Adobe Should Be On Every Investor's Watch List

The creative space has never been more vibrant than it is today.

It once required thousands of dollars of equipment and years of photography experience and training to produce portrait quality photos. Now you can do it with a smartphone and an app, sharing it to the world through Instagram.

Producing videos or even audio shows (now "podcasts") used to require painstaking manual labor to cut together clips, add transitions, overlay sound, etc. Now literally anyone can do it in minutes. YouTube and TikTok are proof of this!

But all this content has laid bare a simple truth.

In this sea of content, the truly great work stands out even more.

All of those low budget YouTube videos can never compete with a professionally shot, professionally edited TV show or movie. And no matter how good a phone photographer you think you may be, a professional photographer will put it to shame when you need a print at 11x17.

When the pros need to produce and edit photos, videos, digital artwork, marketing campaigns, documents, or graphic page designs, there is only one company they turn to for their tools.

That company is Adobe (ADBE). Let's dig into it.

The Toolbox for Digital Creators

The subtitle here sums up Adobe's sprawling business - they create tools for serious digital creators.

Adobe consists of 3 business units.

The Creative Cloud unit is its bedrock offering, delivering over 59% of total revenue. Creative Cloud has a number of different apps, but some of the highlights include:

The second unit is Document Cloud (13% of sales). It consists of one very important product: Acrobat. Acrobat is used to create and edit PDF files - easily the most used format for documents worldwide. This also includes Acrobat Sign, the company's e-signature solution for legal docs such as home sales contracts, employment agreements, business documents, and much more.

Adobe has made several acquisitions over the past decade or so to built out its third and final segment, Experience Cloud. Experience Cloud is just over 25% of sales and consists of a number of offerings. A few of the more important ones:

There is more coming, too. Just a few months ago, Adobe entered an agreement to buy popular user interface design tool Figma for $20 billion. Figma should fit nicely into the Creative Cloud collection as the company's solution for website and application UI designers.

So, as you can see, Adobe offers a lot of solutions for a wide array of digital creatives!

The Revenue Model

About 10 years ago, Adobe embarked on a journey to migrate its entire user base from a legacy license model to a cloud-delivered model. That transition is now complete.

We are left with a highly attractive, fully recurring, subscription-based sales model. Adobe has a lot of subscription plans. Customers can subscribe for just one tool, or by medium (e.g. all photo tools), or just subscribe to everything! Sales are on a per month/per user basis and continue until canceled. Close to 95% of the company's revenue is cloud based.

That's fantastic!

With that settled, let's take a look at growth potential. Adobe is a big company, but it is still growing nicely. 3 year average compound revenue growth is excellent at 21%. It has slowed some in 2022 due to recessionary fears, but should still exceed 12%.

Over the medium to long-term, there are plenty of avenues to maintain +10% growth rates. Management has talked about a $200 billion dollar addressable market - $63B in Creative Cloud, $32B in Document Cloud, and $110B in Experience Cloud. If accurate (take that with a salt shaker), it represents more than 10 times current revenue. With the company openly talking about reaching $30 billion in sales, it's clear that revenue growth is a major priority. That's what I like to see.

Network Effects and Switching Costs For Days

For Creative and Document Cloud, there are two moat factors at play: NETWORK EFFECTS and SWITCHING COSTS.

These two go hand in hand. Adobe has built up a network of creative professionals and companies that rely on its tools to do their jobs. Companies standardize their creative efforts on Adobe because that is what designers know. Universities and trade school programs teach using Adobe tools because that is what is used by the companies hiring them! Now you have a self-reinforcing loop creating a nearly unbreakable industry standard.

For the same reasons, any agency that wanted to consider switching would be faced with some serious difficulties finding talent experienced with competing solutions.

Switching costs are also relevant on the Experience Cloud side. These tools integrate deeply into the core of customer experiences, and are timely and costly to switch away from. A firm that has spent the time and effort to integrate Adobe's analytics platform isn't going to be able to change it tomorrow. And a customer tracking thousands of clients within Adobe's marketing campaign tools won't be able to migrate quickly.

I think this company has some really compelling competitive advantages. It is a wide moat firm, without question.

Management and Financial Strength

Shantanu Narayen is CEO and Chairman. He has been with Adobe since 1998 and CEO since 2007. In his 15 years at the top, Adobe has grown revenue at a 12.5% compound annual rate, net income at 12.1%, and cash flow at 12.2%, all respectable figures. He also owns a sizable $135 million worth of company shares.

Narayen's tenure has mostly been one of success. He steered the company through a very tricky and risky - but highly lucrative - cloud transition, almost seamlessly. He made several acquisitions to build out the Experience Cloud segment that now represents Adobe's biggest growth opportunity going forward.

While I'm not generally a fan of growth-by-acquisition, Adobe has done it effectively, so far. The firm is still generating outstanding free cash returns on invested capital of over 35%, confirming they have not massively overpaid for those acquired firms.

The rest of the financial picture is equally rosy. Free cash flow margin sits at 40%, one of the best figures you will ever see, anywhere. This firm gushes cash. The balance sheet is strong too, with over $2 billion in net cash. Financially, I see no concerns whatsoever.

Risks

I consider Adobe a relatively low-risk investment if bought at an attractive stock price.

The one concern I have is the penchant for acquisition. As mentioned, so far, Adobe has been successful in integrating small-to-medium size acquisitions. Their largest to date was Marketo at $4.75 billion. Figma is another level. The $20 billion acquisition price represents its largest acquisition by 4 times over. Word is that Figma's revenues for 2022 were about $400 million, making that price a 50 times multiple on sales. That's rich!

Even if Figma fails entirely, it won't bring the company down, but will still put a big dent in capital efficiency metrics. It could look a lot better if Figma can continue to grow revenue at 100% year-over-year as it did in 2022. We will see.

What we DON'T want to see is the start of a purchasing spree. If Adobe starts making larger acquisitions left and right, it might be time to reconsider the investment.

Conclusion

Clearly, I'm a fan of the company. It meets all my criteria to make the cut as a "green dot" stock! Adobe will be added to the Watch List immediately and we will look for a good price to buy. Check out the ADBE stock page for our thoughts on valuation and a good buy-in price (members).