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Adobe Delivers Solid Results While Keeping the Big Picture in Focus; FVE Up to $500 Adobe Delivers Solid Results While Keeping the Big Picture in Focus; FVE Up to $500 Dan Romanoff Equity Analyst Analyst Note | by Dan Romanoff Updated Dec 10, 2020 Wide-moat Adobe reported strong fourth-quarter results, including upside to consensus for both revenue and non-GAAP EPS, and provided quarterly guidance that was ahead of Street expectations, but included an extra week along with the Workfront acquisition. Normalizing for these items, we believe the full-year revenue outlook is in line, while EPS is slightly better than expectations. In conjunction with its earnings release, Adobe also provided its annual investor day presentation, which contained some incremental data points but no big surprises. The company did authorize a new $15 billion share buyback plan. New customer engagement levels remained robust and activity on adobe.com remains elevated as a result of the extended remote work environment. We think results and the investor day combine to support our investment case that Adobe will continue to dominate the creative segment, and its well-rounded portfolio, including Magento and Marketo, position the firm as a digital marketing leader. Given results and guidance, in conjunction with advancing our DCF a year, we have included higher growth throughout our forecast and are therefore raising our fair value estimate to $500 per share, from $400. As such, we see shares trading at a modest discount to our fair value. Fourth-quarter revenue grew 14% year over year to $3.424 billion, compared with CapIQ consensus of $3.365 billion. Digital Media was $45 million ahead of our model and drove most of the upside. Advertising was moved from Digital Experience to Publishing, so direct compares are challenging, but we calculate that both of these segments also ahead of our model. Net new digital ARR was $548 million, versus guidance of $540 million, a slowdown from much stronger upside recently but still solid. Document Cloud (within Digital Media) was strong in the quarter and we note that Adobe Sign was more directly discussed this year beyond smaller mentions in the past. Not surprisingly, Magento was also strong. Business Strategy and Outlook | by Dan Romanoff Updated Dec 10, 2020 Adobe has come to dominate in content creation software with its iconic Photoshop and Illustrator solutions, both now part of the broader Creative Cloud. The company has added new products and features to the suite through organic development and bolt-on acquisitions to drive the most comprehensive portfolio of tools used in print, digital, and video content creation. Adobe’s creative strategy has evolved from point solutions, to the bundled Creative Suite, to the Creative Cloud, which is now offered exclusively via a subscription model. The benefits from software as a service are well known in that it offers significantly improved revenue visibility and the elimination of piracy for the company, and a much lower cost hurdle to overcome ($1,000 or more up-front, versus plans as low as $10 per month) and a solution that is regularly updated with new features for users. CEO Shantanu Narayen provided Adobe with another growth leg in 2009 with the acquisition of Omniture, a leading web analytics solution that serves as the foundation of the digital experience segment that Adobe has used as a platform to layer in a variety of other marketing and advertising solutions. Adobe benefits from the natural cross-selling opportunity from Creative Cloud to the business and operational aspects of marketing and advertising. On the heels of the Magento and Marketo acquisitions in the second half of fiscal 2018, we expect Adobe to continue to focus its M&A efforts on the digital experience segment. The Document Cloud is driven by one of Adobe’s first products, Acrobat, and the ubiquitous PDF file format created by the company, and is now a $1.5 billion business. The rise of smartphones and tablets, coupled with bring-your-own-device and a mobile workforce have made a file format that is usable on any screen more relevant than ever. Adobe believes it is attacking an addressable market greater than $147 billion. The company is introducing and leveraging features across its various cloud offerings (like Sensei artificial intelligence) to drive a more cohesive experience, win new clients, upsell users to higher price point solutions, and cross sell digital media offerings. Economic Moat | by Dan Romanoff Updated Dec 10, 2020 For Adobe overall we assign a wide moat, arising from switching costs and network effects. Based on the company’s segments, we believe digital media has a wide moat from switching costs and network effects, digital experience has a narrow moat arising from switching costs, and publishing has a narrow moat from switching costs. Digital media represented approximately 70% of revenue in fiscal 2018. This segment contains Creative Cloud, which was approximately 59% of revenue in fiscal 2018, and Document Cloud, which was approximately 11% of revenue in fiscal 2018. While both product groups generate strong revenue growth, growth in Creative Cloud is materially higher. Creative Cloud is composed of the iconic products Photoshop, Premier, Illustrator, InDesign, After Effects, Fireworks, XD, and Dreamweaver, among