Stock Analysis - Adobe Inc. (ADBE)
Updated: Jun 22, 2020
The second stock evaluation on stockreview.org will be focusing on Adobe Inc (ADBE).
The below references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
While in the last analysis we were evaluating a stock / industry that was particularly hard hit by Covid19, today we will have a look at a company that might have profited from worldwide stay at home orders and people searching for new hobbies or other ways to get their work done. Adobe just reported its second quarterly earnings a few days ago, so we have fresh information to take into consideration here.
Without further ado, here are the fundamentals and the introduction:
Who are they?
What’s the easiest way to send a document to your colleague, friends or family without destroying the format? Use a PDF! Which software is used by more than 90% of creative professionals? Photoshop! These and a few others are Adobe products that I guess by now many people have become familiar with or at least heard of.
Founded in December 1982 Adobe became profitable in the same year by selling part of the company to Steve Jobs and carving out a license deal with him for their first product “PostScript”, the first international standard for computer printing. After the introduction of Photoshop in 1989 Adobe has been steadily growing their now called “Digital Media” segment, reaching huge penetration of the creative market and has reached de facto standard with its’ PDF Format (it’s an actual ISO).
The company is now also leveraging its’ capabilities to enter another Software as a Service (SaaS) market, as it attempts to offer data analysis support and digital marketing tools to businesses.
How do they earn money?
Adobe was one of the earliest adopters of what is now an industry standard not only for the SaaS sector, but also many others. That concept is ARR or Annualized Recurring Revenue. Through monthly invoiced subscription payments Adobe generates a stable income stream from its customers that makes up roughly 90% of their total sales.
This kind of stable recurring cash flow provides a significant measure of safety, when planning overall expenses, new or additional developments or entering new markets.
Out of the 3 segments in which ADBE has divided its’ activities, Digital Media is by far the biggest and (so far) also the most profitable. Besides dominating the market for creative softwares, Adobe has recently started to make a push on expanding its Business-to-business activities, which are bundled inside the “Digital Experience” segment and include services like data analytics and advertising. While growing significantly in FY 2019 it is currently (Q2 2020) outmatched by the digital media segment that seems to find even more customers and market penetration recently.
With relatively low cost of sales and mostly overhead cost to cover, Adobe has the ability to steer its’ developing and marketing efforts in the direction they want, without necessarily increasing their cost base.
With an overall score of 8, Adobe does exceptionally well in this section, the only current downsides being that they do not pay a dividend (While the Cash Flow would be available, it is currently mostly reinvested in further growth) and the EBIT/EV ratio being “only” 1,7%, suggesting a relatively high valuation.
All other metrics were spot on with high margins, strong growth and a great capital structure. Cash Flow that is currently used neither for paying dividends nor for investments, ADBE is utilizing to further reduce its’ already low debt-to-equity ratio or to execute share buybacks, both of which should finally be in shareholders interest.
Being the industry leader in its’ main segment, Adobe scores 12/15 in the Five Forces Analysis, with only a few point deductions as I explain in the following:
Starting from the top, ADBE gets the maximum 3 points in the Competition category. By practically dominating the creative market with its diverse portfolio, there is by now little competition remaining and Adobe operates in a near monopoly. Nevertheless its’ current software solutions are continuously being developed and gaining further advantage.
While this is not (yet) the case for its’ “Digital Experience” segment, the continuous growth Adobe achieves also here, could be a sign that they are “doing something right”.
While entrance barriers in the Software Market itself are not particularly high in terms of investment, the level of sophistication which Adobe has achieved with its’ tools, as well as their consumer loyalty, provide an ample protection for most potential threats.
Recently a few “free to use” image retouching apps/softwares have been nagging on ADBEs market share especially for entry level tools, but as a creative, as soon as you want to get into a little more detail you are quickly left with very few options. 2 points.
I’m gonna make it a little easier for myself here and say I will give 2 points. The value proposition that Adobe provides to creatives is fairly obvious and if you are a creative professional, you basically have no other choice then to accustom yourself to the variety of Adobes portfolio. However if you are a non-professional and just looking for something fun to do in your free-time, you might be slightly more price sensitive and not necessarily willing to pay a 100 dollars per year for the entry level photography plan.
An easy 3 points, as Adobe does most of its’ software development in-house. Besides the fact that software development nowadays requires increasingly high investments into human capital, most other supplier relations are fairly basic. This might include standard contracts for hardware servicing as well as a few licenses to be paid in case of utilizing external solutions.
The two biggest factors in the Substitutes category lead to a final score of 2. On the one side Adobe is mitigating the substitution risk fairly well, by diversifying its’ creative portfolio and trying to occupy all possible niches as much as possible. On the other hand, the biggest risk of substitution might not be a different app or software, but people actively “not-using” any processing tool and just sticking with what they got fresh out of the camera (which might already be processed and sufficient for their cause).
Completing the scoring analysis of ADBE Stock will be the “Other Factors” Category. As what you would superficially call a “tech company”, Adobe is leveraging the capabilities of its market dominance in the creative sector to push further on other frontiers. A score of 14 out of 15 is testament to that.
