A Wonderful Business
What makes a visionary company? Jim Collins and Jerry Porras answer this question in the renowned business book Built to Last: Successful Habits of Visionary Companies. First, an intense core ideology that extends far past ‘maximizing profitability’. In the recent annual report, Adobe (NASDAQ:ADBE) described their business in such a way: “We deliver tools and services to empower individuals to create, collaborate and express their vision, transform businesses with compelling, personalized experiences in streamlined workflows and connect communities with new levels of collaboration.”
Another crucial component is ‘Big Hairy Audacious Goals’, something Adobe also meets:
“[on the Digital Media segment] Our goal for our Digital Media business is to be the leading platform for creativity and digital document solutions, where we offer a range of products and services…to design and deliver content seamlessly.”
“[on the Digital Experience segment] Our goal is to be a leading provider of cloud-based solutions for delivering digital experiences and enabling digital transformation.”
Clear, concise, and simple; but not easy. Naturally, it’s unwise to make investment decisions based exclusively on what management believes their opportunities are. However, Adobe has a proven record of navigating the rapidly changing and growing Tech industry and is well-positioned to benefit from the next big steps in tech: Digital transformation and Artificial Intelligence.
What Makes a Tech Company Valuable?
As the internet has embedded itself throughout nearly every corner of the Earth, there’s been a corresponding rise in the study of the economics of information. The core of this field is the network effect, which is what gives the internet so much business value. Before big tech rocketed the American economy into the 21st century, there were serious concerns about the decline of many American industries brought on by globalization. Globalization has tradeoffs; on one hand, it has kept inflation very subdued for 40 years, on the other hand, manufacturing, once a key driver of American growth, has shifted largely out of the United States which caused severe economic damage to many major industrial cities. There were serious concerns about US economic dominance in the early 1980s, but those concerns were burnt to a crisp by the fire emitted from the engine of American ingenuity, which thrived on the internet.
To say the internet fundamentally shifted the United States economy seems like an understatement. It has fundamentally changed the lives of nearly every single person alive today and anyone born in the future. Technological progress is exponential, and the internet is proving that in real-time, at all times. In the beginning, there were prohibitively high costs and limited uses for the internet, but progress increases at an increasing rate. As a result of the US capitalist system, progress is richly rewarded. The combination of internet technology and the US economic system caused the meteoric rise of the modern service-driven US economy and has left no room to question who the most dominant economy has been for the past 30 years.
A major component of the business value of the internet is the network effect. As simple as it is powerful, the network effect states that the value of software is a function of its number of users. For example, imagine you are the first user of an Adobe PDF file. Since you are the first user, no one else has access to anything you produce with this file. Imagine you have an entire book in a PDF file, but when you try to share it on the internet, no one has the capability to access it! What is the value of this software? Nothing. However, now Adobe has gained another PDF user, and the other user buys your book for $10. The value of the software is driven by the economic activity it stimulates. This effect does not scale linearly. As additional inputs – users – are added to the growth function, the output of the function – economic activity caused by the software – grows exponentially. This mechanic was key to the historic rise of US tech.
Another important piece of the puzzle is the concept of ‘industry standard’. Becoming the industry standard was the prime goal and core focus of many early internet companies. There are numerous stories of ruthless business practices by Microsoft, Apple, and other tech businesses. There have been lawsuits filed by the United States government over anti-competitive behavior, but ultimately the internet was the Wild West for much of its early life. Market share drives brand value, so that was the core focus of software companies. Many of the companies you’d expect earned industry-standard status, in which their product became the default (Microsoft Windows OS, Google search engine, Apple App Store, etc.).
Intellectual property protection and the network effect make possible the rapid destruction of software products as well. Apple caused the beginning of a long descent to worthlessness for Adobe Flash Player. Steve Jobs was unhappy with the efficiency and security of the Flash platform for creating advanced graphics on the internet and removed Adobe Flash Player entirely from the Apple ecosystem by 2010. This reversed the network effect’s exponential growth function, instead becoming exponential decay until it was ultimately discontinued at the end of 2020. Flash was once the industry standard in delivering video-based web content, but disruption to its network effect and fundamental cybersecurity shortcomings caused its collapse and replacement. This is the fundamental risk but also the driver of value in the information economy. With ambitious business goals comes failure, and the aggressive pursuit of becoming an industry-standard in the most competitive industry is a challenging path.
In essence, there are two primary components to the value of a Tech company: the network effect and the industry standard.
The Next 10 Years
Adobe is focused on the next generation of American technology (artificial intelligence) and on embedding its products within existing software networks/ecosystems. Additionally, Adobe’s product suite provides companies with the ability to embrace the digital age. Many companies are leaning into the Adobe product ecosystem to modernize their business, and with nearly all products offering recurring revenue streams for Adobe, the business looks set to consistently grow in the coming years.
