After Adobe's (NASDAQ:ADBE) overall bullish earnings received a negative market reception, it finally lit up on my watch list. The consistent growth and handsome capital return to shareholders really brightens my day, and so it's hard not to put it on record and place Adobe on the bull side of my ideas. But beyond the growth, the fantastic margins, and the well-executed capital return program, I'm also thinking about how I first discovered Adobe back in 2007. Now, after nearly 15 years since my initial research, it's time I get bullish on Adobe once more.
It Was High School And The Good Times Rolled
A senior in high school taking AP Calculus; classmates eager to learn and compete for who was the best.
It was the best of times in the early 2000s, and as I was reaching the pinnacle of my secondary education, my AP teacher asked my slightly impressive-sized top-level math class if we wanted to compete in something called Moody's Mega Math Challenge.
"Moody's? Who's Moody?"
Ah, we were so young...
The topic is what grabbed me; there was no doubt I was competing. That year, 2007, the challenge was to write a paper allocating $30,000 to a portfolio using only the 18 stocks listed in the challenge and defend and justify our reasoning for picking them and their allocations (the rules of the problem to solve is three-quarters down in the link). In addition, we had to use specific valuation metrics and justify why we relied on some over others. The time horizon was one year.
I remember getting to work with a handful of teammates from that AP Calc class, and there on the list was Adobe. We each researched a stock and came together to allocate and submit a final paper. I took Adobe and ran with it. It was $38.66 a share back on March 2, 2007. And while we didn't place in the competition, we all experienced a crash course in stock and stock market analysis.
For me, that was more fuel for my investing soul already filled with desire from my earlier teen years.
And, for the record, Adobe closed at $32.86 one year later. But who was I to know the market crash of 2008 was just around the corner when we sat in my high school library banging out a $30,000 portfolio? Many of the stocks on the list mirrored the ADBE chart below as the market began getting shaky into the October crash of 2008. For example, Microsoft (MSFT), which was on the list, lost half its value in the October crash; Adobe very similar.
(Chart is from March 2, 2007, to April 1, 2008)
Almost 15 Years Later
Now, I'm going to cast off the bad luck here because you could have thrown a dart at a list of stocks in 2007, and the stock it landed on would have likely been down by a hefty amount by the end of 2008. Being down only 15% was pretty close to a win in my book as tech took a January dive that year, so don't think my being bullish today is a contrarian indicator (at least not, yet - give the article a chance).
At any rate, 15 years later, the stock is up nearly 1,400%. That far exceeds the returns for the S&P 500 (SP500) and the Nasdaq (COMP.IND).
So it begs the question, why be bullish here again after such a ridiculous return?
After keeping my figurative (and literal) peripheral vision on Adobe over the last year, it was the outsized negative reaction to the recent well-rounded earnings - now about 10% - which forced my complete focus.
Until then, I hadn't recently dug deep into the company and its financials, but when I did I was thoroughly impressed - it was a far different Adobe than the one I met in 2007.
Now, the recent earnings report does have its own things to glean, but because of the consistency of the financials in no small part due to the massive subscription business, this quarter is just another piece of the puzzle. Therefore, I'm taking a holistic view of the business and using the recent report as another data point of recent business performance.
I have my thesis broken down into three parts:
- Major subscription business
- World-class margins
- Shareholder friendly management
Cash...Er...Subscription Is King
The pièce de résistance of any software company in the 2020s is getting the business to a subscription-based model and making it the primary driver of growth and earnings. One of the reasons Adobe stuck out to me as a senior in high school was the familiarity I had with its software. I used it quite extensively in my hobbies (graphic and web design - I wanted to be a webmaster back then). However, because the product was cost-prohibitive, I would use a student license through my school. But that high cost and class-leading software led me to be bullish on the market Adobe served.
Today, though, the cost is not prohibitive for basically anyone who has a use for its software like Photoshop, InDesign, or Premiere. And that's because the subscription-based model breaks down the ownership costs through monthly or yearly payments, making it much easier to finance its use for the end-user. As a result, some users may wind up paying more than the outright cost of a perpetual legacy license over the years; some may never spend more than $20 to get their use out of it.
