Stop thinking of Adobe as a $600 stock
Adobe Inc. (NASDAQ: ADBE) has been an outstanding achievement over the past decade. As such, its share price reflected not only management’s strong business model and vision for the future, but also a decade-long monetary experience that brought strong duration stocks at unsustainable levels.
This has created a pegging bias for many investors, who are now seeing their beloved names trading at significantly lower levels and thinking the price they are paying is somehow a bargain.
While that may be the case for some names, I believe Adobe is one of them, for reasons I’ll outline below.
What a difference six months makes
About six months ago, I warned that Adobe’s stock price would face outdated returns, even as the company continues to perform well.
At the time, the sentiment around Adobe was still close to ecstasy and it was indeed difficult to envision a negative scenario for the share price going forward.
Fast forward just six months, however, and the stock price is now down more than 30% at a time when the market has only fallen just under 8% and other names in the industry have consistently outperformed Adobe.
Of course, by far the biggest driver of these abysmal returns was the Federal Reserve’s policy shift, which disproportionately punished high growth and momentum stocks.
Although for some investors this change in policy may seem like a fluke, caused by recent geopolitical events or the current recession, the reality is that this change was obvious. In November of last year, I spent a lot of time talking about these risks:
What we notice is that INTU, CRM, ADBE and WDAY are at greater risk of reversal in trading momentum. The big players in the ecosystem – AMZN, MSFT and GOOG are much less exposed due to their larger size and more diversified operations, however, as I noted earlier, the political risk here is much higher .
Source: Alpha Research
Going forward, we should recognize these risks and break away from the peg of exceptionally high valuations during the peak of excess liquidity in recent years. In other words, just because many companies are now trading at significantly lower levels doesn’t necessarily mean they’re good business opportunities.
Trading close to fair value
If we compare gross margins to multiple forward prices/sales within large cap cloud and software as a service players, we see that there is now a relatively strong relationship (see chart below).
In this regard, Adobe is right on the above trend line with its gross profitability of 88%.
The high gross margin players in the space typically have both the pricing power and the scale to support this. However, this is not always the case as some business models require an increasing level of fixed expenses in order to support their larger size. Inefficiencies and inorganic growth could also be attributed to players such as Salesforce, Workday (WDAY) and SAP (SAP) as they offer EBITDA margins well below what their gross profitability would suggest.
Although WDAY is still significantly smaller, this dynamic helps explain why CRM and SAP may seem undervalued based on their P/S multiples we saw above.
In this regard, Adobe’s business model does a fairly good job of translating gross profitability into EBITDA margins as we move down the P&L, but not as well as companies like Microsoft (MSFT) and Oracle (ORCL ).
In terms of expected future growth, Adobe is roughly in line with the average of its peers (see below). However, its expected revenue growth of almost 16% is still behind the other high-growth names in the peer group below.
If we compare these numbers today to what they were two years ago, we notice that in addition to the monetary conditions I discussed above, there is a broader theme of slowing growth. Only 4 of the 11 companies reviewed below are now expected to experience higher revenue growth compared to October 2020.
It is worth mentioning that Intuit (INTU) and Oracle both engaged in significant M&A transactions during this period, which helps to raise their growth profile.
With all of that in mind, Adobe appears to be trading close to fair value, assuming there won’t be another event of unlimited liquidity provided by monetary authorities yet.
Capital allocation issues
While Adobe’s stock price has been in the eye of the storm from the recent normalization of monetary policy, issues surrounding the company’s capital allocation are also beginning to surface.
The recently announced mega-deal for Figma was a significant shift from Adobe’s recent strategy of smaller, add-on acquisitions.
The $20 billion deal for Figma eclipses even Adobe’s biggest deal for Marketo in 2018 when the company also acquired Magento.
On the one hand, it rekindles fears that Adobe is likely facing a slowdown in expected revenue growth and management embarking on a frenzy of new deals, a strategy that rarely succeeds in creating long-term value. .
I sounded the alarm earlier this year, but it seems the deals for Workfront and Frame.io were just the start.
Slowing growth could also explain why Adobe has suddenly embarked on two major acquisitions since November 2020 – those of Workfront and Frame.io.
Source: Alpha Research
Although I was expecting a similar scenario, I wasn’t counting that big so fast.
It usually follows that a company in such a situation embarks on an aggressive M&A strategy in order to achieve these optimistic growth projections. This has been the case with Salesforce and lately seems to be the case with Intuit. While this isn’t necessarily a bad thing, it does introduce significant additional risk to shareholders of an already highly valued company.
Source: Alpha Research
But big M&A deals aren’t always a bad omen, though investors should be wary of management teams that get too aggressive in their M&A strategies.
Figma, like all the previously mentioned acquisitions, indeed seems very well suited to Adobe’s business model.
Besides the high price, another issue from my perspective is the focus on the total addressable market. An estimate that, as we saw last time, is highly arbitrary and subject to sudden changes.
During the last conference call, the CEO of Adobe mentioned that Figma had a total addressable market of around $16 billion “as it exists today”.
So when we talk about the fact that Figma has a TAM of $16 billion, this refers to the TAM as it exists todayin terms of what they do, both in terms of product design, as well as in terms of collaborative whiteboarding and ideation, which, as you know, let’s say, FigJam this amazing product that I believe has a much, much bigger addressable opportunity available.
Shantanu Narayen – President and CEO
Source: Alpha Research
But in the revenue set, we see that this is an estimate of TAM by 2025.
While this may be a small detail, it clearly illustrates the amount of future expectations and beliefs that go into these numbers. This is yet another reason, in my opinion, why the market reacted so abruptly to the announcement.
If we were to justify how much to spend on the deal, we have to rely on many assumptions and forecasts that go beyond the short term and become highly speculative.
However, if we compare the two total addressable markets – Adobe’s pre-deal and Figma’s – we’ll notice that the latter only accounts for 8% of Adobe’s TAM.
Meanwhile, the $20 billion Figma deal represents more than 14% of Adobe’s current enterprise value.
This illustrates the exceptionally high premium that Adobe management is willing to pay for a dollar of TAM.
Over the years, Adobe has created a unique ecosystem of digital services used by freelancers, students, small businesses and large enterprises. Most of the offerings are also pretty sticky and benefit massively from scale. Naturally, this has made the company a notable success story of the past decade.
Still, it’s not uncommon for even the most capable management teams to get carried away during peaks in the stock market cycle and be tempted by the opportunity to acquire whatever comes their way. In my view, this creates exceptionally high risks for shareholders and is often associated with the destruction of shareholder value.
Additionally, as I pointed out last time, Adobe has been at the epicenter of exuberant business momentum in recent years, fueled by excessive market liquidity. This has now brought ADBE down to earth and it hasn’t necessarily created a bargain opportunity.
A note for misguided investors
The analysis above follows my strategy of finding misdirected investments. These are high-quality, reasonably priced companies with strong competitive advantages, where management is focused on running the business with a strong long-term vision.
In The roundabout investor service I will focus on my strongest ideas and also introduce readers to an all-equity focused portfolio and potential ideas to keep on their watchlists.
The service is set to launch next Thursday, September 22. I will also be offering a discount for early subscribers, so stay tuned.