Investment Thesis
Adobe (NASDAQ:ADBE) had a record second quarter, driven mainly by strength in its digital media channel. The company also launched a whole suite of AI tools for its products and the initial reaction has been extremely positive. In this article, I argue how the company can be one of the biggest beneficiaries of the AI revolution that is taking place in the creative industry. However, the company’s valuation today remains a concern.
A Snapshot of Adobe’s Q2 Performance
The company had a strong second quarter, with revenues coming in at a record $4.82 billion, a year-over-year increase of 9.80%, and beating estimates by $43.20 million. EPS came in at $3.91, which represents a year-over-year increase of 16.7%, and which beat estimates by $0.12. The main driver of the record quarter was the strong demand that was seen across the company’s Creative Cloud, Document Cloud, and Experience Cloud.
With the launch of its AI engine, Firefly, the demand is likely to be sustainable and this was evident when the management raised its FY23 guidance. Total revenues are expected to come in between $19.25 and $19.35 billion and non-GAAP EPS is expected to come in between $15.65 and $15.75.
AI Capabilities Should Help Adobe Capitalize on the AI Revolution in the Creative Industry
Adobe’s generative engine, Firefly, launched in March, has made the company’s future a lot brighter, in my opinion, than it was before. The company has already seen users of Firefly generate 0.5 billion assets, both through its website and through Photoshop, making it one of the most successful beta launches in the company’s history.
Furthermore, the company announced that it is set to launch its generative Recolor AI model for Adobe Illustrator, which is capable of producing color themes based on text prompts or audio samples. ADBE also launched a brand-new Firefly-integrated Adobe Express, which should be a blessing for small business owners. Finally, through partnerships with Google and Apple, the company has laid out the foundation to further boost the scale and reach of its AI tools in the coming years.
Incorporating AI into its products should place Adobe in a great position to scale new heights in the creative industry. For instance, take the case of the fashion industry. According to McKinsey’s analysis, generative AI could boost operating profits in the apparel, fashion, and luxury sectors by up to $275 billion in the next three to five years. Moreover, according to Market.us, generative AI in the fashion space is set to grow at a CAGR of 36.9% and reach $1.48 billion by 2032. Adobe’s AI-integrated Photoshop and Illustrator stand to significantly gain from this development, especially in the merchandising and product stages. This is just one example of how the company can leverage its AI capabilities to open up a new source of ARR in the future.
Furthermore, according to Goldman Sachs, generative AI could automate 26% of the tasks within the arts, design, entertainment, media, and sports sectors, which is further proof of how Adobe stands to gain from the AI revolution in the creative space. There is also the added bonus of Adobe’s enterprise customers being protected from any copyright issues as the company is offering financial indemnity from copyright claims, which should only strengthen customer engagement and loyalty.
Continued Strength in Digital Media Channel Should Power Growth in the Medium Term
The full potential of Adobe’s AI capabilities is not likely to be felt in the company’s top and bottom lines in the near to medium term. This is where the growth in the company’s Digital Media segment comes into play.
The segment had a strong performance in the second quarter and the continued strong demand prompted the management to raise its FY23 ARR and revenue targets for this segment. More specifically, the segment generated revenues of $3.51 billion, a 10% year-over-year growth, with Creative Cloud revenues growing 9% year-over-year and Document Cloud revenues growing 11% year-over-year. The growth in the latter was, in particular, impressive, with the company managing to add net new ARRs of $116 million, thereby finishing the quarter with an ARR growth of 22%.
The management is seeing strong tailwinds in PDF demand, which is attributed to the observation that PDF is becoming the de-facto standard for unstructured data. The company’s partnerships with Google, through which Chrome users can quickly edit text and images directly from Chrome, and Microsoft, under which Microsoft Edge’s built-in PDF reader is set to be powered by Acrobat’s rendering engine, are also, in my opinion, strong growth drivers for the company’s Document Cloud business.
The company now sees FY23 net new ARRs for the Digital Media segment to come in at $1.75 billion and FY23 revenues for the segment to come in between $14.1 and $14.15 billion. Both Document Cloud and Creative Cloud are likely to be strong catalysts for ADBE once enterprise customers resume their cloud spending and especially when the company fully incorporates its AI tools into this segment.
Valuation
|
Forward P/E Approach |
|
|
Price Target |
$504.00 |
|
Projected Forward P/E Multiple |
$28.2x |
|
PEG Ratio (NTM) |
2.04x |
|
Projected Earnings Growth |
13.8% |
|
Projected FY24 EPS |
$17.87 |
Source: Company’s Q2 Earnings Release, Refinitiv, and Author’s Calculations
The company now sees adjusted FY23 EPS coming in between $15.65 and $15.75. I have assumed FY23 EPS to be $15.70, the midpoint of the company’s guidance.
The company currently trades at a forward P/E of 28.2x, which is not unreasonably expensive. Salesforce, for instance, trades at 26.4x and Autodesk trades at 26.7x. Furthermore, compared to its historical multiple of 33x, the stock is relatively cheap. As such, I have assumed the company’s forward P/E to be 28.2x.
The company currently trades at a forward PEG ratio of 2.04x. Assuming a forward P/E of 28.2x, this results in an EPS growth rate of 13.8% and an FY24 EPS of $17.87.
A forward P/E of 28.2x and an EPS of $17.87 result in a price target of $504, which is only about 5% higher than current levels.
Risk Factors
Despite the long-term potential of ADBE’s AI tools, the pathway to monetisation is a long one and is filled with uncertainty. There is the possibility that the integration of AI into the company’s products falls short of expectations.
Then there’s the antitrust scrutiny that the company faces for its pending acquisition of Figma. Should the deal fail to materialise, it would put a significant dent in the company’s design ambitions, especially after Adobe XD, the tool that was launched by the company to compete with Figma, has failed to gain traction.
Concluding Thoughts
ADBE has finally joined the AI party. In the long run, this is a company that is likely to be one of the biggest winners of the AI revolution in the creative industry, especially since its products are well-positioned to capitalize on the adoption of AI in this space. Furthermore, the company’s growth across all its segments in general and digital media in particular is only going to get stronger once the company starts to integrate AI into these segments.
The issue I have with the company today is its valuation. After a monster run to date, the stock is priced to perfection in my opinion. Having said that, a meaningful pullback should be a great opportunity for investors to consider buying this company with both hands.
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