The beauty is the company breaks down the walls of expensive ownership and expands the use-cases it serves, like individuals with hobbies, by way of the subscription model. But it also allows businesses to manage their costs over time rather than entirely upfront. All the while, Adobe has a predictable revenue stream each month. It's a win-win for everyone.
Over the last two years, annual recurring revenue (ARR) for its Digital Media business (its largest) has grown from $8.4B to an expected $12.22B in FQ4 '21. The growth has been relatively consistent over these two years, topping out at 23% growth year-over-year in FQ4 '19 to an expected 20% growth in the upcoming quarter. The line showing year-over-year growth in the chart below seems rather steep, but when you see it's over a 3% area, you realize it's remained pretty consistent over the two-year period.
(Source: Chart mine, revenue from Adobe Earnings Releases And Transcripts)
But that's only one of the three subscription segments of the company. Creative ARR grew to $9.87 billion in the recent quarter, while Document Cloud ARR grew to $1.79 billion.
But the amount of recurring revenue is only as good as how much it contributes to overall revenue each quarter. If ARR is a small percentage, it means a vast majority of sales are susceptible to being lost each quarter. The company must push harder for non-recurring revenue (wins are contingent on each quarter's closing of deals or perpetual license purchases). But this isn't the case as nearly all of its revenue is subscription-based, meaning there's a considerable consistency and predictability factor involved in the company's business.
(Source: Chart mine, data from Adobe Earnings Releases)
At times, forex and acquisitions don't allow for one-to-one comparisons, which adds some noise to the subscription business's contributions to overall revenue. That being said, Adobe is one of the best in terms of having nearly all subscription revenue. In the last two years, it was as low at 90% of sales and, just as recently as the just reported quarter, as high as 93% of sales. This is monumental as this didn't start at 90% but had to be transitioned over many, many quarters to achieve this. Adobe was once a big-ticket software company whose products cost hundreds, if not thousands, of dollars in one purchase. But that would be the end of the sale until the next version came out, which usually had some kind of discounted upgrade cycle.
So not only does Adobe have great and consistent growth in its subscription business it also makes up over 90% of its revenue each quarter consistently. These two metrics are solid reasons to see Adobe as not just a growth machine but also a cash cow. I've always said uncertainty is one of the market's biggest fears. So when you have consistent and reliable revenue, it means the market has a small uncertainty factor built-in, rewarding a company's stock much more than it would otherwise.
Margins As High As Its Subscription Business
I didn't think I would be impressed by two things with Adobe, but when I opened up the margins panel during my research and shared with my subscribers what I found, I was hit with another wave of impressiveness. Of course, I already had high expectations going into this area of the company considering subscription revenue is generally high margin to begin with, but what I found was beyond anything I have come across in the industry.
Starting with gross margins, it's almost as if the company has no overhead to run its subscription business. On the subscription side alone, gross margins were 90.5% in the most recent quarter. Two quarters ago it was as much as 91%. The company apparently likes things on an A- or higher grade level - and I would have happily accepted that in my AP Calc class if Adobe was grading me.
And things don't taper off much when we look at overall gross margins.
Company-wide gross margins were just 237 basis points lower than the subscription business in the recent quarter. In other words, other areas of the company are not a drag on the subscription business. This is a good start, but how does this compare against peers and other software companies?
It turns out, Adobe is above any beyond any of its peers. The above chart is what it looks like to be a leader in your industry and a leader in technology broadly. Operating margins are similar and are beat only by Facebook (FB) and Microsoft.
