Investment Thesis
Adobe (NASDAQ:ADBE) stock jumps 15% premarket as investors cheer its outlook. The bull case here is that Adobe’s profit margins continue to bedazzle investors. But once the dust has settled, a lot of the bearish aspects will resurface.
Namely, will AI disrupt many of Adobe’s products? Or, will it be the case, that management can continue to embrace AI to drive more demand for its services?
For my part, I make the case that paying 26x next year’s non-GAAP EPS leaves me with no room for error. Accordingly, I know I can find better stocks elsewhere, so I will stick to neutral here.
Rapid Recap
Immediately on the back of its fiscal Q1 2024 results, in March, I said,
[…] what’s more critical here is that Adobe’s growth rates are so tepid that they struggle to support its valuation of approximately 27x forward EPS (including the pre-market drop).
All in all, I’m finding so many bargains elsewhere, that I cannot bring myself to be bullish on this stock.
I’ve been neutral on Adobe for a while and the stock has clearly underperformed the S&P500, see above. This, is in a period when an AI-fueled rally has been strong and driving the market higher.
More concretely, consider the context that drove the stock to jump after hours. This was a stock that was rapidly moving in one direction since the last earnings call. Down, down, down. With the stock already down 25% in 90 days, a lot of near-term negative news was priced in. Hence, if the results were slightly better than hoped, the stock could rally, as shorts ran for cover. But I continue to question whether this stock makes sense long-term.
Adobe’s Near-Term Prospects
Adobe develops software tools to enhance creativity. Their product lineup includes Adobe Creative Cloud for design and editing, Document Cloud for document management, and Experience Cloud for digital marketing and customer experience management.
Adobe empowers users to interact with content, from graphic design and document editing to personalized marketing campaigns. Adobe’s customer base is highly diversified, it’s for anyone who seeks to design a stimulating digital experience, being used by students, individuals, and organizations of all sizes.
Moving on, during the earnings call, Adobe contends that its products are resonating with a wide range of users.
The company’s success is being fueled by advancements across its core product offerings-Creative Cloud, Document Cloud, and Experience Cloud.
Adobe’s strategic focus on integrating AI to enhance user productivity and creativity is a significant growth driver. For example, innovations like Acrobat AI Assistant and Adobe Express are revolutionizing document productivity and creativity, further solidifying Adobe’s market position.
Indeed, if you recall, many investors have had concerns that Adobe’s product offering would be impaired by AI. However, management came out with their best foot first, to dispel these assertions.
The argument is that AI could disrupt Adobe’s growth prospects by replacing many of Adobe’s products. As AI technology advances, it could offer automated solutions for creative tasks traditionally performed using Adobe’s flagship applications like Photoshop, Illustrator, and Premiere.
Additionally, AI-driven platforms might enable users to generate high-quality images, videos, and designs with minimal effort, reducing the demand for Adobe’s more complex tools.
Given this balanced background, let’s now discuss its fundamentals.
Adobe’s Growth Rates Impress
Adobe’s guidance for fiscal 2024 comes in line with analysts’ expectations. But given that Adobe’s fiscal Q2 2024 beat analysts’ expectations, albeit by a sliver, investors are sighing a sign of relief.
And even if we presume that Adobe’s management is being conservative with its guidance, the facts remain, that Adobe guided for $5.30 billion in revenues for fiscal Q2 2024, while its actual revenues were reported at $5.31 billion. For more context, look below.
The size of Adobe’s revenue beats is tiny. This is not a growth company any longer. And it makes sense, after all, Adobe’s been a public company for nearly 40 years.
Can Adobe be counted on for sustainable low teen growth rates? That’s the implicit bet that investors are being asked to take here. From my point of view, I believe that investors are already pricing in the best-case scenario, something that we discuss next.
ADBE Stock Valuation — 26x Next Year’s EPS
Adobe guides for approximately $18.20 of EPS. Naturally, investors are hoping that management is being conservative and that Adobe’s bottom line EPS ends up around $18.25 or slightly higher, say, $18.30. Assuming the high end of its non-GAAP EPS guidance, and then some, Adobe’s EPS figure would be up 13.9% y/y.
Looking ahead to fiscal year 2026, if Adobe achieves approximately 11% revenue growth, let’s assume they also find additional efficiencies. However, this seems unlikely since Adobe already has a very high non-GAAP operating profit margin of 46%, which is one of the highest among tech companies (maybe even the highest of all tech companies).
If Adobe manages to grow its EPS by 13% y/y, despite the challenge of improving their already high profit margins, their EPS would reach $20.68 by fiscal 2026.
This leaves Adobe priced at 26x next year’s EPS, for a business that’s growing at approximately 11%-12% CAGR? That’s a really tough price for me to get involved here.
The Bottom Line
Paying 26x next year’s EPS for Adobe already prices in the best-case scenario for the stock because it assumes the company can continue to achieve high profit margins and steady growth amidst significant challenges.
Adobe’s current valuation suggests an expectation of sustained low teen growth rates and continued dominance in the creative software market, despite the potential disruption from AI technologies.
The company’s fiscal Q2 2024 revenue barely exceeded expectations, highlighting the modest nature of its growth.
Given Adobe’s nearly 40-year tenure as a public company and its high non-GAAP operating profit margin of 46%, any further efficiency gains are unlikely. Thus, investors are betting that Adobe can maintain its growth trajectory and fend off AI-driven competition, leaving little room for error and making the stock fully valued.
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