others: a variety of mobile versions of these products and additional discrete mobile solutions; and consumer-targeted Photoshop Elements and Premiere Elements. Document Cloud consists of the Acrobat family of products, including Scan and Sign. Since its introduction in 1989, Photoshop quickly became the industry leader and eventually the industry standard for image editing software. Rather than remaining complacent, Adobe has consistently invested in the solution, introducing new features and adding applications that could be sold to existing users of Photoshop. These features and products were both internally developed and as a result of acquisitions. Notably, Fireworks and Dreamweaver came from the 2005 Macromedia acquisition, while InDesign and PageMaker came from the 1994 acquisition of Aldus. Over the years, Photoshop, Illustrator, Premier, InDesign, and After Effects were the company's most popular products, and beginning in 2003 were available as the Creative Suite bundle. While that bundle no longer exists, we believe these same products drive the bulk of demand in Creative Cloud. Other products serve more specialized needs or tend to be in more emerging technology areas within graphics, such as 3D illustrating. The high switching costs moat source is the primary driver of the wide moat surrounding Creative Cloud. While there is a wide variety of competitive products, Adobe Creative Cloud is so pervasive within the creative world and the educational system that replacing it would be an insurmountable barrier, in our view. Further, because nearly all creative professionals use it, it makes it so all other creative professionals must use it. While the Creative Cloud has its issues, particularly premium pricing, and any one organization or freelance professional might be willing to switch, they would find it difficult to work with anybody else. Similarly, it helps ensure that when Adobe releases a related new solution it too becomes widely adopted. Creative Cloud also benefits from a network effect. By virtue of the widespread penetration of Creative Cloud, creative professionals have significant incentive to become well versed in the solutions therein. For example, Photoshop has become so ingrained in the creative world that design curriculum at major universities incorporates all critical Creative Cloud applications. As more prospective employees learn Photoshop, enterprises have even more incentive to deploy Photoshop within their organizations, perpetuating the positive flywheel effect. Further, the rapid adoption of Photoshop within the creative professions more broadly (advertising, graphics, web design, content creation, and so on) allowed Adobe to fill in adjacent needs with new products, further entrenching itself within the creative world. Because of its popularity, there are hundreds of plug-ins from third-party developers available for Photoshop alone. These add even more features to the Creative Cloud, attracting even more users. Within Document Cloud, Adobe created the portable document format, or PDF, as an evolution of its original product, PostScript. In 1990, there was no file format that was readily usable across operating system platforms, but by the mid-1990s, there were several products vying for widespread adoption. Adobe's PDF won, thanks in part to distributing Acrobat Reader for free to PC OEMs, and has become the standard. Adobe developed an enterprise Acrobat product (currently Acrobat Pro DC) as a PDF editor and workflow solution. Currently we believe there are no truly competitive solutions to the PDF file format, even if there is a wide variety of PDF editors in free and paid versions. By any measure, Acrobat Pro DC remains the gold standard in PDF editors, but it is also the most expensive solution. We believe the company's creation of the PDF file format, its first-mover advantage with Acrobat, and significant installed base have created a narrow moat based on switching costs for Adobe's Document Cloud. Digital experience represented approximately 27% of revenue in fiscal 2018. This segment contains Advertising Cloud, Analytics Cloud, Marketing Cloud, and Magento Commerce Cloud. The Magento Commerce Cloud was added with the Magento acquisition in June 2018. Adobe does not break out revenue associated with each product group within the Digital Experience Cloud but instead groups them as Experience Cloud. Adobe does not have a first-mover advantage within digital experience. Rather than building this area out organically, the company acquired its way in. Indeed, the main thrust of this segment came in 2009 when Adobe acquired Omniture for $1.8 billion. In the latest 12 months leading up to the acquisition, Omniture generated $345 million in revenue, representing 35% growth over the comparable prior period. Other more significant acquisitions in the segment have included Neolane in 2013 for $600 million, TubeMogul in 2016 for $629 million ($212 million in last 12 months, or LTM, revenue), Magento in 2018 for $1.8 billion, and Marketo in 2018 for $4.8 billion ($240 million in LTM as of June 2016 before it went private). Through acquisitions and eventual organic feature and product development, Adobe has established itself as a leader in various categories that fall under the digital experience umbrella, including digital marketing analytics, campaign management, and customer engagement, among