Business model

Adobe’s high-quality business model is worth a look (ADBE)

David Tran

By the Valuentum team

Adobe Inc. (NASDAQ:NASDAQ: ADBE) is worth keeping on your radar as ADBE shares have sold off aggressively year-to-date, though its underlying business model remains rock-solid and is backed by a flawless record. Thanks to our company’s cash flow analysis process, which we’ll discuss in detail in this article, we assign Adobe a fair value estimate of $580 per share, well above the company’s current value at time of writing this article. Bearing that in mind, Adobe’s shares have come under fire as concerns over its near-term financial performance cloud its promising longer-term growth track.

Key Adobe Investment Considerations

Investment Considerations

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Adobe is one of the largest software companies in the world. The company’s flagship offering in its digital media business is Adobe Creative Cloud, which allows customers to download the latest version of Adobe Creative Suite products. The company also continues to focus on digital marketing solutions. It was founded in 1982 and is based in San Jose, California.

About 90% of Adobe’s revenue comes from recurring sources. Please note that Adobe’s fiscal year ends in late November or early December. We appreciate its potential for margin expansion and prospects for sales growth as recurring revenue continues to grow. Recurring revenue streams provide great visibility into Adobe’s future financial performance and translate into stronger cash flow profiles. Adobe continues to gain momentum when it comes to Creative Cloud subscriptions, and we like this subscription-based recurring model. Adobe Marketing Cloud is becoming a favorite among CMOs as digital marketing bookings continue to grow at a healthy pace. The company expects years of growth ahead of it.

Adobe is investing in its artificial intelligence capabilities to help its customers by providing enhanced automation features across all of its offerings. The company is well positioned to capitalize on the proliferation of e-commerce around the world, particularly through its “Adobe Experience Cloud” suite of products and services.

Financial Update and Guidance Commentary

Adobe’s cash-rich business model rejects excess amounts of capital. Traditional free cash flow (defined as net operating cash flow less capital expenditures) has averaged ~$5.6 billion over the past three fiscal years (2019-21), helping to repurchase approximately $9.8 billion of treasury stock during this period. Its asset-light operations provide significant free cash flow generation due to its relatively modest capital expenditure requirements to maintain a given level of revenue. Adobe does not pay a common dividend at this time because management prefers to invest in the company and buy back shares.

On June 16, Adobe announced results for the second quarter of fiscal 2022 (period ended June 3, 2022) that exceeded consensus high and low estimates. Its GAAP revenue grew 14% year-over-year to $4.4 billion, helped by its subscription revenue growth of 16% year-over-year in the second fiscal quarter. Adobe’s GAAP operating income increased 9% year-over-year to $1.5 billion in the second quarter of the fiscal year, as growth in its operating expenses reduced growth of his income. The company’s GAAP diluted EPS reached $2.50 in the second quarter of the fiscal year, up 7% year-over-year, as a higher provision for corporate taxes was was offset to some extent by a reduction in its number of diluted shares outstanding.

Adobe exited June 3 with $5.3 billion in cash, cash equivalents, and short-term investments versus $0.5 billion in short-term debt and $3.6 billion in long-term debt. long-term properties for net cash of approximately $1.2 billion. The company generated $1.9 billion of free cash flow in the first half of fiscal 2022 while spending a negligible amount on acquisitions and repurchasing $1.2 billion of its stock. We appreciate Adobe’s ability to generate substantial free cash flow in almost any operating environment.

However, Adobe lowered its guidance for fiscal year 2022 in its second quarter earnings update. The company now expects total revenue to reach ~$17.65 billion compared to guidance of ~$17.9 billion released during its fourth quarter fiscal 2021 earnings update. Adobe now expects to generate approximately $9.95 of GAAP EPS (vs. ~$10.25) and ~$13.50 of non-GAAP adjusted EPS (vs. ~$13.70) in fiscal 2022.

