Adobe's Moat Is in Creative Solutions, but Its Enterprise Offerings Are Under Threat
Adobe Inc. (NASDAQ:ADBE) is an older but highly valuable investment in digital software suites, including a specific moat in advanced digital creative design studios, where I believe it is unmatched by any peers. However, it faces threats in its digital experience offerings related to broader enterprise solutions. While I consider the stock to be undervalued at this time, the premium over its wider industry adds somewhat more risk to the investment.
Overview and updates
Adobe is one of the most prominent companies in the technology industry, with a main role in digital content creation. Here is a brief breakdown of its core areas of expertise:
Digital Media: Operations from its Creative Cloud, including Photoshop, Illustrator and Premiere Pro.
Digital Experience: Offers an integrated platform for analytics, commerce, marketing and customer engagement.
Publishing and Advertising: E-learning solutions, technical document publishing, web conferencing and other solutions.
For fiscal fourth-quarter 2023, the company reported record revenue of $5.05 billion, reflecting year-over-year growth of 12%. It has set its target total revenue in the range of $5.10 billion to $5.15 billion for the first quarter of 2024, highlighting expectations for significant growth in its Digital Media and Digital Experience segments.
Notably, its Digital Media segment is supported by artificial intelligence through integrations into its software products. In particular, it introduced Firefly, a generative AI platform developed to empower creative, development and marketing workflows. During the Adobe MAX 2023 event, the company unveiled three new AI models:
Firefly Image 2 Model: Generates high-quality images, improving rendering and creative control.
Adobe Firefly Vector Model: Creates vector graphics through text prompts, simplifying the design process for creating logos and icons.
Adobe Firefly Design Model: Enables the instant generation of design templates from text descriptions, streamlining marketing and design operations.
I believe each of these advances is a critical step in the right direction for Adobe, but I also think the company still has some way to go in terms of mastering the art of prompt-generated creativity. As is the same in the writing industry, it is next to impossible in visual arts to get high-caliber results from artificial intelligence. Arguably, this is something that will be developed in time, but Adobe will have a significant role in how it balances the art of artificial assistance in visual creativity with high levels of involvement from creative directors, balancing between efficiency and human creative vision. It is awfully easy to sacrifice the vision part for efficiency, and I believe Adobe has to be careful not to cheapen its brand at this time by focusing too intently on quick results from its programs rather than adding depth to creative capabilities.
Market and competition
What I find particularly interesting about Adobe is that it is unique in its operational scope. Few, if any, companies of its size command the areas of operation it specifically caters to. Arguably, no other company on the planet offers a comprehensive creative suite quite like Adobe, as it focuses on the elite visual creator. Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) have capabilities similar to Adobe's offerings, but it offers a more concentrated tool base for the top-end professional. Apple and Microsoft's offerings are widely scattered and not focused enough on this demographic to have any real, lasting competitive value in the area.
There are also smaller competitors, like Canva and Affinity by Serif. While Canva is evidently catered toward novice designers, Affinity directly competes with Adobe Photoshop and Illustrator, but distinctly at a one-time purchase price. It is considered a cost-effective alternative to Adobe Illustrator in particular, and it has positive reviews, but users have also noted some limitations, including performance dips on Windows.
Nonetheless, I assess Adobe to be a one-of-a-kind and high-operational value technology company with minimal direct competitors, allowing it to command a strong moat in its specific niche of advanced visual design. Adobe Experience Cloud, on the other hand, faces more distinct competitors, including from Salesforce (NYSE:CRM), ServiceNow (NYSE:NOW), SAP (NYSE:SAP) and Oracle (NYSE:ORCL). I believe its digital experience offerings are much more prone to competitive risks than its creative suite, given such an aggressive advance from multiple companies in the space at this time.
Financials
For the purposes of this analysis, I have chosen to compare Adobe to Salesforce, SAP and ServiceNow. While I understand the overlap is not ideal, I believe it offers a valid peer comparison for the analysis of opportunity cost. Each of these is of similar market cap, and I believe they are all highly compelling investments, to varying degrees, at a time of heightened adoption of AI.
First of all, let's take a snapshot of the core financial statistics of each of these peers:
Adobe: Equity-to-asset ratio of 0.56, net margin of 27.97%, three-year revenue growth rate of 16.8% and forward price-earnings ratio of 28.66.