others. We applaud Adobe’s vision and bold foray into the digital marketing space. In our view, marketing professionals prefer an independent platform for analytics and other solutions, as opposed to relying on the tools and data provided by the hyperscale Internet service providers. However, unlike with Photoshop where no serious competitive threat exists, there are a wide variety of large competitors in the various marketing analytics, campaign management, customer engagement, advertising platform, and related areas. We believe Adobe’s tightly integrated and robust platform is seen as a strong suite by the marketplace, but the space is nascent and evolving rapidly, with often blurry lines between solutions. While there seems to be an emerging leadership group containing, Adobe, salesforce.com, Oracle, and SAP, the solutions offered by these companies are not perfect substitutes for one another. Further, there are many small privately held companies that innovate and continue to provide leading point solutions with no unified platform. Adobe is clearly using M&A to bolster its position and deliver a broad suite of marketing-related solutions to companies in a digital age. We believe there are switching costs to leaving the platform, especially given the breadth of solutions the company has to offer. In our view, there is no more-comprehensive marketing platform. This approach makes sense to us in that Adobe is leveraging its already strong position within the creative professional market. We believe switching costs drive a narrow moat for Adobe's digital experience segment. While we believe in the strong and comprehensive solutions under this umbrella, we note Adobe did not create the markets involved, does not have a first-mover advantage, and does not enjoy any quasi-monopoly status with products here. Further, the company competes against other large cap software peers for marketing platforms--notably salesforce.com, Oracle, and SAP. Additionally, we believe that as a result of the explosion in demand for a more data-driven approach to marketing and advertising, there has been rapid evolution in the underlying technology, and myriad solutions for potential customers, which is why we do not believe Adobe enjoys a wide moat in this segment. The publishing segment represented approximately 3% of revenue in fiscal 2018. This segment contains the company's first product, PostScript, along with ColdFusion, the eLearning Suite, Technical Communications Suite, Type, Shockwave, and a variety of other products that do not fit well in either digital media or digital experience. We believe this segment has a narrow moat based on switching costs to support it given that many users have been using Adobe for decades. Fair Value and Profit Drivers | by Dan Romanoff Updated Dec 10, 2020 Our fair value estimate for Adobe is $500 per share, which implies a fiscal 2020 enterprise value/sales multiple of 16 times, adjusted P/E multiple of 45 times, and a 4.3% free cash flow yield. We model total revenue growth slowly decelerating from 15% (actual) in fiscal 2020 to 14% in fiscal 2025, representing a CAGR of approximately 15%. We foresee solid growth in both digital media and digital experience even as both steadily slow over time. Digital experience should benefit from increasing penetration into a $85 billion market as defined by Adobe. We believe a relatively easy cross-selling opportunity exists for the company, as creative professionals are already steeped in Adobe products. The desire to consolidate vendors makes Adobe an obvious choice to turn to for needed marketing software solutions, and the fact that Adobe’s products are strong should help initially in what we believe is a large greenfield opportunity. Within digital media, we have been impressed by Adobe’s ability to draw in new users that many did not believe existed. We believe some of this is related to piracy, which is effectively eliminated in the SaaS model. Additionally, the company has had success upselling existing users to higher price point products. We believe continued innovation, gathering new users, and upselling existing users in Creative Cloud should help drive strong growth for the next several years. We model non-GAAP operating margins increasing from 43% in fiscal 2020 (actual) to 44% in fiscal 2025 driven by improving scale in the Digital Experience segment and general operating leverage. We note that Adobe’s operating margins have already expanded meaningfully over the last five years. Changes from ASC 606 adoption and two large acquisitions in the second half of fiscal 2018 hurt margins modestly in fiscal 2019, but we expect a continued improvement over time. Risk and Uncertainty | by Dan Romanoff Updated Dec 10, 2020 We assign Adobe with a medium uncertainty rating. Adobe faces risks that vary by segment. High market share with Creative Cloud over the past 25 years means that a significant portion of high-margin revenue is at risk, however slight that risk may be, if any competitors can make inroads with new or innovative software. While the immediate financial impact would be bad, the dampening of cross-selling opportunities with digital experience would likely be worse, as digital experience represents the larger growth opportunity over the next five years in our view. Adobe is generally considered a leader in the various categories included under its digital