Last month, we published Adobe: Shares Are Languishing, But AI Could Catalyze Growth. Since we published the article, Adobe (NASDAQ:ADBE) shares have appreciated around 50%, driven by stronger-than-expected FYQ2 results and the AI catalyst playing out much quicker than we anticipated. The lesson we learned is that it doesn’t pay to get too cute on timing: next time we see a good opportunity and catalyst but are unsure about timing, we will make sure to establish a position.
In this article, we review ADBE’s FYQ2 earnings and share our key takeaways, as well as provide a comprehensive update on the company’s financial and valuation analysis.
FYQ2 Takeaways: Beat & Raise, Generative AI, and Figma
Adobe’s Q2 results beat consensus and guidance across metrics, primarily driven by the exceptional performance of the Digital Media segment. The segment outperformed due to increased Adobe.com traffic, growth in newer applications, Acrobat seat expansion, and robust mobile activity. This beat comes in the wake of heightened expectations and puts the company in a strong position heading into the next quarter. The growth momentum is set to continue across the Creative and Document Cloud portfolio, affirming our bullish stance on Adobe’s ongoing performance.
The company’s ability to raise FY23 guidance amid a challenging macroeconomic environment speaks volumes about its operational efficiency and resilience. Adobe has increased its total revenue guidance to $19.25B-$19.35B, up from $19.1B-$19.3B, which represents a year-over-year increase of 9-10%. This move comes in the wake of the successful beta release of Firefly, a promising new venture that’s already drawing a large number of new users to Adobe. Firefly could significantly expand Adobe’s user base, unlock greater adoption within its enterprise base, and drive a considerable increase in content creation. We believe this investment could deliver substantial returns for Adobe.
Moreover, Adobe’s General AI (GenAI) offerings, including Firefly, Generative Fill, and Generative Recolor, provide the company with several monetizable opportunities. The company’s GenAI solutions are designed to drive higher Average Revenue Per User (ARPU) and are offered both as standalone freemium solutions and as part of integrated enterprise offerings. By enabling users to generate additional content on its platform through subscription “credits,” Adobe is strategically positioning itself to enhance revenues. While AI-driven revenues are expected to be modest in Q4, they are projected to grow significantly thereafter.
However, there’s still a cloud of uncertainty hanging over Adobe’s pending acquisition of Figma. The deal, which is valued at around $20B, is currently under review by regulators. This could be a potential risk factor for Adobe, given the increasing scrutiny of large acquisitions by antitrust authorities. Despite this, we remain optimistic, considering Figma’s immense potential to expand Adobe’s footprint in browser-based design and collaboration. The acquisition could prove to be strategically significant, albeit dilutive initially.
Financial & Valuation
Note: All historical data in this section comes from the company’s 10-K filings, and all consensus numbers come from FactSet.
In the recent Q2 earnings report, Adobe Systems performed in line with expectations. With revenue climbing 9.8% year-over-year to reach $4.816 billion and EPS soaring 17% y/y to $3.91, ADBE demonstrates a robust growth model. Indeed, it’s notable that ADBE managed to beat the consensus EPS estimate by 3.2%, and its operating margin improved slightly to 45.2%, a 0.2% improvement compared to the previous year.
Peering into ADBE’s recent financial trends, it’s clear that growth has been a key storyline. Over the past three fiscal years, the company has grown revenue at an impressive CAGR of 16.4%. Looking ahead, consensus estimates anticipate revenue growth to reach $19.4 billion, marking a 10.1% increase this fiscal year, and surge by 12.5% the following fiscal year to $21.8 billion. This trajectory, in our view, signals a consistent and healthy expansion rate, positioning ADBE well in a rapidly evolving digital landscape.
On the downside, consensus estimates predict a contraction in EBIT margin by 51 basis points this fiscal year to 44.6% and a further 12 basis point contraction the following fiscal year. Despite this, the company’s EBIT margin has indeed expanded by 5.2% points over the past three fiscal years from 39.9% to 45.1%, demonstrating an efficient operational framework.
Furthermore, ADBE’s strategy of using share repurchases to offset shareholder dilution appears to be effective, with diluted outstanding common shares decreasing by 5% over the past three years. This approach is reflected in the company’s robust EPS growth, which, having outpaced revenue growth, reflects an encouraging trend for potential investors.
The company’s financial health is further underscored by a strong balance sheet, boasting a net cash position of $5,118 million. The free cash flow (FCF) margin is projected to rise to 39.8% this fiscal year, up from 36.6% four years ago.
ADBE’s relatively low capex as a % of revenue, averaging 2.8%, characterizes it as a capital-light business, which is beneficial in terms of generating high free cash flows. Additionally, the strong return on invested capital of 25.4% indicates the company’s efficient use of its capital.
Despite not paying a dividend, compared to the S&P 500’s average dividend yield of 1.5%, Adobe’s stock has delivered commendable returns over the past year, outperforming the S&P 500 by 12% points and recording an absolute return of 30.2%.
However, ADBE’s current valuations seem rich. Trading at an EV/Sales multiple of 10.3, an EV/EBIT multiple of 23.1, a P/E multiple of 28.5, and a FCF multiple of 25.9, Adobe’s stock is trading at a significant premium to the S&P 500. The FY2 PEG ratio is 1.8, a 20.5% premium compared to the S&P 500’s PEG ratio of 1.5. These figures underscore the market’s high growth expectations for the company.
Conclusion
In summary, Adobe’s Q2 results and the subsequent raise in FY23 guidance underline the firm’s operational strength and adaptability, even in the face of macroeconomic challenges. The firm’s investments in AI, with Firefly, Generative Fill, and Generative Recolor at the forefront, present opportunities to broaden the user base and monetize their product offerings further. Yet, the uncertainty surrounding the pending Figma acquisition, currently under regulatory review, creates a layer of ambiguity in Adobe’s short-term trajectory.
On the financial front, while Adobe has showcased robust financial health and solid growth projections, its valuations seem quite stretched at current levels. Its share repurchase strategy, high margins, and strong cash flows speak to an efficient operational model. However, the company’s metrics, such as its EV/Sales and P/E multiples, imply a significant premium to the broader market, suggesting high investor expectations.
Considering these factors, we assign a Neutral rating to Adobe. The company’s strong performance and innovative strides in AI underline a positive growth trajectory, but the regulatory uncertainty surrounding the Figma acquisition and high valuation multiples warrant a degree of caution. As such, investors should monitor ongoing developments and consider their risk tolerance and investment horizon when making decisions regarding Adobe.
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