Adobe Stock: Here's Why It Is Undervalued Despite High Valuation Multiples

Summary

• Adobe is an industry leader with a wide moat.
• The company has seen impressive growth in the past and will likely continue to do so going forward.
• We estimate Adobe to have an intrinsic value of $530 per share with current market conditions.

Adobe Inc. (NASDAQ:ADBE) is a multi-headed beast with a wide range of products. Some products such as Magento, used for web building, lag way behind the leaders. But for other products such as Photoshop, it is the behemoth of the industry. The company has clear and measurable competitive advantages that have made it a great investment in the past. We believe that these factors will continue to make it a great investment going forward.

Industry Analysis and Positioning

Adobe has estimated that it will have a total addressable market (TAM) of $147B by 2023, up from an estimated TAM of $118B in 2022. This definitely fits the bill for a fast-growing industry. The company further breaks down the TAM into 3 segments: Creative Cloud, Document Cloud, and Experience Cloud.

The Creative Cloud segment is what contains its most recognized software, such as Photoshop. It's hard to argue a company is not a leader when one of its products becomes popular enough to be used as a verb: "Do you like this picture I Photoshopped?". Although Photoshop is its most widely known product by far, it's not the only one that many businesses rely on. Others such as Illustrator, InDesign CC, and Premiere Pro are also considered as industry standards.

Creative software is difficult to learn. Most of Adobe's products and its competitors' products have their own learning curves which take a lot of time even if they are similar. Given this hurdle, once users become familiar with all the features and are able to perform tasks efficiently, they feel discouraged at the thought of starting all over again with a new platform.

This is especially true for larger companies who are working on a lot of projects with urgent deadlines and have employees already trained in Adobe's products. The costs of switching over to a competitor are significantly greater than Adobe's price increases. As a result, most gladly or reluctantly opt for accepting the higher fees despite cheaper or even free alternatives.

Recognizing this advantage, Adobe targets schools and students with discounted packages in order to hook those interested in fields such as graphic design. Since the company's products are widely used, it makes sense for students and schools to learn and teach how to use them. In addition, with students continuing to graduate from schools with these skills, it makes sense for employers to continue demanding these skills. This creates a virtuous cycle for the company and continues to drive demand for its products.

Source: adobe.com

In fact, we took a brief look at job postings for graphic design on Indeed.com. The sample we used was all the postings on the first page of each of the Canadian provinces and the top 5 most populous states in the US. The results were very consistent and predictable in each province and state - the vast majority of job postings explicitly mentioned by name Adobe or its products as required skills. The few that didn't were mostly vague job postings that were very short in length. Given the strong consistency of our observations, it is reasonable to assume that this pattern most likely continues throughout all the other states and pages.

In addition, Adobe has been investing heavily to ensure that most or all the products a company needs in order to function optimally are included in their offerings. This appears to be working as per the screenshot below:

Source: Investor Presentation

As you can see, its number of top 100 customers with more than 3 products has increased from 61% in 2015 to 93% in 2020. This further reinforces the notion that companies are unwilling to switch to competitors. Instead, its largest customers are becoming even more reliant on Adobe's products. This has led to the growth of its other 2 segments: Experience Cloud and Document Cloud.

The Experience Cloud segment in particular is the most interesting. It focuses on marketing and analytics software to help companies focus on creating the best experience for their customers (hence the name). This segment has the largest TAM of the three segments but second largest driver of revenue. This segment seems like a natural progression for a company that has built a strong reputation in developing software that is used for creating advertising and media content.

Furthermore, Adobe's competitive advantage is reflected in its profitability margins. The images below provide an overview of the company's profitability rank in the overall tech sector (excludes OTC stocks).

Source of Images: Author using data provided by Finbox

For gross profit margins, ROIC and free cash flow margins, Adobe ranks 25th, 22nd and 13th, respectively. This is impressive especially when you consider that most of the companies that rank higher than them aren't even competitors and Mastercard (MA) is the only one that ranks higher in all three metrics. This is despite the fact that Adobe invests 17% of its revenue into research and development which is higher than the sector average of 9.9%.

Growth Catalysts

The main growth catalyst for Adobe is the growth of the industry as a whole. The move towards cloud computing and the need for more efficient workflow processes continue to act as industry tailwinds. Each of the company's segments continue to grow as do their total addressable markets. With expected revenues of $15B for 2021, the company has plenty of room to grow if the TAM reaches $148B by 2023.

