Adobe: Reinvention At Its Finest
Summary
- Adobe is far and away the leader in providing software to creative professionals.
- Adobe's switch from large one-time purchases to a recurring subscription model significantly improved the company's resiliency.
- With a lack of large competitors and an incredibly strong balance sheet, Adobe is well positioned to continue its dominance.
Adobe (NASDAQ:ADBE) is the industry leader in offering software for the world's creative professionals. It has targeted and often exceeded large year-over-year growth estimates and continues to deliver the best user experience across its full suite of tools. As the growth and technology sector continues to fall out of favor, it is important not to abandon the sector but to hold the very best. With this in mind, Adobe should be the cornerstone of a portfolio for the foreseeable future. Its large moat, happy customer base, and sticky recurring revenue are incredible indicators of the company's staying power along with a management team that prides itself on constantly evolving and delivering the best possible product. This last fact is highlighted by Adobe's masterclass in corporate reinvention; its creation of the Creative Cloud.
The Creative Cloud
During the Great Recession, Adobe Inc. was in a state of crisis. Annual revenue had dropped 20% and recurring revenue stood at just 5% annually leaving little to no buffer to rely on. The stock price was falling rapidly; however, the company was the industry leader in offering software for creatives. How could this be happening? At the time, Adobe’s perpetual licensing model meant 3 million units were shipped a year. This number remained constant for quite some time and revenue growth was largely driven by increasing the per-unit sale price. The price of a product can only be pushed so high before consumers no longer feel the need to upgrade or, worse, they begin to look elsewhere. Adobe knew this and the drop in the company’s stock price showed that everyone else did too. Adobe had to innovate. The licensing model meant that the company was sending out product updates every 18 to 24 months, but with the speed of technology development elsewhere, this simply did not meet rapidly-changing consumer demands. What if there was a way to deliver quicker software updates and lock in recurring revenue? Other software companies had done it and fared much better during the recession.
It only takes a quick analysis of the psychology of consumption to see why. We, as consumers, follow interesting patterns in our spending habits. Large one-time purchases lead to a greater sunk cost effect. Initially, we feel the weight of the purchase and increase our usage. However, we often quickly forget the large amount we spent and usage tapers off. In this instance, we are much less likely to purchase or renew the product again. Monthly payments serve as a reminder of our “continual” sunk cost and thus lead to more usage of a product. More usage leads to a higher likelihood of renewal. Repeat this long enough and we will continue to renew our purchases over and over. Higher consumption leads to higher sales. It is easy to see why in the case of Adobe, even if the company was growing its customer base each year, large one-time purchases every 18 to 24 months almost certainly meant a tapering off in product usage, consequently leading to a lower likelihood of every customer purchasing the latest edition. Transitioning to a monthly subscription system would be a win-win not only for Adobe but also for the customer who would always receive the latest and greatest products. Enter the Creative Cloud.
Source: (Harvard Business Review)
In May 2012, the Creative Cloud was launched in tandem with the perpetual licensing model. The Creative Cloud offers a monthly subscription with access to Adobe’s full suite of tools and can be canceled at any point. With its launch, Adobe saw an instant increase in its user base as well as a change in the preferences of its existing users who otherwise would not have upgraded under the licensing model. After a year, Adobe pivoted to only offering new releases of its Creative Suite online. Today, updates to the product happen much quicker than the 18 to 24 months previously needed and Adobe can use much smaller teams of engineers to effectively design, test, and implement these updates. Adobe also did not just take its existing Creative Suite and make it available online for a monthly subscription. While this most likely would have worked in the short term, Adobe would not have developed into the industry-leading software provider it is today. The company looked to extend its product in new ways through multiple acquisitions and the development of in-house products. As Dan Cohen, the former Vice President of Strategy, puts it, “Our website is no longer just the place where you get product and company information. It is the product. It is the start of a dynamic customer experience.”
