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  • Glenn

Adobe: A company with a significant competitive advantage and substantial growth potential.

Opdateret: 12. dec. 2023

It is no secret that I like companies with a large moat. I also like companies with huge growth potential. I like companies with a gross profit margin of more than 85% and an operating margin of more than 30%. Adobe has all the above and has beenon my watch list for a long time. In this analysis, I will investigate whether now is the time to buy Adobe.

This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.

Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and briefly go through why the company has meaning to me. I have changed the format of the analysis a bit to try to make it shorter and with less numbers. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.

For full disclosure, I should mention that at the time of writing this analysis, I do not own any shares in Adobe. If you would like to copy my portfolio or view the stocks in my portfolio, you can find instructions on how to do so here. Adobe has been on my watch list for years, but I have never pulled the trigger. If you want to purchase share or fractional shares in Adobe, you can do so through eToro. eToro is a highly user-friendly platform that allows you to start your investment journey with as little as $50.

Adobe was founded in 1982 and describes itself as one of the largest and most diversified software companies in the world. Adobe has divided their business into three different segments: Digital Media, Digital Experience and Publishing and Advertising. Digital media is their largest segment, contributing 73% of the revenue. Digital Media revolves around Adobe Creative Cloud and Adobe Document Cloud, which encompass Creative Cloud Express, Photoshop, Illustrator, Lightroom, Premiere Pro, and Acrobat. Digital Experience is the second largest segment and contributes 24% of the revenue. It is an integrated platform and set of applications within the Adobe Experience Cloud that enable businesses to create, manage, execute, measure, monetize, and optimize customer experiences across various domains, includinganalytics and commerce. Publishing and advertising is a small segment that contributes 3% of the revenue. It includes e-learning solutions, technical document publishing, and web conferencing. Adobe generates 92 % of their revenue from subscriptions, which is something I like as it is recurring revenue. I believe that Adobe has both a brand moat and a switching moat. To Photoshop is now a verb, which indicates a strong brand moat. Besides that, Adobe is listed as the 21st most valuable brand in the world by Interbrand. They have a switching moat because it is difficult for customers to switch to a competitor once they have learned to master Photoshop.

Their CEO is Shantanu Narayen. He joined Adobe in 1998 as the Vice President and General Manager of Adobe's Engineering Technology Group. He became President and COO in 2005 before assuming the role of CEO in 2007. He became chairman of the board in 2017. He has a bachelor's degree in engineering from Osmania University in India, a master's degree in computer science from Bowling Green State University in Ohio, and an MBA from the University of California at Berkeley. He has been named to Barron's list of The World's Best CEOs several times and has also been ranked fifth on Glassdoor's Top 100 CEOs list. According to Comparably, he is listed in the top 5% of CEOs in similarlysized companies, with an employee rating of 93/100. He has been credited with transforming Adobe into one of the world's most valuable and respected companies. I believe that based on his results, extensive experience, and excellentratings, it is safe to say that Shantanu Narayan is a great CEO and the ideal person to lead Adobe's growth in the future.

I believe that Adobe has two moats that protect its market position: a strong brand moat, and a high switching moat.Furthermore, I really like the management. Now let's investigate the numbers to see if Adobe lives up to our requirements for a strong moat. In case you want an explanation about what the numbers are, you can have a look at "MY STRATEGY" on the website.

The first number I will investigate is the return on invested capital, also known as ROIC. Ideally, you would like to see a ROIC above 10% in all years. In the past decade, Adobe delivered an underwhelming ROIC in its early years. However, there has been a significant change since 2016, with Adobe consistently delivering a great ROIC every year. I would like to see an increase in ROIC year over year, but it doesn't concern me that ROIC decreased slightly from 2020 to 2021, as they still managed to deliver a high ROIC of 24,8%, and increased ROIC again in 2022. All in all, I'm very impressed with the return on invested capital (ROIC) that Adobe has delivered since 2015.

The following numbers represent the sum of the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the percentage growth year over year. I believe that the numbers are very encouraging, as Adobe has managed to grow their equity every year in the last 10 years, except for the most recent year. However, it is still higher than it was two years ago, so I see no reason to be concerned. There are years that are better than others, but as with the ROIC, we observe a higher rate of increase in the numbers in the later years compared to the earlier years. I am very encouraged by these numbers.

Finally, we will investigate the free cash flow. In short, free cash flow refers to the cash that a company generates after covering its operating expenses and capital expenditures. Levered free cash flow is the amount of money a company has remaining after paying all of its financial obligations. I use the margin to provide a clearer understanding. Free cash flow yield refers to the amount of free cash flow per share that a company is projected to generate in relation to its market value per share. Once again, Adobe delivers some great numbers. They have increased their free cash flow every year forthe past 10 years. They deliver a very high leveraged free cash flow margin, which is impressive to see. Additionally, the high free cash flow yield suggests that the company is not overpriced. We will get back to that later though.

Another important thing to investigate is debt, and we want to see if a business has a reasonable debt that can be paid off within 3 years by calculation long-term debt to earnings. Doing the calculation on Adobe, I can see that Adobe has 0,76 years earnings in debt, which is great. Hence, debt is certainly not a concern for Adobe.