Salesforce: Equity-to-asset ratio of 0.6, net margin of 11.87%, three-year revenue growth rate of 15.7% and forward price-earnings ratio of 30.88.
SAP: Equity-to-asset ratio of 0.63, net margin of 20.68%, three-year revenue growth rate of 4.6% and forward price-earnings ratio of 37.30.
ServiceNow: Equity-to-asset ratio of 0.44, net margin of 19.30%, three-year revenue growth rate of 25% and forward price-earnings ratio of 57.08.
Adobe is evidently in a very strong position with an immensely high growth rate, considering how long it has been around in comparison to the other companies in my peer analysis. ServiceNow particularly shines for being high growth, but this is to be expected; the company is fairly new, with its initial public offering in 2012. Adobe, on the other hand, had its IPO in 1986. Yet, I consider all of these companies to have remarkably strong financial profiles in general. Where Adobe particularly stands out is in the relative stability of the balance sheet alongside competitive growth that is expected to continue at an earnings per share without non-recurring items compound annual growth rate of 14% over the next three reports, based on consensus analyst estimates.
The company has a significant tendency to perform share buybacks, buying its own stock at varying and often very high amounts, like in 2022 when it bought back $6.55 billion worth. I believe this is an excellent investment from the company to bolster long-term equity value for shareholders, and thankfully its balance sheet, not too overburdened by debt, warrants this kind of action without it negatively impacting its overall financial health too significantly.
Valuation
Over the past 10 years, Adobe has had a median price-earnings ratio of 53.14. At this time, its price-earnings ratio is 43.49, which indicates a discount from the valuation typical for the stock of 18.16%.
We can also compare Adobe to its competitors to gauge what is normal for the group. The average forward price-earnings ratio of Salesforce, SAP and ServiceNow is 32.28. Adobe has a forward price-earnings ratio at this time of 28.66, which is 11.21% lower than its peers on average.
My current estimate is a median of these two figures, an estimated margin of safety in the present stock price of around 15%. Investors should understand my value analysis and associated safety margin do not include an analysis of intrinsic value, and the reason I have left this out is because of the high premium investors are willing to pay for the stock, which unfortunately seems to nullify a discounted cash flow analysis at the time of writing.
My value analysis and associated conclusion of Adobe's undervaluation, therefore, come with more risk for downside volatility as a result of significant shifts in investor sentiment that may occur. However, it should be noted that shifts in purchase sentiment can also be as random as shifts in investor sentiment, meaning my valuation method has considerable weight against a DCF analysis.
Risks
Other than the associated risk with my valuation method, Adobe faces a few critical company-specific risks, including rapid changes in the generative AI and co-pilot technology landscape, which has the potential over time to make an investment quite obsolete if it does not successfully hire experts in new fields of advanced capabilities. Other peers who have the potential to take market share through potential expansion strategies, particularly as it relates to digital experience, include CrowdStrike (NASDAQ:CRWD), Palantir (NYSE:PLTR) and Snowflake (NYSE:SNOW), all serious threats in terms of intelligent data analysis and security-of-software processes. Many of these new platforms offer a one-point solution for all enterprise software needs, significantly challenging some of Adobe's offerings.
Additionally, there are threats to Adobe's creative tools, including from OpenAI and its suite of image creation tools, but also its new Sora technology, which has the ability to smart-render video from text prompts. I believe Adobe is significantly behind OpenAI. And with the backing of Microsoft, I highly doubt that Adobe will be able to remain at the cutting edge of advanced AI generation like OpenAI will. Still, Adobe will likely remain a vital tool for creative professionals if it can continue to corner the market of advanced, highly professional digital imaging with a full breadth of capabilities. This is something OpenAI does not even scratch the surface of at present.
Conclusion
Adobe is a unique company that is positioned particularly well in digital creative design studios, where its moat commands lasting shareholder value. Yet the threats to its other enterprise solutions offerings are significant and I think the company would be wise to focus on its core moat in creative solutions, as I see a considerable likelihood that it will be outcompeted in terms of its broader analytics and customer relationship management efforts. While this may cause some slower growth for Adobe long term, the overall operations look positioned to continue succeeding, at least for now. At this time, I rate the stock a buy with a caveat to watch carefully where it places its strategic focus moving forward.
This article first appeared on GuruFocus.
