(Disclaimer: Excel file attached below the post)
Adobe (ADBE) recently reported its FY '23 results, and being that I am an avid user of Adobe products, I wanted to look at its operations, history, and the future. This valuation will be slightly different than my prior works because instead of valuing the company simply through DCF, I decided to analyze and predict its financial statements and let them drive my valuation. I will stick to my tradition of first reviewing the stock performance, then going over the company's segments and mulling over its operational history and performance, and finally moving on to valuation coupled with sensitivity and statistical analysis of my findings.
Adobe- Overview
My typical approach to any valuation- for a publicly traded company- is to look at the stock performance over the past decade, and judge how prone the equity is to the broader market and the macro fluctuations, and as such, here is Adobe's stock performance for the past decade along with its trading volume.
As is observable from its performance over the past decade, Adobe has seen steady and predictable growth from FY '13 to FY '20, but since the breakout of the pandemic, the story has been anything but predictable. The stock went through its ups and downs during the last three years, but these ups and downs have mainly been in line with the broader market. One more thing that stands out is its exponential growth over the last one year alone; it went from around $300/ share at the end of '22 and the beginning of '23 to almost $580/ share at the time of this post. Why the drastic growth? Well, that can be majorly attributed to the generative AI mania among other factors. In order to further understand Adobe's performance and past operational history, I think we should move on to its history and look at all of its products, offerings, and services.
Offerings
Adobe was founded in '82, and incorporated in California in '83; it was later reincorporated in Delaware in '97. Adobe is one of the largest and most diversified software companies in the world. It offers products and services that are vastly used by creative professionals, including photographers, game developers and designers, and content creators to name a few. The company reports subscription revenue in three segments: Digital Media, Digital Experience, and Publishing and Advertising.
The Digital Media segment offers products, services, and solutions that enable individuals, teams, and organizations to create, publish, and promote their content. The segment is centered around Adobe Creative Cloud and Adobe Document Cloud. Adobe Creative Cloud is a subscription based service that allows its users to utilize Adobe's Cloud services along with its other creative products. Adobe Document Cloud is a cloud based document services platform that integrates Adobe's PDF technology with its Acrobat and Acrobat Sign applications to integrate and deliver a smooth flow of documents.
Digital Experience side of the business provides an integrated platform that enables brands and organizations to not only create, but also manage, monetize, and optimize customer experiences. The company provides data insights, analytics, and various other tools that help businesses and organizations attain and retain consumers through superior and frictionless experience. Lastly, Publishing and Advertising segment contains legacy products and services that are majorly used in the publishing and advertising market space. The company generates revenue in Publishing part of this segment by licensing its technology to OEMs; and through usage-based offerings for its Advertising part of the segment. Enough with words, following is a snapshot of Adobe's past decade.
Adobe's Historical Financials
Adobe's revenues have grown from $2.9B in FY '09 to $19.4B in FY '23, at a CAGR of 14.42%. As is evident from the image above, revenue growth has not been steady. There have been years when Adobe put up double digit growth, but then there have also been instances when its revenues shrank, e.g., -7.9% in FY '13. Moving on to its operating income and margins, despite its unpredictable growth in revenues, its operating margins have surprisingly been steady and in double digits. Upon further scrutiny, its margins are vividly beyond standard for its industry; this could be because of its competitive advantage, its elongated operational history, competent management, brand, and due to its first mover advantage in most its products and services. Furthermore, Adobe had Net Income of $386M and net margins of 13% in FY '09; the company has managed to increase its Net Income at a CAGR of 21% to $5.4B in FY '23, yielding a net margin of 28%. For the kindred spirits that enjoy graphs and charts, below is a graphical representation of its revenues, operating income, and margins.
Valuation
Income Statement
The first logical step in my valuation was assessing Adobe's Income statement. I do not have access to paid data platforms and so I will only look at the last four years of historical data and, with the understanding of the company's business and operations, try to project out the next five years. Historically, Adobe's revenues have grown from $12.8B in FY '20 to $19.4B in FY '23. Adobe reports subscription (comprised of Digital Media, Digital Experience and Publishing and Advertising), products, and services revenues on its income statement, with subscription revenue accounting for the bulk of the revenues; $11.6B (90.4% of TR), $14.5B (92.3% of TR), $16.3B (93.1% of TR), and $18.2B (94.2% of TR) in FYs '20, '21, '22, and '23, respectively.
Adobe divides its cost of revenues in line with its revenue segments; cost of revenues consist of costs for subscription, product, and services and other revenues. Cost of subscription, for obvious reasons, is the bulk of its total cost of revenues; subscription costs have been around 10% of subscription revenue for the observed period. Costs of product were 7.1% of the product revenue in FY '20, and 6.3% in FY '23. Lastly, cost of services and other was 78.6% (FY '20) and 75.6% (FY '23) of the services and other revenue. Adobe has additionally put up gross margins around 85% for the last four years. The company also has other operating expenses such as research and development, sales and marketing, and general and administrative; all of which have been hovering around 53% of TR for the last four years. Another notable thing here might be the cheapness of Adobe's debt as its interest expense was $116M (FY '20) and $113M (FY '23), cheap if you compare the interest expense paid to the total amount of debt which in FY '23 was $3.6B. Moving on to shareholder's equity, big items that stand out have been Adobe's retained earnings and its share repurchases; the company has clearly been returning cash back to its shareholders through its share repurchase program (which in FY '22 was $6.5B, 120% of its NI).