Like every other investment, there are risks associated with investing in Adobe. One risk for most companies now, including Adobe, is macroeconomics. Adobe has a wide range of customers, including large corporations, smaller businesses, and individuals. If there is an economic slowdown, Adobe, like other companies, could experience a decreasein the high growth it has enjoyed over the past decade or so. Management feels confident that they will handle a possible economic slowdown well, thanks to the importance of their products. However, I believe an economic slowdown could negatively impact Adobe's growth. Another issue is foreign currency fluctuations. The dollar has appreciated against other currencies recently due to the increase in interest rates. As Adobe is a global business that generates approximately 43% of its revenue from customers outside of the United States, it could hurt profits. This is because income from foreign sales will decrease in value on their balance sheets. In a previous earnings call, management mentioned several times how this has negatively impacted Adobe's results. Finally, in their annual report, Adobe mentioned security breaches as a risk associated with the operation of their business.If there are security breaches in data centers that Adobe manages or that are managed by third parties on their behalf, Adobe could be subject to claims, liabilities, regulatory investigations, or fines. Even more importantly, it could damage their reputation and brand, which could weaken their strong brand moat.

There is also a lot of potential for Adobe moving forward. In the latest letter to shareholders, CEO Shantanu Narayan mentioned what would drive the next decade of growth. Adobe Creative Cloud. Adobe wants to empower more people than ever with the tools to create, communicate, distribute, monetize their content, and actively participate in the Creator Economy. Adobe mentioned that for creative businesses to succeed, they will need to be filled with rich, interactive.creative content, truly ownable digital assets and deliver uniquely engaging events and experiences, which are all areaswhere Adobe plays a pivotal role. Adobe believes that the total addressable market for Creative Cloud will be approximately $63 billion in 2024. Adobe Document Cloud. The paper-to-digital revolution will grow at a fast pace as remote and hybrid work gets ingrained in workplaces all over the world. Adobe benefits from this by innovating their PDF format to enable frictionless document actions across web, desktop and mobile. Adobe would like to deepen the integration between Adobe Acrobat and Adobe Sign to extent the value of Acrobat in eSignature workflows. They want to use AI to automate workflows, which should add value by enabling new levels of productivity for small businesses. Adobe believes that the total addressable market for Document Cloud will reach $32 billion by 2024. Adobe Experience Cloud. Adobe believes that businesses will need to address consumer expectations of personalized content to their interests, needs and preferences, while protecting privacy and security of their data. Adobe Experience Cloud offers a solution that enables businesses to deliver personalized experiences to millions of people in milliseconds.Adobe believes that that the total addressable market for Experience Cloud is $110 billion in 2024. It means that Creative Cloud, Document Cloud, and Experience Cloud are expected to have a combined addressable market of $205 billion by 2024, whereas Adobe's revenue in fiscal 2022 was $17,61 billion. Hence, there is plenty of room to grow for Adobe.

All right, we have gone through the numbers, potential and risk regarding Adobe, and now it is time for us to calculate a price for Adobe. To calculate price, we will need numbers that I have explained in the "MY STRATEGY" section of the website. I do not want to go through the whole calculation here. I chose to use an EPS at 10,10, which is the one from fiscal 2022 I chose an Estimated future EPS growth rate of 15 % (Adobe has grown by 16% a year since 2005 but 15% is the highest growth rate I use), Estimated future PE 30 (which the is double of the growth rate, as the historically PE for Adobe has been higher) and we already have the minimum acceptable return rate on 15%. Doing the calculations, we come up with the sticker price (some call it fair value or intrinsic value) of $303,00. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Adobe at a price of $151,50 (or lower, of course) if we use the margin of safety price.

Our second way to calculate a buy price is the Ten Cap price, which is also explained at "MY STRATEGY". To do so, we need some numbers from their financial statements, keep in mind that all numbers are in millions. The operating cash flow last year was 7.838. The capital expenditures were 442. I tried to look through their annual reportto see how much of the capital expenditures were used on maintenance. I couldn't find it, though. As a rule of thumb, you can expect 70% of the capital expenditures to be used for maintenance. This means that we will use 309,4 in our further calculations. The tax provision was 1.252. We have 462 outstanding shares. Hence, the calculation will be as follows:(7.838 - 309,4 + 1.252) / 462 x 10 = $190,05 in Ten Cap price.

The last calculation is the Payback Time price I also described in "MY STRATEGY". With Adobe's Free Cash Flow Per Share at 15,96 and a growth rate of 15%, if you want to recoup your investment in 8 years, the Payback Time price is $241,83.

I believe that Adobe is a great company with two significant competitive advantages. I also feel very comfortable with the management team because of the CEO's experience and track record. I see some short-term risks for Adobe due to macroeconomic factors and the strength of the U.S. dollar. However, these things are transient and will not last forever. It is important to understand that the addressable market does not guarantee that Adobe will reach that level, as they won't have a 100% market share. I still feel like the addressable market appears to be very high compared to current revenue though. Nonetheless, it shows that management believes that there are plenty of room to grow for Adobe moving forward. I don't expect to be able to buy Adobe at a 50 % discount to intrinsic value at any point but as Warren Buffett once said, "it is better to buy a wonderful company at a fair price than a fair company at a wonderful price." I would still need to get it below the intrinsic value on all my calculations though. Hence, I will open a position in Adobe at $300.

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