Please note that its latest total revenue and non-GAAP EPS guidance still calls for annual growth of 11% and 8%, respectively, while its latest GAAP EPS guidance calls for a slight year-over-year decline. ‘other. Foreign currency headwinds are a big reason why Adobe lowered its guidance for fiscal year 2022, keeping an eye on the strength of the US dollar seen lately. Additionally, its earnings forecast has been negatively impacted by an expected increase in its effective corporate tax rates. Additionally, Adobe’s business faces near-term headwinds from its decision to halt all new sales in Belarus and Russia. We view them primarily as special items that do not reflect Adobe’s underlying performance.

In our view, Adobe’s business model remains rock solid and its underlying growth trajectory remains intact (its revenue is expected to continue to grow at a healthy pace this fiscal year and its adjusted earnings, which removes a part of the impact of the aforementioned special items, are also expected to grow at a healthy pace in fiscal 2022). The company’s free cash flow generating capabilities are impressive, and its pristine balance sheet provides Adobe with enough firepower to buy back its shares while continuing to invest in the business. We view his stock buybacks favorably given that ADBE shares have been trading well below their estimated fair value for some time and continue to do so at the time of writing.

Analysis of Adobe’s economic benefits

The best measure of a company’s ability to create value for its shareholders is expressed by comparing its return on invested capital [‘ROIC’] with its weighted average cost of capital [‘WACC’]. The gap or difference between ROIC and WACC is called the economic profit gap of the firm. Adobe’s historical 3-year return on invested capital (excluding goodwill) is 91.4%, which is higher than its cost of capital estimate of 8.4%.

In the chart below, we show the likely trajectory of ROIC in the coming years based on the estimated volatility of the main drivers of the metric. The solid gray line reflects the most likely outcome, in our view, and represents the scenario that results in our estimate of fair value. Adobe has always been a strong driver of shareholder value and we expect this to continue to be the case over the coming years.

Adjusted return on invested capital

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Adobe Cash Flow Valuation Analysis

Cash flow generation

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Our discounted cash flow process evaluates each business based on the present value of all future free cash flows, net of its balance sheet considerations. We believe Adobe is worth $580 per share with a fair value range of $464.00 to $696.00. ADBE shares are trading below the lower end of our fair value estimate range at the time of this writing, indicating that the company’s shares are currently undervalued.

The short-term operating forecasts used in our business cash flow models, including revenues and earnings, do not differ materially from consensus estimates or management guidance. Our model reflects a revenue compound annual growth rate of 12.4% over the next five years, a pace lower than the company’s historical 3-year compound annual growth rate of 20.5%. Our model reflects a projected 5-year average operating margin of 46%, which is above Adobe’s 3-year average. Beyond year 5, we assume that free cash flow will grow at an annual rate of 6.4% for the next 15 years and 3% in perpetuity. For Adobe, we use a weighted average cost of capital of 8.4% to discount future free cash flow.

Valuation assumptions

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Rating Breakdown

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Adobe Headroom Analysis

Range of potential results

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Although we estimate Adobe’s fair value at around $580 per share, each company has a range of likely fair values ​​created by the uncertainty of key valuation factors (such as future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn’t see much volatility in the markets, as stocks would trade precisely at their known fair values.

In the chart above, we show this likely range of fair values ​​for Adobe. We think the company is attractive below $464 per share (the green line), but quite expensive above $696 per share (the red line). Prices that fall along the yellow line, which includes our estimate of fair value, represent a reasonable valuation for the business, in our view.

Final Thoughts

Adobe shares are down about 30% year-to-date, and we think the selloff is overdone. While Adobe faces a variety of short-term hurdles, from inflationary pressures to headwinds resulting from rising geopolitical tensions, the company’s long-term growth track remains firmly intact. The company is a great free cash flow generator with a healthy balance sheet, and Adobe will likely continue to take advantage of its year-to-date decline in its share price to buy back “gobs” of its stock in the future. coming. Adobe deserves to be kept on your radar as an opportunity for capital appreciation.

This article or report and any links it contains are for informational purposes only and should not be considered a solicitation to buy or sell any securities. Valuentum is not responsible for any errors or omissions or results obtained from the use of this article and assumes no responsibility for how readers may choose to use the content. Assumptions, opinions and estimates are based on our judgment as of the date of the article and are subject to change without notice.