Adobe: A Digital Powerhouse With The Potential To Double By 2025

Summary

• Adobe is the third largest Software-as-a-Service (SaaS) provider in the world in terms of revenue, behind only Microsoft and Salesforce.
• Adobe’s portfolio of cloud-based software applications leverages machine learning and artificial intelligence to empower a diverse user base.
• Adobe estimates its total addressable market will be ~$128 billion by 2022, indicating enormous growth opportunity in the years ahead.
• Adobe's financial performance has been exceptional in recent years.
• Adobe is a strong buy.

Investment Thesis:

Adobe (NASDAQ:ADBE) offers a wide range of cloud-based software applications that enable users to create digital media and provide personalized digital experiences. In an age of digitization, Adobe’s products have an enormous total addressable market, making Adobe a very compelling long-term investment.

My investment thesis can be summarized as follows:

(1) Adobe's products enable businesses to create and publish digital content and provide audiences with personalized digital experiences. There will be enormous demand for these products in the coming years.

(2) Adobe’s Software-as-a-Service business model generates strong recurring revenue, with exceptionally high gross margins (mid-80%).

(3) Adobe has consistently posted incredible financial results over the last five years, growing revenue at 21% annually and profits at 60% annually.

Adobe's Software:

Adobe is one of the most diversified software companies in the world. And at the end of 2019, Adobe was the third largest SaaS provider in terms of revenue, behind Microsoft (MSFT) and Salesforce (CRM).

The chart below shows Adobe’s three business segments:

Source: Created by the author using information from Adobe 2019 10K.

Adobe focuses investments on two of these segments: Digital Media and Digital Experience.

The Digital Media segment includes cloud-based applications that provide creative professionals with tools for designing, creating, and publishing creative content. Customers include a variety of creative professionals, from photographers and video editors to graphic designers and game developers. The graphic below depicts some of Adobe's Digital Media products.

Source: Adobe Investor Presentation (January 2020).

The Digital Experience segment is an array of cloud-based applications built on Adobe's artificial intelligence platform, Adobe Sensei. These applications provide functionality in analytics, marketing, advertising, and commerce - all of which are aimed at managing customer experience. Customers of this segment include advertisers, marketers, merchants, data scientists, and developers. The graphic below depicts some of Adobe's Digital Experience products.

Source: Adobe Investor Presentation (January 2020).

Adobe's Market Opportunity:

The global software-as-a-service market is presently valued at roughly $158 billion. This figure is expected to reach $307 billion by 2026, an 11.7% CAGR. Adobe, as the third largest provider of SaaS in the world, is well positioned to capture gains.

Adobe estimates its total addressable market (TAM) at roughly $128 billion by 2022. The graphic below shows the breakdown between different revenue segments:

Source: Created by the author using the Adobe Investor Presentation (March 2020).

Over the trailing twelve months (TTM), Adobe has generated $12 billion in revenue. This represents less than 10% of the estimated TAM of $128 billion by 2022. Management clearly sees ample room for growth in the coming years.

Digging deeper, the majority of this opportunity comes from the Digital Experience segment. Digital Media presently accounts for $8.4 billion of Adobe's TTM revenue, which represents 19% of the estimated TAM. But Digital Experience accounts for only $3.4 billion of Adobe's TTM revenue, representing only 4% of the estimated TAM.

Digital Experience:

It's easy to understand why management sees the Digital Experience segment as the largest growth opportunity. There is ample data that suggests providing a personalized customer experience can dramatically improve conversion rates; for instance, a 2018 report by Epsilon found that 80% of consumers are more likely to make a purchase when brands offer personalized experiences. As a result, more businesses are focusing on providing this type of interaction for their customers.

According to Gartner, Adobe is already a leader in the digital experience platform market.

Source: Adobe Press Release

But Adobe’s Digital Experience segment provides more than personalized experiences; it is an array of products that provides solutions in analytics, marketing, advertising, and commerce - each of which is poised to grow quickly.

Analytics: Adobe’s Analytics Cloud gathers and processes customer data from every interaction, across multiple channels (web, mobile, social, video) in real time to create customer profiles. Leveraging machine learning and AI, customer interactions are turned into actionable insights through predictive modeling, which helps improve marketing spend.

The customer journey analytics market is expected to reach $27 billion by 2026, growing at 21% per year.

Marketing: Adobe’s Marketing Cloud uses customer data and AI tools to help users manage, deliver, and automate personalized experiences. These experiences can be dynamic and synchronized across multiple digital channels, including web, mobile, email, video, and others.

