Is Adobe a Value Investment or a Value trap?

A lot of people have a grand idea about the next big thing, and they’ll get all worked up about a company’s past successes and future projections. The truth is, the world is full of companies that had a good run but couldn’t keep it up. What’s important is the business itself, its competitive position, and the people running it. Let’s take a look at Adobe, a company that has been a long-time fixture in the world of creative software.

What Adobe Does and Its Business Model

Adobe is a multinational software company that has built a formidable empire on the back of its digital tools. Their core business is in providing software for creative professionals, marketers, and businesses to create, manage, and deliver a wide range of content. You’ve heard of their flagship products: Photoshop for image editing, Illustrator for vector graphics, and Premiere Pro for video editing.

What’s particularly shrewd about Adobe’s business model is its transition to a subscription-based model, which they call the Creative Cloud. Back in the day, you’d buy a software package in a box for a one-time, hefty price. Now, customers pay a monthly or annual fee to access the full suite of their products. This model creates a stable, predictable, and recurring revenue stream for Adobe. It also has a powerful psychological effect on the customer, making them feel like they always have the latest and greatest version of the software without a huge upfront cost. From a business standpoint, this is a beautiful thing. It allows Adobe to collect a steady stream of cash and makes their revenue much more predictable and less lumpy than it was in the past.

Business Segments and Competition

Adobe operates primarily in two main segments: Digital Media and Digital Experience.

1. Digital Media: This is the bread and butter, where the famous Creative Cloud suite resides. It includes products like Photoshop, Illustrator, InDesign, and Premiere Pro, which are used by everyone from professional artists and designers to hobbyists. It also includes the Document Cloud, with its ubiquitous PDF and Acrobat products.
2. Digital Experience: This is their enterprise-focused business, offering a suite of tools for digital marketing, analytics, and commerce.  This segment competes with the likes of Salesforce, Oracle, and even Google in some areas.

When you look at the competition, it’s a mixed bag. In the creative space, there are challengers, to be sure. Companies like Canva and Figma have gained traction with their collaborative, cloud-native tools. Open-source software and other niche players also exist.  In the digital experience space, it’s a war with some of the biggest and most well-capitalized companies in the world.

The Moat and the Elephant in the Room: AI

Now, the most important question for any serious investor is, “What’s the moat?” A business without a moat is like a castle without a wall—it’s just a matter of time before it’s overrun.

Adobe’s moat has historically been built on a few strong foundations:

1. Switching Costs: Once a professional or a business is deeply integrated into the Adobe ecosystem, the cost and effort of switching to a new platform are enormous. Think about the years of work and training invested in mastering Photoshop, or the countless files saved in proprietary Adobe formats. It’s not a decision made lightly.
2. Intangible Assets: The Adobe brand is practically synonymous with creative work. For decades, “Photoshop” has been a verb. This brand recognition and the immense body of work created on their platform are powerful intangible assets.
3. Network Effects: While not a traditional social network, the Adobe ecosystem benefits from a sort of network effect. The more professionals who use Adobe products, the more others are pressured to use them for collaboration and file compatibility.

However, the elephant in the room is artificial intelligence. AI is a disruptive force, and it’s affecting every business. The fear is that a new AI-first company could come along and offer tools that are so much faster, easier, and cheaper that they render Adobe’s traditional software obsolete.

Adobe is not sleeping on this. They’ve integrated their own generative AI engine, Firefly, directly into their core products. They are trying to augment their existing tools with AI, not replace them. The question is whether this is enough to maintain their dominant position. The jury is still out. I would argue that their established customer base, the high switching costs, and the sheer volume of intellectual property they’ve built up gives them a significant head start. But you must watch this development with a hawk’s eye. A moat is a hard thing to build and an easy thing to lose if you’re not constantly deepening it.

Financial Performance: ROIC, Revenue, and EPS

A company with a good moat should be able to earn high returns on its capital. Let’s look at the numbers.

Return on Invested Capital (ROIC): In recent years, Adobe’s ROIC has been impressive, hovering in the high 20s or even higher. A high ROIC tells you that the company is a good business and is skillfully allocating its capital to produce a lot of profit relative to the money invested in it. This is a tell-tale sign of a company with a strong competitive advantage.

Revenue Growth: Over the last five years, Adobe’s revenue has grown at a healthy clip. It’s been in the mid-to-high teens, a testament to the success of its subscription model and its expansion into new markets. Analysts project that revenue growth will continue, but perhaps at a slightly slower pace in the next five years, closer to the high single-digits or low double-digits. This is to be expected as a company gets larger; it’s much harder to grow at a high rate when your starting base is so big.

EPS Growth: Earnings per share (EPS) growth over the last five years has been a bit more volatile, but still quite strong on average. The past few years have seen impressive growth. For the next five years, analysts are forecasting continued solid EPS growth. This growth is a reflection of not only revenue expansion but also the company’s ability to maintain or even improve its profit margins. For the year 2024, Adobe’s EPS was $18.42 per share. The average Analyst projection for Adobe’s EPS by 2029 to be $30.48 which is a 65% growth in the next 5 years.

Valuation

A great company at a bad price is a bad investment. You have to be careful not to get caught up in the enthusiasm.

Adobe’s valuation today appears to be undervalued. Recently, the company’s stock price declined by 38% over the last year due to concerns of disruption by AI and competition from other major AI firms such as Alphabet. However, the current stock price appears to be approximately 36% below its intrinsic value. The big question for the investor is whether the company can maintain its moat.

I don’t get excited about a company just because it’s a good business. I get excited when it’s a good business at a good price. You have to consider the long-term prospects, the durability of the moat, and the potential for a setback. The current valuation suggests the market has a great deal of confidence in Adobe’s ability to navigate the challenges of AI and continue its profitable growth.
Adobe is a magnificent business with a very strong position. The key is to watch how they integrate and monetize AI, and whether they can keep their moat deep and wide against a new class of competitors. If you’re a long-term investor, you want to own companies that will be worth a lot more ten or twenty years from now. Adobe has the potential to be one of those provided it is able to maintain and deepen its existing moat.