Adobe more than justifies its valuation

The company is a pioneer of digital design, developing products that span a huge range of industries and budgets – almost all of which are sold on incredibly reliable subscriptions. And the company’s super products lend themselves to super profitability. Adobe’s return on capital employed (ROCE), which indicates how effectively money invested in a business is turned into profit, hit 25 per cent in 2019, up from 10 per cent just four years previously. Importantly, those profits are converted to cash with ease: free and operating cash conversion have both averaged more than 150 per cent in the past five years.

Adobe's quality leads its peer group

Sales, unsurprisingly, have accelerated in a world that is turning increasingly digital and the company recently booked record revenues of $3.23bn for the eighth consecutive quarter. This solid sales growth, alongside widening margins and a generous share buyback scheme, means the company has also generated compound annual earnings growth of 37 per cent over the past five years, a rate that gives Adobe a price/earnings growth (PEG) ratio of 1.3 times. 

How to build a cash flow king

Like several other Silicon Valley tech titans, Adobe was born in a garage in California. Charles Geschke and John Warnock co-founded the software company in 1982 in the same year that Apple (US:AAPL) founder Steve Jobs reportedly offered $5m for the company. 

Messrs Geschke and Warnock (who still chairs the company’s board) were right to believe that their creation did not require Apple’s financial might for long-term success. Only four years after it was founded, Adobe listed on the US stock exchange, where it now has a market capitalisation of $232bn and employs more than 22,000 people worldwide. 

But its transformation into a leading player in the US technology sector did not happen overnight. The real game-changer for Adobe came in 2013, when it switched to a subscription-based ‘software-as-a-service’ (‘SaaS’) model, making it a pioneer of what is now one of the most sought-after business models by investors. 

Adobe through the years

Even before this transition, Adobe was still delivering healthy profits through its licence model – in fact, it is one of the few tech start-ups to turn a profit in its first year on the market back in the 1980s. Admittedly, the licence model was less elegant than its successor: customers re-purchased Adobe’s software on a monthly basis through a complicated billing process. Yet even then Adobe’s capital-light operations meant that gross profit margins averaged a healthy 87.9 per cent in the three financial years between 2010 and 2012. 

But the transition to the subscription model is what jump-started Adobe’s share price, which rocketed 55 per cent over the course of 2013 alone. The shift first came at a cost to revenues – the company’s top line stumbled 8 per cent in 2013, although this may have been compounded by a customer data breach in the same year, which affected 3m customers. Even so, by 2015 revenues had not only recovered but came in 9 per cent higher than levels recorded in 2012 and are now running at about 2.5 times the 2015 level. 

Significantly, by the end of 2015, 67 per cent of the company’s revenue came from reliable, recurring subscriptions. And that proportion continues to climb, with subscription-based sales accounting for 89 per cent of the company’s top line in 2019. 

Success feeds success

Subscriptions by their nature are very reliable forms of revenue and require little expenditure to maintain. Indeed, in the three months to May 2020, Adobe’s subscription sales contributed 92 per cent of group revenue, but just 76 per cent of cost of sales. 

And so, rather than spend money on maintaining current revenue, Adobe can deploy most of its profits into capturing new revenue. Sales and marketing ($3.2bn in the 2019 financial year, or 29 per cent of sales) and research and development ($1.9bn in the same period, equivalent to 17 per cent) make up the bulk of the group's costs and these in turn drive impressive top-line growth. Sales have risen at a compound annual rate of 18 per cent in the past five years – a period that has seen operating margins tick up from 19 per cent to 29 per cent (a small slip on the prior year accounted for by acquisition activity). In the most recent period to August 2020, group operating margins hit 33 per cent.

Adobe’s operating margins have improved

Today, Adobe splits its products into three core operating divisions: Creative, Document (which together make up the Digital Media subsidiary) and Experience. The former – which includes the company’s flagship PDF, Photoshop and Acrobat products, among many others – contribute the bulk of the company’s revenue (72 per cent in the three months to August), with the remainder coming from the company’s marketing solutions, housed within the Digital Experience division. 

On the face of it, Adobe’s products are a sprawling mass, encompassing basic tools (the PDF), consumer products for hobbyist designers (Illustrator, Photoshop) and sophisticated services for elite creators (Dimension). But the suite ties neatly together: the PDF is free and used almost universally and so for businesses and individuals who require encrypted or secure document sharing, a PDF Pro account (just $15 per person per month) makes sense. And once you’re in the system, why look elsewhere? Cross promotion of the product suite is one of the reasons Adobe has managed to add more than $300m of annualised recurring revenue in each of the past eight quarters. 

The sprawling product suite and subscription model also lend themselves to innovation. Under the old licensing model, engineers had to wait for renewals to roll out software upgrades. Today they can do so on a continual basis. Meanwhile, new products are regularly bolted on either through innovation or acquisition.

Adobe’s product development centres around its focus on providing companies and individuals with tools to create, distribute and purchase digital content – a well-placed strategy in a world that has recently experienced “a tectonic shift towards all things digital”, according to the company’s chief executive, Shantanu Narayen. 

In early 2018, the company acquired Magento – an open-source platform that allows companies to design and create their own e-commerce platforms, including marketing, analytics and content creation solutions. In October of the same year, the company bought tech marketing company Marketo to give it a stronger foothold in the increasingly competitive business-to-business space. The company’s first foray into commerce has allowed it to provide customers with a full suite of services: now, if you have a product or service to sell, Adobe has all the solutions you need.

The hefty price tags for Magento and Marketo ($1.7bn and $4.8bn, respectively) were perhaps justified by the 31 per cent leap in Digital Experience revenues in the 2019 fiscal year to $3.21bn, but the timing of the acquisitions was unlucky. New commercial customers have dried up in 2020 as businesses tighten their belts to protect themselves from the economic downturn. Still, even at the height of the lockdown the division was expected to report flat 2020 revenues, which is testament to the reliability of subscription revenues in turbulent times. 

Indeed, the value of such a reliable revenue stream has encouraged management to accelerate the transition of the last remaining business that relies on lumpy licensing revenues. The company is set to stop selling Adobe Advertising licences and the products will instead be rolled into the highly profitable Adobe Exhibition subscription service. Investors should expect a brief blip in revenues as these customers are shifted to the new payment model, but if history is anything to go by, revenues should bounce back quickly in a far more reliable and profitable guise. 

Adobe's valuation compared with peers