After Earnings, Is Adobe Stock a Buy, a Sell, or Fairly Valued?

Adobe ADBE released its second-quarter earnings report on June 13. Here’s Morningstar’s take on Adobe’s earnings and our outlook for its stock.

Key Morningstar Metrics for Adobe

• Fair Value Estimate: $635.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: High

What We Thought of Adobe’s Q2 Earnings

• Last quarter, Adobe’s stock sold off 15%—in our opinion, based on an uneven discussion around net new digital media annual recurring revenue performance and guidance. We thought that created a buying opportunity. This time, the company crushed it, with net new digital media ARR at $487 million, representing an 11% beat vs. the $440 million in guidance. Management didn’t waver on raising its full-year guidance from $1.90 billion to $1.95 billion.
• Various artificial intelligence features have been rolled out in many new products. Notably, Express is attracting new users based on a $10 per month price point, who are then converting to higher-priced SKUs, including the full creative cloud suite for $60 per month. These conversions occur at a greater-than-expected rate, and these AI features are raising the retention of existing clients.
• Document cloud grew 19%, a massive year-over-year and sequential acceleration, as AI features push rapid adoption of higher-priced SKUs. This is also a $2.7 billion book of business, so that inflection is impressive. In comparison, the similarly sized DocuSign DOCU reported 7% growth in the quarter.
• We raised our fair value estimate of Adobe from $610 per share to $635, based on slightly better topline growth estimates over the next several quarters. The firm has tailwinds for the back half of the year, including building momentum on recent product launches, clear AI leadership, and easier comparisons from price increases in prior periods, which were pressuring first-half results. We think there is still room to run.

Fair Value Estimate for Adobe Stock

With its 4-star rating, we believe Adobe’s stock is undervalued compared with our long-term fair value estimate of $635 per share, which implies a fiscal 2024 enterprise value/sales multiple of 13 times and an adjusted P/E multiple of 35 times.

We model a five-year revenue compound annual growth rate of approximately 11%. We foresee solid growth in digital media and digital experience, even as both steadily slow over time. Digital experience should benefit from 2023 price increases that should filter in over several years, as well as increasing penetration into an enormous market as defined by Adobe.

We believe the company has a relatively frictionless cross-selling opportunity, as creative professionals are already steeped in Adobe products. The desire to consolidate vendors makes Adobe an obvious choice for marketing software solutions, and its products are strong, which should help in what we believe is a large greenfield opportunity. Within digital media, we have been impressed by Adobe’s ability to draw in new users that many did not believe existed. We believe some of this is related to piracy, which is effectively eliminated in the software-as-a-service model.

Additionally, the company has had success upselling existing users to higher price point products and cross-selling acquired technologies, such as Workfront and Frame.io. We believe continued innovation, gathering new users, and upselling existing users in Creative Cloud should help drive strong growth for the next several years.

Read more about Adobe’s fair value estimate.

Economic Moat Rating

We assign Adobe overall a wide moat based on switching costs. Looking at the company’s segments, we believe digital media has a wide moat and digital experience has a narrow moat, both also arising from switching costs. We think Adobe’s moat will let it earn returns over its cost of capital for the next 20 years.

Read more about Adobe’s economic moat.

Financial Strength

We believe Adobe enjoys excellent financial strength arising from its strong balance sheet, growing revenue, and high and expanding margins. As of November 2023, the company has $7.8 billion in cash and equivalents, offset by $3.6 billion in debt, resulting in a net cash position of $4.2 billion.

Adobe has historically generated strong operating margins. Free cash flow generation was $6.9 billion in fiscal 2023, representing a free cash flow margin of 36%. We believe margins should grind higher as the digital experience segment scales. Adobe reinvests for growth, repurchases shares, and makes acquisitions. The company does not pay a dividend. Over the last three years, it has spent approximately $2.8 billion on acquisitions and $14.9 billion on buybacks. We believe the company will continue repurchasing shares as its primary means of returning cash to shareholders over the medium term. We also believe it will continue to make opportunistic and strategic tuck-in acquisitions, despite the failure to close the Figma deal.

Read more about Adobe’s financial strength.

Risk and Uncertainty

We assign Adobe a High Uncertainty Rating. It faces risks that vary by segment. Creative Cloud’s high market share over the last 25 years means a significant portion of high-margin revenue would be at risk (however slight) if a competitor made inroads in the space. The dampening of cross-selling opportunities with digital experience would likely then be diminished, which would be problematic, as we think digital experience represents the larger growth opportunity over the next five years. While Adobe is generally considered a leader in the various categories under its digital experience umbrella, it did not create any of these categories and does not dominate them the way it does with Creative Cloud.

Read more about Adobe’s risk and uncertainty.

ADBE Bulls Say

• Adobe is the de facto standard in content creation software and PDF file editing—categories the company created and still dominates.
• The shift to subscriptions eliminates piracy and makes revenue recurrent while removing the high upfront price for customers. Growth has accelerated, and margins are expanding from the initial conversion inflection.
• Adobe is extending its empire in the creative world from content creation to marketing services more broadly through the expansion of its digital experience segment. This segment should drive growth in the coming years.

ADBE Bears Say

• Momentum is slowing in Creative Cloud, after elevated growth driven largely by the model transition to SaaS.
• There is greater uncertainty in digital experience since this is an emerging space—one Adobe neither created nor dominates. Growth could be slower than we anticipate, or margin expansion may not materialize.
• Digital experience has been built largely through acquisition, including Magento and Marketo in 2018. This raises the possibility of disruption from inadequate integration efforts and lends credence to concerns that Adobe may overpay for increasingly large deals.

This article was compiled by Krutang Desai.