Adobe Inc. (ADBE, Financial) has been one of the main beneficiaries of the artificial intelligence wave, with the company demonstrating urgency and agency to rapidly innovate and serve its target market with relevant solutions. Moreover, the company has exhibited innovative ways to deploy cash toward acquisitions and other initiatives that would be accretive to its growth. Investors have been rewarded by the stock's outperformance, with Adobe beating the S&P 500 by roughly three times the benchmark's 20% trailing one-year performance.
Most recently, its deal to acquire Figma was called off due to regulatory scrutiny, which means Adobe will have to find ways to deploy cash in a manner that returns value to its shareholders. I believe this news is great for investors and see further upside in the company's stock.
Business model recap
Based in San Jose, California, Adobe is a cloud software company that sells subscriptions to users in the digital media and digital creation sectors via its web and mobile apps. The company's suite of software tools is most notable among creators, designers and media personnel, enabling them to create powerful media assets such as pictures, videos, documents and other digital assets. In the past five years, the company's software products have also become very popular among social media users and influencers.
Adobe has stood the test of time by successfully adapting through multiple business transformations as its target market evolved. The company successfully completed its transformation into a cloud software company from its primitive software license model. More recently, the company seized market leadership in digital creation and quickly expanded its offerings to include AI capabilities in its core user base. The company deploys and maintains its product suite based on its ‘Digital Flywheel' digital transformation framework, as shown below.
Adobe's platform harnesses the power of data and AI to empower its digital creativity-based users, such as students and retail consumers, while also empowering digital experience-based users, such as developers, small businesses and enterprises.
Since the company is in the business of cloud software, SaaS success metrics that are widely used in the industry, such as annual recurring revenue, will be important in evaluating its growth prospects.
An innovation machine focused on generating cash
I mentioned in the previous section how Adobe has been able to consistently maintain its pace of innovation and keep up with the evolving trends in its target market. Adobe maintains at least 50 creative apps in its Adobe Creative Cloud, Experience Cloud and Document Cloud. But its core revenue driver is its Creative Cloud, which has immense appeal among its creative users. As can be seen below, Adobe Creative Cloud, which is reported under Adobe's Digital Media segment, accounts for almost three-fourths of revenue.
Perhaps the most encouraging sign to me in the most recent quarter was that its Digital Media segment had again started to grow. This segment grew 12.6% year over year, faster than Adobe's overall revenue growth of 11.60%. The segment contains some of the most popular apps for creators, such as Photoshop, Illustrator, Lightroom, etc. Moreover, Adobe launched its own standalone AI app called Firefly last year, which is bundled into the Adobe Creative Cloud subscription and reported under the Digital Media segment.
The Firefly app is meant to allow users access to its generative AI models, enabling them to instantly create imagery and other media content with just basic text commands. The app has become hugely popular since its launch, attracting the largest number of users ever to an Adobe app launch in the beta phase. I believe the momentum the company has seen this year in its revenue is largely due to the higher-than-usual adoption of its AI-based tools. I also believe this momentum will be sustained due to Adobe's track record of innovating in this space, leading to more product and feature launches, attracting more users as well as expanding upsell and cross-selling opportunities for existing subscribers. This helps generate higher ARR, which improves the prospects of growth rates for Adobe's revenue, which I see in the chart below.
Moreover, the quality of Adobe's strong top-line results is also manifesting in its margins. The proliferation of AI, together with the scale of its AI applications and features, is leading to better margins, which is eventually generating more cash for the company and its investors, as can be seen below.
In 2022, Adobe announced its intent to acquire design collaboration tool Figma for $20 billion in a combination of cash and stock. However, regulatory scrutiny pressured the company to walk away from the deal last year.
I believe the termination of the deal bodes well for Adobe's investors since I expect it to return the additional $9 billion to $10 billion in cash to shareholders in the form of share buybacks. Moreover, with the Figma deal being terminated, the company will preserve its shares from being diluted, thus delivering further value to its shareholders. In my opinion, this is a win-win deal that will greatly benefit investors.
What do valuation models suggest for Adobe's share price?
Given the Figma deal is terminated and my expectations of Adobe returning cash to shareholders, I will assume outstanding shares of approximately 430 million, which is 5% lower than its latest annual filing. In addition, I will take management's guidance for the 2024 operating margin as my base case of mid-40s, although I believe it is under-guiding given its outperformance throughout 2023. I expect Adobe to grow its margin by at least 2% over a five-year period, given the strong product adoption rates and higher productivity its AI platforms provide. With this, I estimate Adobe will grow its operating income by 13.50% over a five-year period.
With such impressive growth rates in Adobe's income, I think a forward price-earnings ratio of 27 is extremely reasonable in this case. Based on my valuation, I see shares undervalued by 10% at the minimum, with more room on the upside.
Risks and other factors to consider
In the age of AI, it is imperative that Adobe keep innovating at a rate that is consistent with the evolving pace of its target market. Moreover, the company will need to make sure its underlying AI models are consistently outperforming other models at pace and accuracy when it comes to image generation, video creation and other media tasks. If the company falls behind on innovation or its AI models are not able to accurately provide accurate results for its user base, I expect Adobe's credibility to be impacted and see some users move to other competing platforms such as Stable Diffusion or Midjourney.
On the macro level, my valuation models assume stability in the global economy as portrayed by consensus expectations. However, any deterioration in the macroeconomy, especially in the U.S., will severely affect Adobe's growth forecasts as its users will be expected to switch to a conservative-spending mode.
Finally, Adobe has not provided any indication yet about what it plans to do with the additional cash it has since the Figma acquisition was called off. The company may choose to pursue other acquisitions that it may find accretive to its growth strategy. In this case, I expect a marginal impact on my valuation model since the overall growth opportunity for the company will not be impacted. I expect management to be more indicative of how it intends to use its cash at the upcoming investor meeting in March.
Takeaways
After carefully evaluating Adobe and reviewing the strong trends that are lifting its growth prospects, I am convinced the stock is positioned to deliver shareholder value. Given the economy is set to grow as per consensus estimates and discretionary spending is returning to the economy, I expect the company to greatly benefit from these secular trends and see room for upside in the stock.
