioned that every customer considers the total cost of deploying the software, as well as the necessary steps to achieve payback and ROI. And as a result, there is certainly scrutiny and caution present.
Artificial Intelligence. AI is here to stay, and with the rapid development of artificial intelligence, it is impossible to predict how it will impact Adobe's business. Adobe was quick to implement AI in its solutions, and management views AI as a tool that will enhance Adobe's business in the future. However, the market seems to be less encouraged as the unveiling of ChatGTP's Sora had a negative effect on Adobe. It is uncertain whether Sora or any other AI products will impact Adobe in the future, but investors generally dislike uncertainty. Furthermore, in its annual report, Adobe mentions that it may require additional investment to develop its AI tools, and that these investments could be costly and impact margins.
Laws and Regulations. There are various laws and regulations that could impact Adobe in the future. The US Federal Trade Commission has initiated an investigation into Adobe's disclosure and subscription cancellation policies. According to Adobe, a settlement could entail significant monetary costs or penalties for the company. Another way that Adobe is affected by laws and regulations is that they had to terminate the acquisition of Figma because they couldn't see a clear path to receiving regulatory approval from the European Commission and the U.K. Competition and Markets Authority. Thus, there are several ways that laws and regulations could affect Adobe in the present and in the future.
Reasons to invest
There is also a lot of potential for Adobe moving forward. In his letter to shareholders, CEO Shantanu Narayan mentioned the factors that would drive the next decade of growth. Adobe Creative Cloud. Adobe aims to empower a larger number of individuals with the tools to create, communicate, distribute, monetize their content, and actively participate in the Creator Economy. The future of the Creator Economy looks promising as the global demand for content is accelerating, which continues to benefit Adobe. Creative Cloud remains the preferred creativity platform for creators in imaging photography, design, video, web, animation, and 3D. Goldman Sachs believes that the creator economy could double over the next five years. If Adobe manages to continue to be the preferred creativity platform for creators, there will be significant growth opportunities ahead.
Adobe Document Cloud. The transition from paper to digital is expected to accelerate rapidly as remote and hybrid work becomes more prevalent in workplaces worldwide. Adobe benefits from this innovation by enhancing their PDF format to facilitate seamless document interactions across web, desktop, and mobile platforms. Document Cloud is a leader in digital documents, empowering all common document actions, including editing, sharing, reviewing, scanning, and signing. Adobe is excelling in Document Cloud, with annual recurring revenue growing by 23% year-over-year. Management expects that generative AI will deliver additional value and attract new customers to Document Cloud. Thus, the runway is still huge for Adobe in Document Cloud.
Adobe Experience Cloud. Adobe believes that digital experiences are indispensable for every business in every category, enabling companies of all sizes to engage and transact with customers around the world. Businesses will need to address consumer expectations of personalized content tailored to their interests, needs, and preferences while safeguarding the privacy and security of their data. Adobe Experience Cloud offers a solution that enables businesses to deliver personalized experiences to millions of people in milliseconds. Management believes that Adobe Experience Cloud is well-positioned to continue succeeding with innovative products that drive end-to-end customer experiences and empower companies to drive growth and profitability simultaneously. And they may be right, as subscription growth increased by 12% from 2022 to 2023.
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Valuation
Now it is time to calculate the share price. I perform three different calculations that I learned at a Phil Town seminar. If you want to make the calculations yourself for this or other stocks, you can do so through the tools page on my website, where you have access to all three calculators.
The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 11,82, which is from fiscal year 2023. I have selected a projected future EPS growth rate of 15% (Finbox expects EPS to grow by 20,9% per year over the next five years, but I have chosen to use 15% as the highest rate.) Additionally, I have chosen a projected future P/E ratio of 30, which is twice the growth rate. This decision is based on the fact that Adobe has historically had a higher P/E ratio. Lastly, our minimum acceptable rate of return is already set at 15%. After performing the calculations, we determined the sticker price (also known as fair value or intrinsic value) to be $354,60. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Adobe at a price of $177,30 (or lower, obviously) if we use the Margin of Safety price.
The second calculation is called the Ten Cap price. The rate of return that a company owner (or stockholder) receives on the purchase price of the company is essentially its return on investment. The minimum annual return should be at least 10%. I calculate it as follows: The operating cash flow last year was 7.861, and the capital expenditures were 438. I attempted to analyze their annual report in order to determine the percentage of capital expenditures allocated for maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated to maintenance purposes. This means that we will use 307 in our calculations. The tax provision was 1.371. We have 455 outstanding shares. Hence, the calculation will be as follows: (7.861 – 307 +1.371) / 455 x 10 = $196,15 in Ten Cap price.
The final calculation is referred to as the Payback Time price. It is a calculation based on the free cash flow per share. With Adobe's free cash flow per share at $15,25 and a growth rate of 15%, if you want to recoup your investment in 8 years, the Payback Time price is $240,73.
Conclusion
I believe that Adobe is a great company with a competitive advantage. I also feel very comfortable with the management team due to the CEO's experience and track record. Adobe is facing a short-term headwind due to macroeconomic factors, as mentioned by the management. However, macroeconomics will eventually improve. Laws and regulations may potentially affect Adobe both in the short term and the long term as we await the results of the probe from the Federal Trade Commission. The termination of the Figma acquisition will likely lead to Adobe developing its own product to compete with Figma, incurring additional costs. However, the major risk for Adobe is artificial intelligence (AI). Adobe has been successful in integrating AI into their solutions, but there is considerable uncertainty surrounding AI and its potential impact on various sectors in the future. Thus, it is something that needs to be monitored. Nonetheless, Adobe has plenty of tailwinds in Creative Cloud, Document Cloud, and Experience Cloud, all of which are expected to grow. Adobe still maintains significant competitive advantages in all three segments. Hence, I will buy Adobe shares if they reach $390, which is the intrinsic value of the Ten Cap price. This price will be below the intrinsic value of the Payback Time price and slightly above the intrinsic value of the Margin of Safety price.
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