The marketing cloud platform market is expected to reach $12 billion by 2023, growing at 8% per year. And the customer experience management market is expected to reach $23.6 billion by 2027, growing at 18% per year.

Gartner has recognized Adobe as a leader in web content management. And, as seen below, Gardner also recognizes Adobe as a leader in multichannel marketing hubs.

Source: Adobe.

Advertising: Adobe’s Advertising Cloud DSP (demand-side platform) provides programmatic omnichannel advertising capabilities, allowing users to buy, measure, and optimize advertising campaigns across connected and linear TV, video, display, audio, search, and social media. The demand side platform market is expected to reach $30 billion by 2025, growing at 30% per year.

As seen below, Gartner recognizes Adobe as a leader in Ad Tech.

Source: Adobe

Commerce: Magento Commerce enables enterprise merchants to create highly customizable online stores across a range of industries. The e-commerce software market is expected to reach over $20 billion by 2027, growing at 16% per year.

The Forrester Wave recently recognized Adobe as a leading provider of both B2B and B2C commerce suites.

Source: Magento.

The above synopses make it evident that Adobe not only competes in multiple quickly growing markets, but that it is often a leader in those markets. Additionally, while Adobe has many competitors, no single competitor is present in every market in which Adobe operates. That is to say, Adobe’s product offering is beyond robust and unparalleled in terms of breadth.

Financial Analysis:

In terms of financial performance, Adobe has been a powerhouse over the last 5 years. Since the end of fiscal 2014, Adobe has posted the following metrics.

• Revenue growth: 21% annually
• Gross margins: 86% (average)
• EPS growth: 60% annually
• FCF growth: 30% annually

Data by YCharts

As the above chart indicates, Adobe has executed exceptionally well during this time period, a testament to the strength of their SaaS business model and the demand for their products.

However, in the most recent two quarters, revenue growth decelerated to 19% and 14%, respectively. This was primarily due to a strong deceleration in the Digital Experience segment. On the Q2 earnings call, Adobe CEO Shantanu Narayen noted that second quarter coincided with the peak of the COVID pandemic. During this quarter, Digital Experience revenue grew only 5%, due to delays in enterprise bookings and weakness from small and medium size businesses; this effect was most pronounced in the Advertising Cloud, as there was a significant reduction in global advertising spend during this time. However, these short-term headwinds should reverse as the global situation improves.

Annualized Recurring Revenue:

Annualized recurring revenue (ARR) is a useful metric for analyzing the Digital Media segment. It indicates the annual value of subscriptions, services, and ETLA license agreements for Creative Cloud and Document Cloud products. Digital Media ARR was $4 billion at the end of fiscal 2016. That number has increased to $9.2 billion as of Q2'2020, representing 27% annualized growth. Increasing ARR is an indicator of a healthy, stable business. And while ARR has grown only 10% YTD, it is still moving in the right direction despite the recession. And as businesses reopen and advertising spend returns to normal, ARR growth should re-accelerate.

Source: Adobe Investor Presentation (March 2020).

Deferred Revenue:

Deferred (unearned) revenue can be misleading, but it can also be a gauge of future performance. According to a report published in the Quarterly Journal of Finance and Accounting, increasing deferred revenue tends to have a positive impact on sales growth, gross margins, and profit margins. The effect on margins is partially a result of mismatched revenue and expenses - that is to say, once deferred revenue is added to the balance sheet, the company has incurred certain expenses (labor, marketing), but they have not yet recognized the revenue associated with these expenses. So, financial statements for that period will reflect the outflow of capital, but not the inflow, which results in compressed margins for the current period and expanded margins in the following period(s). But there is more to it. Deferred revenue essentially represents customer payments made in advance; so increasing deferred revenue means more payments are being made in advance, which implies that those customers are not even considering switching products. And if they are willing to pay in advance, maybe they'd be willing to pay a little more too. In this way, deferred revenue may be seen as a proxy for pricing power, and pricing power translates directly into gross margin expansion, which trickles down the income statement.

Here, again, Adobe's metrics are solid. At the end of fiscal 2016, Adobe had roughly $2 billion in deferred revenue on its balance sheet. That number has increased to $3.46 billion as of Q2'2020, representing 17% annualized growth. As discussed above, this has positive implications for sales growth, gross margins, and profit margins in the coming years. While investors shouldn't rely too much on this statistic, the trend here is still positive.

Increasing Switching Costs:

One of Adobe's strongest competitive advantages, apart from its brand name and intellectual property, is the high switching costs associated with its products. After a customer invests the time to become proficient with an Adobe product, switching to a different product can be costly in terms of effort and productivity (i.e. the customer would have to spend time learning to use the new product, which would diminish productivity). Likewise, the more products a particular customer uses, the higher the switching costs become. And as the graphic below indicates, customers' usage has expanded significantly in recent years.

