Investing in Adobe Inc. - Creative Cloud and the SaaS Revolution

Adobe - Not Just Photoshop Anymore

The world has officially changed. Back when corporate jobs first starting leveraging technology to increase productivity, they'd head down to Staples or Office Depot and spend a few hundred dollars on a CD-ROM that contained the entire Microsoft Office suite. One install and *boom* you're up and running. No more messing with updates or fees. Now, however, the life of office tools has shifted. Now you need accounts online, no more CD's and what is the "annual subscription" nonsense? Welcome to the world of Software as a Service that has taken the world by storm. One company that followed suit? Well that would be the company company that is the corner stone of every liberal arts education: Adobe. Today, I'm going to look at their business model, dive into their recent earnings report and figure out if this photo editing, sound recording, analytics suite of a company is a good buy with your hard-earned cash. Let's go!

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Top-Line Numbers

• 2020 Revenue: $12.87 billion (+15.19% YoY)

• 2020 Net Income: $5.26 billion (+78.24% YoY)

• Fiscal Q3 2021 Revenue: $3.94 billion (+22.02% YoY)

• Fiscal Q3 2021 Net Income: $$1.21 billion (+26.91% YoY)

How Was Adobe Founded?

As you can probably guess from the company being a software juggernaut, this company was founded out of a garage in Los Altos, California. I'm getting so sick of typing "founded in California" I'm going to start putting some kind of beat behind it. "Founded in California *bop* *bop* *bop* *bop*."

Anyway, the company was founded in California and named "Adobe" because that was the name of a small creek that ran behind founder John Warnock's house. Warnock also apparently liked the "creative nature" of adobe as a building material, which lent to the creative nature of the company, although that definitely sounds like something you say after the first billion hits the checking account and you start doing press tours. Fun side note: the logo was designed by in-house graphic designer Marva Warnock. She was in-house because she happened to be married to John Warnock, so that was a pretty easy RFP. I wonder if she used Illustrator...?

This company was destined for greatness from the start. Warnock and his business partner Charles Gescke rounded up some investors after leaving their jobs at Xerox in 1982 and set out to develop a digital creative technology company. And develop they did. In its first year, their PostScript technology caught the attention of a certain Steve Jobs of Apple, who attempted to buy the company for $5 million. The founders refused, but their investors urged them into some kind of deal, leading to Apple owning 19% of the company at a 5x multiple. They also struck a licensing deal for PostScript for the next five years, which made Adobe the first company "in the history of Silicon Valley" to turn a profit in its first year. From there, they were off.

What's Adobe's Business?

Their business is very straight forward, but also a little convoluted. At a high level, they develop software for creatives, whether that's video editing, sound editing, image editing, website editing, newspaper or magazine layout editing....OK they make editing software. And they are damn good at it.

They do, however, make much more complex products. They are also masters of the bolt-on acquisition, adding more and more vectors to their already impressive list of tools. After the acquisition of Macromedia in 2005, they added much more complex programs to their arsenal. For example, Flash is a multimedia production software that is essentially the backbone of HTML coding. Dreamweaver is their low-code website development tool also acquired in the Macromedia acquisition. In 2009, the company went in a radical new direction and acquired Omniture, allowing them to break into the marketing and data analytics space with their "Adobe Omniture" analytics product, a direct shot across the bow of Google. They doubled down on this space in 2018 with the acquisition of Marketo, a marketing automation software company, as well as in 2020 with the acquisition of workplace-marketing collaboration tool Workfront.

Will I Invest In Adobe?

As noted above, Adobe has now reached the size of a Silicon Valley company where they can expand into whatever region they want to and find success in it. Like Facebook expanding in virtual reality or Amazon expanding into cloud-data, Adobe expanding into marketing and data analytics was a move out of left-field that has actually been pretty successful. As a marketer in my 9-5 life, I have personally used Adobe's: Premier Pro, Audition, Omniture (now Adobe Analytics) and Workfront.

Full disclosure: I was also part of a test program for Adobe's social media marketing program back in 2018. That program was a rare miss for Adobe; an abject failure and caused the shuttering of the program based on my team's results.

The company itself is just an unstoppable force in its core competencies. Photoshop is essentially the only game in town when it comes to professional photo editing. Illustrator is right there with it, unless you use Apple's Lightroom. Like I mentioned earlier, Flash is the backbone of any HTML used in non-Apple products, and now they have products like Adobe Sign designed to take on DocuSign. So now that I've sufficiently drooled over their product suite, let's chat numbers.

Adobe's most recent earning's call on September 22 showed off record revenue numbers of $3.94 billion, which is 22% higher than this time last year. They also reported in strong EPS of $3.11, again up over 20% from this time last year. I mentioned their core competencies, and that gained again from last year over 20%. Their digital marketing and media business continues to see expansion to the tune of 23% and their document cloud business is growing rapidly at over 30% year-over-year. None of this includes future value of locked-in contracts, called "obligations," which is a further $12 billion in sales for the company. This helps to lower the key recurring revenue metric of "churn," which is the amount of customers that do not renew contracts with the company. Locking in longer-term contracts to sticky programs like what lies in the Adobe suite of tools has helped to reduce churn, and therefore sees an uptick in obligations.

Now, let's get to valuation. Valuation is always tricky because it's like statistics in baseball: you can pretty much find any number you want to back up any argument you have. I'm going to take a look at Adobe versus a couple of its digital SaaS peers. First up, price-to-earnings. Since Adobe crushed earnings this quarter, its PE ratio has effectively leveled out to about a 51. While that is high for a standard metric, it's pretty much the media for its competitor set. Looking at Atlassian at a 252 or Crowdstrike at a 563 is enough to make me start chewing baby Aspirin, let alone wanting to invest in those companies. Adobe's forward PE is at a 47, indicating good, steady growth, but nothing explosive. This is backed up by the analyst consensus on their 5-year EPS growth rate of ~46%. Slow and steady in an upward march. Again comparing this Atlassian at a 38%, and you're getting a better, more proven deal in Adobe for your cash. "But what about Crowdstrike?" I hear you croon from the back row like a drunk concert-goer asking for Free Bird. Well I can't actually find a 5-year EPS growth for them, so take that you new-age Gen-Z memelord.

They also saw it prudent to allocate some capital to share buy-backs, purchasing nearly 2 million of their own shares. Overall, the company crushed its earnings expectations. So why did shares immediately fall 4% on Wednesday?

Adobe's Business Risks

During their earnings call, both CEO Shantanu Narayen and CFO John Murphy alluded to the idea of "seasonality" in their products, indicating that the summer months are typically their weakest sales season. While that may be true, this inexplicably spooked some investors who decided not to dig into the numbers and ran for the hills, sparking a wide sell-off and dropping the stock 4% on earnings. Aside from that, you're not staring at too many business risks with this company unless there's some sort of nuclear winter that wipes out computers everywhere, but then we'd have bigger fish to fry.

The Bottom Line

Adobe is a monster, and one that I'm kicking myself for not having shares in. Their core component pieces are unrivaled, their expansion into digital marketing is going about as well as it can be and their shift into cloud-based subscription was seamless. I would like to see them use less of that cash on buy-backs and either make another bolt-on acquisition, or start to pay some sort of dividend to juice those shares. Other than that, I cannot have a more positive outlook on investing in Adobe if I tried.

Short-term: Long

Long-term: Long

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The following article is for entertainment purposes only. Please do not buy or sell a security based solely on what you read here. Please do your own research prior to trading.