I was curious how Adobe had such strong gross margins but placed third in the operating margin category. Looking at where expenses go for the latest quarter, it made more sense for Adobe's type of business.
| Company / % of Rev | R&D | Sales and Marketing | General and Administrative |
| Adobe | 16.5% | 27.1% | 9.3% |
| 21.0% | 11.2% | 6.7% | |
| Microsoft | 12.3% | 12.7% | 3.3% |
Adobe spends quite a bit on sales and marketing. This makes sense as the company is still growing the subscription business - not through conversion, although there is some - but through new business. But the trend is in the right direction as the operating margin chart shows a slow but steady increase in margins. The below table represents this finding but from a different view.
| % Growth Y/Y | Q3 '21 | Q2 '21 | Q1 '21 |
| R&D | 15.0% | 15.0% | 16.5% |
| Sales and Marketing | 19.7% | 19.1% | 22.4% |
| General and Administrative | 15.2% | 14.3% | 7.0% |
| Revenue | 22.0% | 22.6% | 26.33% |
It's clear the company is keeping costs in check by not growing them more than overall revenue but still pursuing consistent revenue growth through the needed investments in sales and marketing. This is the mark of good management and sound capital allocation. And good management is the second of my three investing pillars, after good fundamentals. It's clear the subscription business and the high margins with room to see further operational leverage gives way to good fundamentals and good management.
Shareholder Friendly, Too
Speaking of good management, the next level down in analyzing good management is how well they steward capital returns to shareholders. At this point, Adobe is not surprising on this level. The company doesn't have a dividend, which doesn't deter me, but it does have a well-executed share buyback.
The company is repurchasing and seeing a decrease in outstanding shares. That naturally means there is less stock-based compensation than repurchases. The company repurchased $1B in shares during the quarter, reducing the count by 1.7M shares.
These aren't huge moves in the outstanding shares over the years, but they are going in the right direction. The company has a lot more firepower left in its arsenal and continues to deploy it strategically.
We repurchased approximately 1.7 million shares in the quarter at a cost of $1 billion. We currently have $14.1 billion remaining of our $15 billion authority granted in December 2020...
- John Murphy, CFO, Q3 '21 Earnings Call
Again, a little comparison is all you need sometimes. Adobe has been executing better than the peers I mentioned earlier.
Of course, the questions of share buybacks are generally followed by valuation.
"Is management buying overvalued shares?"
Adobe's "High" Valuation
To this point, I've considered Adobe on a standalone basis first and then on a peer-to-peer basis. For valuation analysis, it's easier to start comparing peers and work backward to individual company valuation.
Most take a quick look at Adobe's valuation and balk at the double-digit price-to-sales ratio or relatively high P/E. But for where we are in the market and how well Adobe performs, a comparison between peers puts the company at a relatively fair value.
The company falls in the middle of the road on a forward price-to-sales basis compared to the same peers used for margin analysis. While 15 is high on a standalone basis, Adobe isn't running too hot for the current tech environment. I'm not alarmed by this, not as much as I would be about Atlassian (TEAM), for example.
On a forward P/E basis, Adobe appears even further undervalued relative to peers, coming in the bottom only behind Facebook and Microsoft, very similar to the operating margin comparison.
Given the very consistent revenue growth and predictable sales for the foreseeable future, having a slightly elevated yet still subdued valuation compared to peers continues to make me interested in Adobe.
Moving to its historical valuation, the company is seeing a pullback in its multiple. I would agree with someone skeptical of Adobe's valuation compared to its historical self, but the premise I began the article with holds: the recent downturn has livened up the bullish thesis. A quick look at a F.A.S.T. Graph will tell you it believes fair value is around $523 for FY21.
(Source: FAST Graphs)
But if we look a year ahead to see where the market is going and not where it has been, F.A.S.T. Graphs sees a fair valuation at almost exactly $600. This doesn't account for any future earnings beats, raises in guidance, or consensus estimates moving up over the course of the fiscal year. Splitting the difference in the near-term and long-term shows us ADBE is fairly valued around $561. That's only a 3% downside from Friday's close. If one wanted to be sure they are waiting for the best value, the downside to $523 would have you waiting for a 9.5% drop.
The question is, does it get there?
Adobe Is Attractive Here
I already told my subscribers to be working on a position here and any downside from here is icing on the cake. I'm willing to dollar cost average in at current levels and add if the multiples continue to contract. The consistent 20%-range growth in revenue, the extremely high margins, and the shareholder-friendly management executing phenomenally place the fundamental downside at limited levels. The market may swing Adobe further down from here, but it only increases the upside later when sentiment in the market shifts again.
It's good to be back analyzing Adobe, this time with an audience bigger than seven judges.
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