Source: Adobe Investor Presentation (March 2020).

In 2014, 66% of Adobe's top 100 customers had 3+ products in the Digital Experience segment. That number increased to 90% by the end of fiscal 2019. This indicates that switching costs are increasing, strengthening Adobe's competitive advantage.

Valuation & Risks:

The Bull Case

At ~$520 per share, Adobe is currently valued at 69x earnings and 21x sales, a premium compared to the broader S&P 500 in both cases. But Adobe is a premium company with an enormous addressable market, so I believe the valuation is warranted.

Presently, Adobe's market cap is ~$252 billion, meaning Adobe would be a ~$504 billion business by 2025 if the share price were to double, as I asserted in the title of this article.

Assuming the PS ratio remains unchanged at 21x by 2025, Adobe would need to grow revenue at 15% per year for the stock to double. This seems doable, considering Adobe has grown revenue at 21% annually since 2014.

But what if the PS ratio contracts to a more conservative 15x by 2025? In this scenario, Adobe would need to grow revenue at 23% annually for the stock to double. This would be more difficult, but Adobe's revenue growth has actually accelerated to 23% annually since 2016. And I believe this is sustainable over the next five years, as Adobe should benefit from its strong competitive advantages and its leadership position in an expanding market.

Of course, the above assumes shares outstanding remains constant, which is unlikely, as Adobe has repurchased 5 million shares already in 2020, and 50 million shares since the end of fiscal 2014. But share buybacks (theoretically) increase the value of remaining shares, which only strengthens my thesis. For example, if Adobe were to repurchase another 50 million shares over the next five years, assuming a PS ratio of 15x, Adobe would only need to grow revenue at 20% annually for the stock price to double, rather than the previously stated 23%.

The chart below summarizes the above calculations. Sales growth estimates are paired with PS ratios that would result in 100% return over the next five years.

Source: valuation created using the author's estimates.

I chose a PS-based valuation model because I believe there is too much guesswork involved in a DCF. Adobe has an innovative research division and may generate additional FCF from products that don't currently exist. For example, Project Glasswing could translate into Adobe being a major player in the augmented reality market. While this PS-based valuation method doesn't account for unanticipated revenue streams, per se, it does provide a range of PS ratio vs sales growth scenarios that may help investors decide if Adobe is capable of returning 100% over the next five years.

Finally, while past appreciation is no indication of future performance, Adobe's stock has already risen 583% in the past five years (and 1,830% in the past decade). This past appreciation may make some investors leery, but I see it as a sign of strength. This stock has outperformed the S&P 500 by over 500% since 2015, and it will continue to outperform for all the reasons I've discussed in this article: market leading products, an enormous and expanding TAM, strong competitive advantages, and exceptional financial performance.

Data by YCharts

The Bear Case

Before moving on, let's take a look at Adobe's future from a more bearish perspective.

As mentioned previously, Adobe's revenue growth has decelerated in 2020, dropping to 19% in Q1'20 and 14% in Q2'20. This was largely driven by weakness in the Digital Experience segment related to the pandemic. So, what if this trend continues and Adobe is unable to maintain 20%+ revenue growth over the next five years?

In the chart below, I've used the same PS ratio scenarios as in the bull case, but I've changed sales growth to 14%. I selected this number because it represents Adobe's slowest revenue growth over the last 12 quarters. I've also included the annualized return for each scenario on the right. For reference, the S&P 500 has returned ~8% annually since 1957 (the year the index was introduced).

As you can see, the outcomes are less desirable. But Adobe still beats the market in 2 of the 4 scenarios, assuming the market grows at historical rates over the next five years.

Even in the worst case scenario, which assumes 14% sales growth and a PS ratio of 12x, the return is 2% per year through 2025. While that almost certainly isn't a market-beating return, if this was the worst thing that happened to your portfolio over the next five years, I think you'd be okay.

So, while it certainly wouldn't be ideal if slower revenue growth became the new normal, the downside potential doesn't look that bad.

Conclusion:

As the world's third largest SaaS provider, Adobe has seen strong growth over the last decade. But the world is undergoing a digital transformation, and we are still in the early stages of that process, so the next decade looks very bright as well. Adobe has a strong brand name and an enormous market opportunity in both Digital Media and Digital Experience, and I believe Adobe will continue to yield marketing beating returns.

For that reason, Adobe is a strong buy.

Disclosure: I am/we are long ADBE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.