experience umbrella. However, the company did not create any of these categories and does not dominate them the way it does with Creative Cloud (Photoshop, Illustrator, and so on) and Document Cloud (Acrobat Pro DC). Adobe has built the digital experience business largely through acquisitions. The two recent acquisitions of Magento and Marketo also pose risks, as those were on the large side for the company, despite its $125 billion market cap. Any integration missteps could cause delays in new contract signings. Further, material missteps could possibly result in substantial write-downs regarding these (or other) acquisitions. Further, while the margin structure may ultimately be lower in digital experience relative to Creative Cloud, the company has worked to improve margins over time, and we believe Adobe must continue to drive down costs and expand margins to meet investor expectations. Last, we generally model the publishing segment as modestly declining throughout our projections. This segment is largely composed of legacy products with very high margins. At this point we believe this cash cow business could be a source of disappointment if it were to begin to rapidly deteriorate, which is not contemplated in our model. Stewardship | by Dan Romanoff Updated Dec 10, 2020 We give Adobe an Exemplary stewardship rating. Shantanu Narayen joined the company in 1999 as senior vice president of worldwide product development. He was promoted to COO, and ultimately to CEO, a position he has had since 2007. Narayen has steered the company through a variety of critical changes over the years. Narayen is responsible for initially bundling Photoshop, Illustrator, and other products into what was then known as the Creative Suite in 2003. The Creative Suite was sold through 2013, when Narayen decided to steer the core creative products from a perpetual license model to a SaaS model, and the suite was rebranded as the Creative Cloud. While moving to a SaaS model was not a novel move by 2013, it had never been attempted at a company the size of Adobe. Narayen bit the bullet and accepted the ensuing revenue decline and margin crunch in fiscal 2013. After the initial hit, both growth and margins improved markedly. By fiscal 2016, margins had already rebounded to approximately the same level Adobe achieved in fiscal 2012, immediately before the shift to SaaS began. Revenue also accelerated each year from fiscal 2014 to fiscal 2017, before slowing modestly in fiscal 2018. Because of the recurring revenue, investors have grown to embrace these transitions, but that was not always the case. While the transition to SaaS was a critical shift for Adobe, the acquisition of Omniture in 2009 represented a new strategic direction for the company. Omniture was purchased for $1.7 billion and served as the foundation for what was initially Adobe Marketing and is now called the Adobe Analytics Cloud. At its core Omniture is a web analytics platform. By virtue of moving beyond content creation for creative professionals, the company expanded its total addressable market from approximately $30 billion, to more than $80 billion. Omniture served as the core of what has become the Adobe Experience Cloud, which is a collection of leading solutions for marketing, analytics, advertising, and commerce, integrated on a single platform. It also allows Adobe to sell a wide variety of marketing technology solutions into a customer base that already thinks of Adobe as the clear leader in content creation. The strategy has paid off handsomely thus far, as momentum in Experience Cloud is undeniable in a market that is loosely 2 times the size of the market for the company’s content creation solutions. Management recognizes this and has been directing M&A investment in this direction since the Omniture transaction, including large deals for Magento and Marketo in fiscal 2018. After some uneven performance early on, Narayen stepped into to personally oversee parts of the integration, which we believe improved the process. Beyond business model and strategic shifts, Narayen has been continued to shrink the share count, and is likely to continue in this regard in our view. The named executives within the proxy include Shantanu Narayen (CEO), John Murphy (CFO), Bryan Lamkin (EVP and GM, digital media), Scott Belsky (Chief Product Officer and EVP, Creative Cloud), and Abhay Parasnis (Chief Technology Officer and EVP Strategy and Growth). The company promoted John Murphy from Chief Accounting Officer to CFO in April 2018, after Mark Garrett announced his intention to retire. Cash compensation elements top out at $1.8 million, with equity compensation ranging from $7 million to $38 million. For a company the size of Adobe, we do not believe these compensation levels are problematic and that executive compensation is appropriately aligned with shareholder interests.The board consists of 11 members, with Shantanu Narayen serving as the chairman and the only truly internal board member. Officially, Adobe’s co-founder John Warnock is considered an internal board member, but he retired from his role as the CEO in 2000. Warnock was the driving force behind the formation of Adobe, with his PostScript and PDF creations, and should be considered among the true titans of Silicon Valley, in our opinion. Overall, we see no governance issues. |
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