Adobe is benefitting from network effects not in the traditional way in that additional users of their software directly complement the value for other users. Rather through a secondary effect, the ubiquity of users already working with ADBEs tools are creating tutorials, startup guides and all kinds of auxiliary content. Thereby making access to those tools all the more easier for new creatives and creating additional value around the product itself. 4 points.
It is no secret that SaaS companies have been the darlings of Wall Street in recent times. The Scalability and chance for exponential growth is always given as new customers are just a few clicks away. A strong brand and possible network effects can boost this effect and are part of the manner in which Adobe took the market by storm. 5 points.
Just recently Adobe has changed its’ official logo for the first time since 1993. Along with a few other changes, the main logo was updated to just use a single color in order to be “as functional as possible at all sizes and across all surfaces”.
By constantly evolving not only its’ brand, but also questioning and realigning its’ identity, Adobe is making sure to stay one step ahead of the competition while keeping a “fresh face” for its’ existing user base. The brand itself already being within the top40 of most valuable brands worldwide while still growing significant is just a nice side-effect of this. 5 points also in this category.
Final attractiveness rating: 85%
With a total score of 34 out of 40 possible points, ADBE achieves the (so far) highest score in our scoring system, indicating significant fundamental strength
- Through a safe balance sheet and strong growth (8/10)
- By being a market leader in its main industry (12/15) and
- Executing its’ brand strategy while profiting from easy scalability and secondary network effects (14/15)
Intrinsic Value Calculation
While the Coronavirus has wreaked havoc around industries like restaurants, shopping malls and many others, Adobes’ almost 100% software based business has (so far) experienced little to no negative impact from the pandemic. Rather the opposite could turn out to be true in the short to mid-term, as people stuck at home are searching for new activities, hobbies or anything to give their minds some distraction.
In fact ADBE just posted another record quarter 2 in terms of sales about a week ago and despite issuing a rather careful year end guidance, they might be on the way to once again beat the estimates.
Discounted Cash Flow valuations
Deviating a little bit from my standard process of calculating 4 scenarios of possible Cash Flow developments (Realistic, Pessimistic, Optimistic, Flat), I was content enough leaving out the “flat” scenario. In my opinion, unless the world might really be ending soon, the chance of Adobe posting 0 growth from now onwards is close to non-existent. So, in a new kind of overview, here are the scenarios I calculated including the annual growth rate of Cash Flows I considered.
Cash Flow and Sales growth over the past years have both been around the same level (20%-25%) over the last years and notwithstanding any further acquisitions or higher than usual investments, Adobe is on a good way to achieving a $4 billion Cash Flow within this year.
Going on from there I think it is more than realistic that, with the growth in the B2B sector just starting to play out, the recent Cash Flow growth of ~25% can also continue in the following years. While the optimistic scenario considers an even higher growth of ~35% the most pessimistic (and still reasonable) case I came up with was a decrease in annual growth down to 10-12%.
Looking for peer companies in “the same industry” it becomes obvious how utterly alone Adobe leads the market for creative applications. The few competitors offering one or a few similar applications to Adobes comprehensive tool base, are either not even stock listed or way too small to be considered as “comparable”.
Instead, the final peer group now consists of:
- Microsoft and
- VM Ware
Both of these companies are by now running their business in a successful way following the SaaS model (and partly much more of course). VM Ware is currently almost identical in size when compared to Adobe in terms of sales, employees and profit, while recent growth was slightly less strong.
Microsoft has now fully moved the office software to the cloud and started charging a monthly fee to its’ user base (I am using it right now). While much bigger it is comparable also in another way as it is offering a cloud solution to its’ customers. Further, despite its’ size, Microsoft has (and is still) seeing tremendous growth throughout recent years and doesn’t have do shy when compared with Adobes growth key figures.
What is evident in the above is that compared to the selected peers, Adobe’s key comparables are currently on a significantly higher level, indicating a much higher valuation by the market participants.
Summing up the results from the above we can see what happens, if the market believes very strongly that a specific stock / company will be able to outpace not only its’ competitors, but also its’ own ambitious targets.
While it is not out of the way that Adobe will achieve not only past growth rates and instead grow even stronger within the upcoming years (moving close to the “optimistic” DCF scenario), all other market based multiples, indicate the price currently being more on the expensive side, as visible in the above.
“Averaging out” all my valuations indicate a possible downside compared to current valuation levels of ~35%.
Fundamentally on the other hand, few companies are as sound as Adobe and especially when looking long-term, the associated risks should be close to zero. The company generates a healthy cash flow, despite strong growth and does not need to rely on credit lines or additional equity in order to survive even the toughest of situations.
As usual before finishing up, there are other factors that could influence the basic scenarios I have highlighted above in significant ways. Some of those, as written in the below table, might be worth considering if you are wagering an entry into the stock.
What are everyone’s thoughts on tech darling Adobe?
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