Investors likely don’t give much thought to the invention of the PDF (Portable Document Format), but it does have an interesting history. The format was created in 1993 by John Warnock, who co-found Adobe Inc. (ADBE, Financial), and it has been a flagship product for the company ever since.
Today, the company looks much different than its early days as a start-up company in 1982. Adobe operates in three segments: Digital Media, Digital Experience and Publishing and Advertising. The Digital Media segment offers products and services that enable individuals, teams and enterprises to create, publish and promote content. The Document Cloud, which is part of this segment, is a cloud-based document services platform whose flagship product is Creative Cloud, a subscription-based service.
The Digital Experience segment provides a platform and set of applications that enable brands and businesses to create, manage, execute, measure and monetize customer engagement from early analytics to end commerce.
The Publishing and Advertising segment offers products and services such as e-learning solutions, technical document publishing, web conferencing and web application development. This segment also includes Advertising Cloud offerings.
The company was founded in 1982 and currently has a market capitalization of $172 billion.
Figma acquisition troubles
In September 2022, Adobe announced it was acquiring Figma, a leading web-first collaborative design platform, for approximately $20 billion in cash and stock, split roughly equally. Figma is a design platform for employees who build products together. The platform helps teams brainstorm, design and build better products by consolidating tools, simplifying workflows, or collaborating across various employee groups and across multiple time zones.
Figma is a key competitor to Adobe in digital design, and the acquisition has faced intense regulatory scrutiny regarding as a result. The acquisition also was questioned by investors, as Adobe reportedly is paying 50 times recurring revenue, which is a lot.
During the recent earnings call, the company provided an update on the acquisition which has not closed yet. It stated the potential continues to be well received by customers, analysts and industry partners. The company has completed the discovery phase of the U.S. Department of Justice's second request and says it is prepared for next steps. Adobe believes the transaction is on track to be completed by the end of this year, despite the fact that the DoJ is reportedly preparing a lawsuit to block the deal.
Financial review
The company reported fiscal first-quarter earnings in early March for the period ending March 3, 2023. Revenues increased 9.2% year over year (13% in constant currency) with particular strength in the Document Cloud segment. Gross profit increased 9.0% but gross margins were flat at approximately 88%. Adobe has typically carried very high gross margins.
Adobe usually generates high levels of free cash flow. Operating cash flow in the quarter was $1.7 billion and capital expenditures were only $101 million. Uses of cash were primarily $500 million in debt paydown and $1.4 billion in share buybacks. The stock trades at very high multiples so share buybacks may not be the best use of cash. Last year the company bought back $6.5 billion in stock at prices much higher than current levels. Adobe has $4.6 billion in cash and short-term investments on the balance sheet and $3.6 billion in total debt.
Adobe's CEO stated,“Adobe drove record Q1 revenue and we are raising our annual targets based on the tremendous market opportunity and continued confidence in our execution. Creative Cloud, Document Cloud and Experience Cloud are mission-critical in fueling the global digital economy. Our strong engine of innovation combined with world-class operational rigor drove profitable growth in Q1, setting us up to deliver another strong fiscal year.”
Valuation
The company provided a 2023 earnings per share outlook which was approximately $11.00 at the mid-point of the range. The puts the company trading at about 34 times forward earnings. The enterprise-value-to-Ebitda ratio is also elevated at 17. However, these valuation levels are down from 2021 levels. What were investors thinking in 2021 when they were paying over 60 times earnings when the stock was trading above $600 per share? The consequences of that nonsensical investing strategy were a stock price decline of approximately 60%.
The GuruFocus discounted cash flow (DCF) calculator gives a fair value estimate slightly below the price level as of this writing when I plug in $11.00 as the EPS starting point and estimate a long-term earnings growth rate of 15% and a discount rate of 10%. That may prove to be generous as operating income growth was flat and earnings per share only grew 2.0% in the most recent quarterly results. The company does not pay a dividend at this time.
Guru trades
Gurus who have purchased Adobe stock recently include Catherine Wood (Trades, Portfolio) and Jeremy Grantham (Trades, Portfolio). Gurus who have reduced their positions include Baillie Gifford (Trades, Portfolio) and Chuck Akre (Trades, Portfolio).
Summary
The Figma acquisition was an expensive strategic move to take out a serious competitor. Some analysts have suggested that if Figma remained a stand-alone company, its product set and growth rates would have materially cut into Adobe’s growth rates. Until the acquisition closes, Adobe may remain in its current slow growth trajectory. Paying over 30 times earnings for the stock may not be a wise choice at this time in my view.