Adobe's Income Statement
For the future, in my base case, I expect Adobe's subscription revenues (consist of Digital Media, Digital Experience, and Publishing and Advertising) to grow from $18.3B in FY '23 to $34.8B in FY '28, driven mainly by the fact that we live in a world where content creation, promotion, and designing is rapidly increasing by the day, and also the fact that Adobe's Creative Cloud coupled with its Document Cloud- along with a variety of other products and services- provides individuals, teams, and organizations with a synchronous and frictionless experience, an experience that is truly one of a kind. I also expect its subscription revenues to increase due to its dominance within the customer experience and retention space; the company offers myriad of products and services to companies and organizations that allow them to improve and enhance their customer experience, retain consumers, and also to expand their customer base; with consumers being the end goal of every company in existence, I expect Adobe will not only manage to maintain its current customer base within this space, but also find new avenues of growth through either acquisitions, or inflation of its customer base through its pioneering technology, brand name, and its place in the industry. I also expect Publishing and Advertising to contribute a 2% growth by the end FY '28, moderately increasing from $123M in FY '23 to $131M in FY '28. Furthermore, I expect its Product revenues to be a slightly lower part of its overall revenues, decreasing from being 2.4% of TR in FY '23 to 1% of TR by the end of FY '28. Product revenue is comprised primarily of fees related to licensing of its software to OEMs and other partners on a perpetual or fixed basis; as a result, I expect the company to maintain its current operations within this segment, but I do not see a significant growth in this part of the business. Last leg of the revenues, I expect its Services and Other revenue to increase from $665M in FY '23 to $725M in FY '28. Services and Other revenue is primarily made up of fees related to consulting, training, maintenance, and support for its licenses as well as its advertising offerings. To bundle it all together, in my base case, I expect Adobe's revenues to grow from $19.4B in FY '23 to $35.9B by the end of FY '28. Finally, given the growth that I am expecting in its business and operations, I expect its costs of revenue (cost of subscription, product, and services and other) to increase from $2.4B in FY '23 to $4.05B in FY '28.
Balance Sheet
Adobe's Balance Sheet
The company is known for having a significant amount of cash and cash equivalents on hand. Adobe's cash and cash equivalents have increased from $5.8B in FY '21 to $7.8B in FY '23; one thing to note here is the fact that the cash balance has not increased in line with the cash the company generates from its various activities and that is because the company uses a significant chunk of its cash balance to buyback its shares. Its total assets have also increased from $27B in FY '21 to $30B in FY '23. Its liabilities, including both current and non-current, have also increased from $12.4B in FY '21 to $13.2B in FY '23. One last thing to highlight here would be the fact that its treasury stock has been significantly increasing over the last three years; it went up from being $17.3B in FY '21 to $28.1B in FY '23- again, underlining its rampant pace of buying back its shares.
Adobe's Cash Flow Statement
I am not privy to the management's plans for the future and so I project out some significant line items on the balance sheet, but most of them have been straight-lined. I do not know if the company is planning on raising more debt down the road, perhaps to roll over some existing debt or maybe even to raise more for other purposes, and so I have carried its existing debt of $3.6B in to the projected years. I expect its retain earnings to increase from being $33.3B in FY '23 to $75B in FY '28, driven by growth in its operations and the consequent increase in its NI for the projected years. As is evident from its cash flow, the company generates a healthy amount of cash flows and so I expect the company to continue to buy back its shares; I have gradually decreased the share repurchases as a percentage of NI from 120.7% in FY '23 to 100% in FY '28, essentially what I am trying to say here is that the company will be using 100% of its NI to buyback its float, thus increasing its share price and EPS. Adobe does not pay dividends.
Corporate Life Cycle
One last pit stop before the valuation town is to look at the corporate life cycle and where the company is in the cycle.
DCF Valuation
With a deep understanding of its operations, products, offerings, and services, and a well thought-out projection period, let us now move to the Discounted Cash Flow analysis.
DCF Analysis
As stated at the beginning of the post, I have extracted the required information for the DCF analysis from our prior work on the Income Statement and Balance Sheet. Line items such as revenues, operating income, capital expenditures, depreciation and amortization, and changes in NWC have been brought in from other sheets in the workbook. Additionally, I calculated its WACC to be 10.98%, its net debt to be $-3.7B, and expect its growth rate to be 3% in perpetuity. Given my projections and assumptions, I get an enterprise value of $131.7B, which given its diluted shares outstanding of 465.60M, yields a price per share of $290.90; the stock was trading at $573.15 a share at the time of the post.
Sensitivity
I think the next step- in order to further justify my valuation and to better understand why its trading at almost double the price per share- is to do some sensitivity tests and also look at other statistical analysis.
Image 1
Image 2
Image 3
Image 1 shows the price per share at various long term growth rates and WACC. Image 2 shows implied equity value given differing WACC and long term growth rates. Image 3 is the one that I'd like to spend a few seconds on. Image 3 shows the price per share if we sensitize revenues and the operating margins in the final year. As I mentioned before, the stock at the time of this post was trading at $573.15, and in order to justify that price, Adobe needs to generate $62.7B in revenues and attain margins of 54.4% by FY '28; I simply do not see the company achieving that. I understand that the recent rise in price per share is because of the entire mania surrounding generative AI, but I do not think that AI will help the company increase its revenues from $19.4B in FY '23 to $62.7B in FY '28. Furthermore, I believe that given the stage of the corporate cycle that the company is in, AI will only go as far as to help the company manage and maintain low to mid double digit growth. To further solidify my thesis, I also ran a Monte Carlo simulation, and the image below highlights the distribution of values around the mean, which in this case would be my implied share price.
Conclusion
As with any valuation, this is all based on my assumptions and hypothesis. Some might agree, others might vehemently disagree, and I am content with that, and if you believe AI will contribute enough where Adobe will generate $62.7B in revenues yielding margins 54.4%- therefore justifying its current trading price- kudos to you; I for one, do not see that being a possible outcome. As always, I have attached the excel file below, feel free to plug and chug your assumptions. Until next time!
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