Adobe: A large moat company with huge growth potential.
Opdateret: 11. mar.
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 more than 85 % gross profit margin and more than 30 % operating margin. Adobe has all the above and has been on my watch list for a long time. In this analysis I will investigate, if 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 shares in Adobe. If you would like to copy my portfolio or see the stock in my portfolio, you can read about how to do so here. Adobe has been on my watch list for years, but I have never pulled the trigger, maybe now is the time as Adobe is down more than 30 % this year. As always, I will keep this analysis unbiased.
Adobe was founded in 1982 and describes themselves 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 as it contributes with 73 % of the revenue. Digital Media is centered around Adobe Creative Cloud and Adobe Document Cloud and includes Creative Cloud Express, Photoshop, Illustrator, Lightroom, Premiere Pro and Acrobat. Digital Experience is the second largest segment and contributes with 24 % of the revenue. It an integrated platform and set of applications through Adobe Experience Cloud that enable businesses to create, manage, execute, measure, monetize, and optimize customer experiences that span from analytics to commerce. Publishing and Advertising is a small segment that contributes to 3 % of the revenue. It includes eLearning 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 indicate a strong brand moat. Besides that, it got listed as the 21st most valuable brand in the world by Interbrand. They have a switching moat because it is complicated for customers to switch to a competitor once they have learned to master photoshop.
Their CEO is Shantanu Narayan. He joined Adobe in 1998 as vice president and general manager of Adobe's engineering technology group. He became president and COO in 2005 before becoming 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 as Glassdoor's Top 100 CEOs list. According to comparably, he is listed in top 5 % of CEOs in similar sized companies with an employee rating at 93/100. He has been credited for being responsible for transforming Adobe into one of the world's most valuable and respected companies. I believe that based on his results, his vast experience, and great ratings, it is safe to say that Shantanu Narayan is a great CEO and the right person to grow Adobe moving forward.
I believe that Adobe has two moats, a brand moat, and a switching moat. Furthermore, I really like the management. Now let us 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 investment capital, also known as ROIC. Ideally, you would like to see a ROIC above 10 % in all years. In the earliest years in the latest 10 years, Adobe delivered an underwhelming ROIC. However, it certainly changed since 2016 where Adobe has delivered a great ROIC every year. I would like to see ROIC increase 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 increase ROIC again in 2022. All in all, I'm very impressed with the ROIC that Adobe has delivered since 2015.
The next numbers are the book value + dividend. In my old format this was known as the equity growth rate. It was the most important of the four growth rates I used to use in my analyses, which is why I will continue to use it moving forward. As you are used to see the numbers in percentage, I have decided to share both the 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 last year. However, it is still higher than two years prior, so I see no reason to be concerned. There are years that are better than others but as with the ROIC, we see the numbers increasing at a higher rate in the later years than the earliest years. I very encouraged by these numbers.
Finally, we investigate the free cash flow. In short, free cash flow is the cash a company generates after it has paid for operating expenses and capital expenditures. Levered free cash flow is the amount of money a company has left remaining after paying all of its financial obligations, I use the margin for it to make more sense. Free cash flow yield is the free cash flow per share a company is expected to earn against its market value per share. Once again Adobe delivers some great numbers. They have grown their free cash flow every year in the last 10 years. They deliver a very high leveraged free cash flow margin, which is very nice to see, and the high free cash flow yield suggests that the company isn't expensive. We 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 when investing in Adobe. One risk for most companies now, including Adobe, is macroeconomics. Adobe has a wide range of customers from large corporations, smaller businesses, and individuals. If we see economic slowdown, Adobe like other companies, could see a slowdown in the high growth that Adobe experienced over the last decade or so. Management feels rather confident that they will manage just fine during a possible economic slowdown due to the importance of their products, but I believe it could hurt Adobe's growth if we see an economic slowdown. Another is foreign currency fluctuations. The dollar has appreciated against other currencies lately due to the hikes in interest rates. As Adobe is a global business that generates approximately 43 % of their revenue from customers outside of the United States, it could hurt profits, as income from foreign sales will decrease in value on their balance sheets. In the first quarter earnings call in 2022, management mentioned several times how this has hurt the results of Adobe. Finally, in their annual report, Adobe mentioned security breaches as a risk related to the operation of their business. If there are security breaches in data centers that Adobe manages or third parties manage on their behalf, it could be subject to claims or other liabilities, regulatory investigations or fines. Even more important, it could damage their reputation and brand, which could weaken their strong brand moat.
There are 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 areas where 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 automating workflows, which should add value by enabling new levels of productivity for small businesses. Adobe believes that the total addressable market for Document Cloud is $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 so businesses can 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 should have a total addressable market of $205 billion by 2024, while Adobe's revenue in fiscal 2021 was $15,79 billion. Hence, there are 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 I use), Estimated future PE 30 (which the 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 by using the formula I described in "MY STRATEGY", we come up with the sticker price (some call it fair value or intrinsic value) of $303,00 and we want to have a margin of safety on 50 % , so we will divide it by 2 meaning that we want to buy Adobe at price of $151,50 (or lower obviously), 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 was 442. I tried to look through their annual report to see, how much of the capital expenditures were used on maintenance. I couldn't find it though, so as a rule of thumb, you expect 70 % of the capital expenditures to be used on maintenance, meaning 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 like this: (7.838 - 309,4 + 1.252) / 462 x 10 = $190,05 in TEN CAP price.
The last calculation is the PAYBACK TIME. I also described in "MY STRATEGY". With the Free Cash Flow Per Share at 15,96 and a growth rate of 15 %, if you want your purchase back in 8 years, the PAYBACK TIME price is $241,83.
I believe that Adobe is a great company with two large moats. I also feel very comfortable in the management due to the experience and results of the CEO. I see some short-term risks for Adobe due to macroeconomics and the strong U.S. dollar. However, these things are transitory and won't last forever. It is important to understand that the addressable market doesn't mean that it will all belong to Adobe, as they will not have a 100 % market share. I still feel like the addressable market seems 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 probably open a position in Adobe at $300.
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