The PDF file allows for a consistent presentation of documents across operating systems, websites, and hardware. Adobe released the PDF from its proprietary format and published it as an open standard in 2008. It’s now formally a standard format for transmitting information online. Although Adobe can’t profit from the monopoly of its (now royalty-free) patents on the PDF file, they still remain dominant in PDF technology. Now offered as a SaaS product, Adobe Acrobat is the market-leading PDF reader/editor. According to Adobe, more than 400 billion PDFs were opened in Adobe products last year. In the recent earnings call management noted that Acrobat is now the default PDF viewer in Microsoft Edge, which has an estimated 1 billion yearly users. Microsoft is aggressively pushing the frontier in its own right, with the recent implementation of ChatGPT into Bing. As more traffic is driven to Bing, more traffic will be driven to Edge, and any PDFs opened in Edge will use Adobe software. Adobe has embedded its product into one of the strongest information networks in the world, which should prove to be a strong funnel of new business in the future.
Over 90% of the world’s creative professionals use Adobe Photoshop (according to Adobe). Adobe Lightroom Mobile is the default photo editor of the Galaxy S-23. The management team also noted a few key generative AI developments in the Digital Experiences segment, which will be shown in further detail at Adobe Summit starting March 21st, 2023. AI looks set to provide the next (positive) shock to American innovation and growth. One of the key concerns from a variety of industries is the threat of AI displacement. Artists, writers, accountants, lawyers, and many, many other professions feel a threat of being replaced by this technology. Adobe’s focus is on developing AI tools that assist in the creative process, not tools that replace the creative process. Adobe’s core customer base is creative professionals, and they are set on developing AI tools that will help amplify the volume and quality of content those professionals can create. Whether AI will displace many jobs is yet to be seen (to be clear: that is a huge risk to Adobe), but Adobe is well-positioned to enhance its product offerings on the back of this revolutionary technology.
By embedding Adobe products in different software and hardware products, Adobe is developing solid funnels for new customers. Further, Adobe management noted macro risks posing a threat to non-critical business expenses. Marketing is typically such a function for businesses, and one of the first functions to get defunded in the face of financial uncertainty. However, management is seeing a different development in this uncertainty: consolidation. Businesses are decreasing spend by bundling products with one provider, which provides cost advantages versus getting products from a variety of vendors. A company like Salesforce (CRM) has one core product offering: customer relationship management software. Adobe has a competitive offering to this with Adobe Experience Manager, and management believes they will not see a material weakening in this segment because many customers will seek to consolidate vendors. Adobe offers a variety of products and is a strong candidate to be the sole provider of marketing and digital transformation technology for businesses seeking to cut down marketing spend and complexity by finding a single vendor to provide a full suite of applications.
Good investments are not without risk. Although Adobe has strong fundamentals and a solid business model, I have one key concern: dilution. Stock-based compensation has increased nearly 5x since 2013, from ~$330M to ~$1.5B in stock-based comp. At current levels, this represents roughly 1% dilution annually. Management combats this with aggressive share repurchases, which mostly offset the dilution, but is a hefty financial commitment on a yearly basis. If stock-based compensation is being used as a tool to incentivize employees, it’s not a major issue. However, if this is strictly a mechanism for management to line their pockets, it will likely put downward pressure on Adobe’s long-term value.
Further, as noted briefly above, Adobe’s core customer is at risk of mass AI-driven displacement. If fears of AI causing major job losses across a number of digital creative industries, this could pose a serious threat to Adobe’s business model. In fact, this risk may be the glacier that the Adobe ship sees looming on the horizon. Technological innovation with its exponential nature will continue impacting society in unforeseen ways, and a prediction of that impact is just that: a prediction. No one really knows the full range of ripple effects AI will have, we just know that it will have major ripple effects. Adobe is positioning itself to be at the forefront of AI-enhanced product offerings, which should continue to provide value for customers and drive shareholder value.
I currently estimate a value of $350.81 for Adobe. At current market value, Adobe is trading at a multiple of 26x levered free cash flow and has a 10-year trailing CAGR of 36% for free cash flow. I expect that growth rate to increase, which I’ve reflected in an estimated 5% growth of levered free cash flow per year. Adobe is leveraging a number of key growth opportunities across business transformation and AI-assisted digital design which should drive stability and growth of free cashflows to the company. Further, Adobe has more cash on hand than total debt, so the current interest rate environment should not put material downward pressure on levered free cash flow. Discounting these cashflows at a 15% rate and estimating a conservative price/free cash flow multiple of 10x (vs the 26x of today), yields my margin of safety price of $350.81:
|Free Cash Flow to Equity Valuation|
|Est. Growth Rate||Discount rate|
|Est Future FCF||1.05||15%|
|Terminal Value (P/FCF multiple * 2032 est. discounted cashflow)||10.00||$88,842,745,804.66|
|Intrinsic Value (Sum of discounted cashflows and terminal value)||$160,874,859,820.54|
|Current Discounted Equity Value||$160,874,859,820.54|
|Current Discounted Equity Value/share||$350.81|
This is slightly changed from my previous valuation due to a difference in shares outstanding.
In that light, I believe Adobe is currently trading right around its intrinsic value and is worth buying. Personally, I will be somewhat stubborn with my cash and wait for a trigger price of $350.81, but I believe Adobe will richly reward investors over the next 10 years at its current valuation. I rate Adobe stock a Buy because it’s a wonderful business with a really positive long-term outlook and many opportunities to drive consistent growth in its intrinsic value.
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