One company that I believe deserves to be mentioned in the same sentences with big technology names like Microsoft (MSFT, Financial) and Apple (AAPL, Financial) is Adobe (ADBE, Financial).
Adobe is a household name for the creative community, but fewer people are aware of its value as a stock. This software company, headquartered in San Jose, California and founded in 1982 by John Warnock and Charles Geschke, is best known for its suite of creative and multimedia software products, which have become industry standards in various fields, including graphic design, web design, video editing and digital marketing.
Now with the advent and implementation of artificial intelligence (AI), I think Adobe has a chance to build an even larger economic moat. Moreover, I think the chances of its Figma acquisition going through are high, despite opposition from the Department of Justice, which is another positive.
Business model overview
Adobe's business model can be broken into three main segments: Creative Cloud, Experience Cloud and Document Cloud.
Creative Cloud is a subscription-based service that provides users with access to Adobe's entire suite of creative applications and services. Creative Cloud includes industry-leading applications such as Photoshop, Illustrator, InDesign, Premiere Pro and After Effects, among others. Currently, Creative Cloud is estimated to have over 30 million paying users.
Experience Cloud is a comprehensive set of digital marketing and web analytics solutions designed to help businesses create, manage and optimize digital customer experiences across various channels. Key products in the Experience Cloud include Adobe Analytics, Adobe Target, Adobe Campaign and Adobe Experience Manager.
Document Cloud is a cloud-based document management system that allows users to store, share and collaborate on documents. It integrates with Adobe Acrobat and Adobe Sign, allowing for seamless PDF workflows and e-signature capabilities.
Also, the company's freemium product, Adobe Acrobat, continues to be the main platform used for creating, editing and managing PDF files. Adobe Acrobat Reader is a free application for viewing and printing PDF documents, while Acrobat Pro and Acrobat DC provide more advanced features for creating, editing and securing PDFs.
New and exciting developments
Last September, Adobe agreed to purchase budding competitor Figma for $20 billion in a cash and stock transaction. It was a big deal, and at the time, I thought it was a super expensive deal. However, it may be like back when Meta (META, Financial) bought WhatsApp; even if it's expensive, Adobe needs to acquire Figma to knock out a key competitor. Figma specializes in collaborative design, an area where Adobe is relatively weak, and should provide Adobe with the technology needed to operate in group settings. It makes building websites and apps faster and easier. Before the deal was announced, an estimated 4 million paid and free users were active on the platform. The deal is being reviewed by regulatory agencies and is expected to close later this year. The Department of Justice reportedly plans to file a lawsuit against the deal, but I believe it will go through regardless.
Last week, Adobe unveiled Firefly AI to bring AI to its software suite, which seems to be absolutely necessary in order to compete in the decade ahead. Currently available to access in beta, it's a real game changer. With Firefly, users can generate images and text effects from descriptions. On one hand, ChatGPT and MidJourney along with others AI image generators pose a real threat to the livelihoods of Adobe's customers. However, a broader spectrum of possibilities could be just over the horizon. Just like the internet made it possible for virtually anyone to be a journalist (spoiler alert: it actually didn't, it just made it easier for journalists to do their jobs and lowered the barriers to entry), I think AI image generators will serve a similar purpose for artists and web designers.
Adobe has a fortress balance sheet and is incredibly profitable
Not only does the company operate with a virtual monopoly on its industry in terms of brand loyalty and presence, it generates significant returns on capital with very high margins across the board. Adobe produces an 18% return on assets, a 34% return on equity, a gross margin of 87% and a net profit rate of 26%.
Adobe has grown sales, profit and book value at faster than market rates over the last decade as well. In the last 12 months, Adobe generated $4.7 billion in profit on just shy of $18 billion in revenue, up from $290 million in profit on $4 billion in revenue in 2013. Over the same time, retained earnings have increased from $6.9 billion to $29.4 billion as the company bought back over 7.5% of its shares, pushing book value from $13.55 to $30.95. Every dollar in retained earnings produced nearly $7 in market value.
To put it lightly, Adobe has crushed it. Today, it is even harder for new startups to compete with Adobe, and very few seem to be trying. While Adobe’s capitalization fluctuated between 2001 and 2011, since late 2011 the company’s value is up nearly 15-fold. I realize that past doesn’t predict the future, but it can give companies like Adobe an unapproachable head start.
A rare value opportunity
On Nov. 19, 2021, Adobe’s stock price peaked at $688.37, the highest closing price in its 41-year history. Since then, the stock has dropped 60%, and only in the last six months has it rebounded to its current price level.
With a forward price-earnings ratio of 24.7, Adobe looks like a steal even if we don't consider its incredible runway for growth and competitive moat. The underlying business is stronger now than ever with analysts from Morningstar (MORN, Financial) expecting earnings of $15.00 per share this year. That number is also expected to continue growing at a healthy 10% clip for the next decade. If that comes into fruition, earnings pre share would approach $40 in 2032.
Even if we discount earnings growth down to 8% annually, Adobe would be expected to earn $32 a share in a decade. Furthermore, even if Adobe were to trade down to the sector median price-earnings ratio, that still puts my price target between $576 and $720.
