In the month of September, there has been a significant, sharp and quick shift out of momentum stocks — which have been working all year long — into value stocks — which haven’t been working for a long time. In this shift, no momentum stock has been spared, not even blue-chip cloud computing giant Adobe (NASDAQ:ADBE). In fact, over the past five years, ADBE stock has experienced a 10% correction only five times, which is very few for a momentum growth stock.
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Right now, ADBE stock is in the midst of one those 10% corrections. How did the other five corrections play out? With a big ADBE stock rebound, and huge gains in the long run.
This will one play out in a similar fashion.
In the big picture, there’s nothing wrong with momentum stocks or ADBE stock. Instead, investors are simply voicing confidence in the economy by booking profits on their momentum winners, and buying the dip in beaten up, economically sensitive stocks. Historically speaking, such a pivot has almost always happened right before big market rallies. Thus, zooming out, this shift out of momentum stocks will pass soon. When it does, it’ll be replaced by a cyclical bull market rally in all stocks.
With respect to ADBE stock, you still have a secular growth stock supported by favorable long-term trends, with big revenue growth rates, even bigger margins and an exceptional clarity to big profit growth in the long run. On top of all that, recent weakness has plunged ADBE stock into slightly undervalued territory — a rarity for a secular winner.
Net net, don’t worry about the recent weakness in ADBE stock. It isn’t indicative of much. Instead, embrace it, and use it to buy at a discount.
The Fundamentals Are Rock Solid
The fundamentals underlying ADBE stock are about as good as it gets.
Long story short, Adobe is the unchallenged leader in a secular growth market, with a robust track record of big revenue growth, a ton of runway to keep growing and sky-high margins that are only moving higher.
Let’s break this down. The digital media market is a secular growth one. There are three big secular trends here. One, everything is going digital — consumers everywhere are spending more time on their phones, computers and tablets than ever before. Two, everything is going visual — an increasing amount of time spent in the digital channel is spent with visually focused apps, such as Instagram, YouTube, Snapchat, etc. Three, consumers and enterprises alike are increasingly producing and sharing digital media content.
The result? A secular rise in consumer and enterprise demand for digital media and marketing products. This secular rise has powered consistent 20%-plus revenue growth at Adobe over the past several years.
This big growth streak has a lot of runway left. When you combine all of Adobe’s verticals — ranging from helping consumers create movies, to helping businesses digitize their documents and workflows, to improving digital media campaigns for enterprises, the addressable market here is north of $100 billion. Adobe’s revenues this year are expected at just over $11 billion. Thus, there’s plenty of room for this big growth narrative to stay big.
Perhaps most importantly, in this space, Adobe is first, and there’s no close second. Because of this, the company commands tremendous pricing power over customers. This leads to big gross margins, which stand at nearly 90% today. They could go even higher with murmurs of another price hike on the way.
Big picture — Adobe stock has all the ingredients of a long-term winner.
The Valuation Leaves Room for Upside
Usually, when a stock has all the ingredients of a long-term winner like Adobe stock, that stock persistently trades at a premium valuation because investors are willing to pay a premium for all those winning ingredients.
That isn’t the case today, and that means this is a rare opportunity to buy Adobe stock at a discount.
The numbers here are easy to follow. Adobe has reported 20%-plus revenue growth in each of the past several years, and 25%-plus revenue growth each quarter this year. In other words, this is a big growth company whose growth momentum isn’t slowing. Given the aforementioned secular trends supporting the digital media market and the $100 billion-plus addressable opportunity here, I don’t see Adobe’s top-line momentum slowing much into the foreseeable future.
Nor do analysts.
Consensus Street estimates call for 24% revenue growth this year, 18% revenue growth next year and 15% revenue growth in 2021. Into 2025, revenue growth should realistically remain north of 10%, putting revenues on a visible pathway toward $25 billion by 2025, from $9 billion in 2018.
Gross margins are around 88%. They should inch towards 90% thanks to gradual price hikes. The opex rate hovers around 50%. It has room to fall towards 40% in the long run as revenues more than double over the next several years and big revenue growth drives positive operating leverage.
Net net, Adobe could very reasonably turn into a 50% operating margin company by 2025 with revenues of about $25 billion. That combination makes $23 in earnings-per-share seem doable by then. Based on a growth stock average 21-times forward multiple and a 10% discount rate, that implies a 2019 price target of about $300 for ADBE stock.
Bottom Line on ADBE Stock
Adobe stock is down 10% over the past few weeks. But, there’s nothing wrong with Adobe stock. The fundamentals remain strong, the valuation remains reasonable, and the optics remain favorable.
As such, this 10% selloff is nothing more than a small, normal and temporary correction in an otherwise still healthy long-term uptrend. What’s the best thing to do with such temporary corrections? Buy the dip.
As of this writing, Luke Lango was long ADBE.
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