Fast forward to today and Adobe Creative Cloud apps have been downloaded over 449 million times and the company’s social network for creatives, Behance, boasts 25 million active users. Over 90% of the world’s creative professionals use Photoshop. Key to Adobe’s continuous evolution is Adobe Sensei, which uses a proprietary framework along with intelligent services to analyze and improve the user experience. The company is constantly innovating and implementing the latest technology, often at the request of its community. An example of this is the use of machine learning and AI to enhance images within seconds in Photoshop. Adobe implements a mix of free and paid subscription tiers to bring new users in and familiarize them with the Adobe ecosystem. Users can either subscribe to one app, bundle their own combination, or receive the full suite of tools. The company also offers various price points for businesses, students, teachers, and universities. Recurring subscription revenue continues to grow year-over-year and now comprises 90% of total revenue. Adobe is an incredible example of the power of reinvention and is now a model to all software companies.
Financials and Valuation
Adobe simply is a cash cow with sticky recurring revenue and a happy customer base. The company has added to its cloud offerings with the Document Cloud and the Experience Cloud. The company continues to grow the top line with $3.91 billion in revenue in Q1 2021, a 26% increase year-over-year. Gross profit margins stand at 87% (really any metric used to evaluate the company is incredible), and as such, Adobe has earned a healthy valuation to say the least. Adobe is not cheap by any metric and does not pay a dividend. But what it does offer is something few other companies do, cloud margins and growth with actual profit. Is paying 45x sales for a company expensive? Possibly. A mature industry leader targeting 20% growth each year and delivering on it? Maybe not. And I would argue looking at comparable companies, Adobe’s profitability means that it should have greater resiliency as the 10 year moves up and forces multiple compressions among high-growth companies.
Source: (Adobe)
Adobe has long-term debt commitments of $4.1 billion but keeps more than enough cash on hand to service any short-term requirements. The growth at Adobe is very real and it continues to dominate the market. One area to watch is sales and marketing expense as a percentage of revenue relative to year-over-year growth. While not perfect, this can be a good proxy for determining customer acquisition cost. Currently, Adobe spends 28% of revenue on sales and marketing to grow around 20% a year. For reference, Salesforce (CRM) spent 46% of revenue in 2020 to grow 29% and Microsoft (MSFT) spent 14% on sales and marketing to grow 14%. As long as revenue continues to grow in line with sales and marketing expense, then the growth is sustainable. However, if it does not, then there is a deeper customer acquisition problem at hand.
Source: (Adobe)
Competitors and Risks
Adobe products are the gold standard across many industries. Whether it’s using Photoshop and InDesign for graphic design, Premiere Pro and After Effects for video editing, or even Acrobat for something as simple as reading and editing a PDF (yeah, Adobe created those too). Adobe controls the creative software industry and no company comes close to competing at scale. Sure, someone may download a free mobile app to touch up their Instagram post or Canva to make a quick logo, but for anything done professionally, look no further than Adobe. The company continues to redefine the creative process with Creative Cloud.
However, this does not mean that there are no areas in which Adobe can improve. Adobe Animate, while a great tool, is not the standard for animation. Likewise, Sketch is the standard for UI/UX design over Adobe XD. The biggest risk Adobe faces is complacency. While one company alone does not come close to offering the same suite of products, Adobe faces an onslaught of smaller competitors each targeting a very specific tool. Canva, Sketch, Figma, InVision, the list goes on of companies trying to take a piece of Adobe’s market share. While not likely that a single competitor will deliver the killer blow, there is the possibility of Adobe losing small amounts of market share spread across its vast array of products.
Despite these possible risks, with every challenge comes opportunity. Adobe will not sit idly as competitors grow and, if history serves as a guide, the industry leader will not shy away from reinvention. As these competitors continue to develop, it is important to keep in mind that Adobe is known for acquisitions (often completing one or two within a year) and currently sits on a large $4.96 billion mountain of cash. Creative Cloud users may soon be adding any number of these products to their monthly subscriptions.
Source: (Adobe)
Conclusion
In summary, Adobe is not cheap. It is not a diamond in the rough waiting to be discovered and polished. It is the finished article. The company has executed at the highest possible level for years. Its pivot to a cloud-based product offering was a masterclass and serves as an example for corporate reinvention. With an end to the pandemic seemingly near, there is reason to believe that the 10 year should return to and possibly exceed January 2020 levels as reopening becomes more widespread. With this comes uncertainty around growth stocks and will most likely lead to multiple compressions. During this time, it is crucial to hold the very best. Adobe is far and away the industry leader and with that comes a premium. In this case, the premium is worth it.
This article was written by
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.