However, we also believe that the company's biggest driver of growth will be its Experience Cloud segment. It is projected to be the largest of the 3 segments and currently drives only half as much revenue as the Creative Cloud segment. We believe that Adobe can leverage its reputation as the best creative software developer to attract businesses to a platform specialized for optimizing customer experiences. As we already stated but would like to emphasize again, its Creative Cloud products are already used to create marketing and media content. Thus, it seems like it would not take much to cross-sell to existing customers or to attract new customers.

Moreover, Adobe's moat will allow it to continue raising prices as time goes on due to the lack of serious alternatives, especially for large companies. Although not very popular amongst consumers, they can continue getting away with it as long as they don't become too greedy.

Valuation

Many will point to Adobe's price to sales multiple of 18.6 and prematurely declare that the stock is overvalued. However, we need to take a deeper look at the stock because Adobe is not a recent IPO with a cash burn of $100 million per year. It is an established leader that has been around for decades and generates strong free cash flows. Not only that, but both revenues and FCF have been growing and are expected to continue to grow. Therefore, we need to run a DCF in order to justly value it.

Based on the following assumptions, we estimate its fair value to be roughly $530 per share:

Discount Rate

• Marginal tax rate: 28%
• Cost of Debt: 2.6% (1.87% after-tax)
• 2-year weekly beta: 0.8
• Equity risk premium: 5.2%
• Risk-free rate: 1.2%
• Cost of Equity: 5.36%
• Weighted average cost of capital: 5.29%
• Half-year convention used

Revenue Growth

We calculated the fundamental growth rate of revenue as follows:

• Average 5-year reinvestment rate of revenue X average 5-year revenue-to-invested-capital ratio.
• Reinvestment rate calculated as capital expenditures - maintenance capex + change in net-working capital + acquisitions + net R&D.
• Invested capital is calculated as non-cash working capital + long-term assets + capitalized R&D.
• We capitalized R&D to be amortized over a period of 5 years.
• Maintenance capex calculated using the Greenwald method.

This gave us the following result:

16.98% x 110.47% = 18.75%

This is very close to Adobe's expected revenue growth for 2021 and would represent a slight beat on expectations. Given the quality of the company, we believe this is easily achievable. Nonetheless, whether we use Adobe's estimate for 2021 or our own, it does not make a material difference in the overall valuation.

Debt and Free Cash Flow Estimates

Adobe's margins and debt-to-EBITDA ratio have been fairly stable the last 5 years and have averaged the following:

• EBITDA margin: 34.5%
• Debt to EBITDA: 1.0x
• Free cash flow margin (adj. to remove stock-based compensation): 31.49%

Forecast

Source: Author

It's important to note that a DCF model is very sensitive to changes in the discount rate which is primarily impacted by the risk-free rate. Since it's always changing, we have calculated that Adobe is undervalued at $498 per share while the risk-free rate is below 1.4%. The lower the risk-free rate, the higher the valuation. For example, we estimate Adobe to be worth $566 per share if the risk-free rate drops to 1%.

Risks

Despite being an industry leader, Adobe faces stiff competition. As a result, the company has to continuously improve their technology in order to stay ahead of its rivals. Failing to do so could eventually lead to larger customers migrating away from its platform.

In addition, as Adobe continues to increase its prices it will also increase the number of customers it upsets. The internet is filled with comments of frustration aimed at the company. This has led hobbyists and small freelancers to explore different alternatives, many of which are free. If Adobe pushes the envelope too far and too quickly, it may risk having some of its larger customers beginning to look elsewhere.

An even worse scenario may be that the company will be met with government intervention. However, we believe that a situation like this is highly unlikely and not something to be worried about.

Final Thoughts

Despite its high price-to-sales multiple, the amount of free cash flow it is capable of generating actually puts the company in undervalued territory. A wide moat allows Adobe to continue raising prices because most view the cost of switching to be significantly higher. Furthermore, the number of serious alternatives are limited and users with advanced needs may not find all the features they require.

Adobe is without a doubt a fantastic company that has rewarded shareholders in the past and will likely continue to do so going forward.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ADBE over the next 72 hours. 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.