Adobe: Too Creative?
September 18, 2022 (08:52)
Followers: 21852 / Contributor since: 2011
- Adobe has long been the absolute play in creative and design software.
- The company has undergone a successful SaaS business model change in recent yeas.
- Shares have risen and subsequently fallen, like the remainder of the technology sector.
- A huge deal for Figma raised some questions, as the resulting price action increases appeal, but does not trigger me yet.
Shares of Adobe (NASDAQ:ADBE) have seen a huge pullback over the past week as the company announced a mega-deal which was poorly received by investors. To judge the impact of the deal on the merits, it is first time to establish the thesis on Adobe ahead of the deal, to understand where we come from.
The Base Case
In December of last year, Adobe posted its 2021 results which has been a solid year by all means. The company posted a 23% increase in sales to $15.8 billion, with more than 90% of sales being derived from subscription sales after a few years of transition in the business model, a period which has now come to an end.
The company is hugely profitable with operating profits reported at $5.8 billion, that is on a GAAP basis, as after-tax earnings of $4.8 billion came in at $10.02 per share based on a share count of 481 million shares. This realistic earnings number was even understated as amortization charges totaled $0.73 per share for the year, resulting in adjusted earnings of $10.75 per share, as I am not allowing adjustments to be made for stock-based compensation expenses.
With the company holding a net cash position of $1.7 billion, the company was operating in a very strong position. With shares topping at $700 late in 2021, Adobe was valued around $336 billion. At these levels, valuations were sky-high at around 21 times sales and 65 times realistic earnings of $10.75 per share.
Since shares peaked at $700 late in 2021, share fell to the $350 mark in June this year amidst the reversal of the technology market and valuations at large. In the meantime the company continued to grow the business. First quarter sales rose 9% to $4.26 billion as GAAP earnings came in at $2.66 per share. Second quarter sales rose 14% to $4.39 billion with earnings coming in at $2.49 per share, as the company has been hit by a higher effective tax rate this year.
By mid-September, Adobe posted a 13% increase in third quarter sales, with growth being relatively solid despite the concerns about slower economic growth and the impact of a stronger dollar. So far this year earnings came in at $7.57 per share, twelve cents ahead of last year, with the modest advancement being the result of a higher effective tax rate.
With 469 million shares trading at nearly $400 now, the company is awarded a $187 billion equity valuation, for a $186 billion valuation if we factor in net cash. With revenues trending at $17.5 billion a year, valuations come in at around 11 times sales and around 35 times realistic earnings.
These are still elevated valuation multiples as Adobe has traditionally traded at a high valuation, driven by the very strong position in a long-term secular growth industry.
A Big Deal
Adobe is not really known as a too acquisitive business, at least not with respect to very large transactions, long having demonstrated on solid organic growth. Alongside the release of the third quarter results, the company announced a huge deal. Adobe has reached a $20 billion deal to acquire Figma, split in a roughly equal cash and stock component.
The transaction will give Adobe ownership of a web-first collaborative design platform. Founded in 2012, Figma employs 850 to make design accessible for all, especially to foster design in teams settings. The company is expected to exit 2022 with an annual run rate of $400 million in annual recurring revenues, accompanied by 90% gross margins. Based on the topline sales number, that reveals that a 50 times sales multiple has been paid, all while Adobe´s multiple has fallen from about 20 times to 11 times over the past year.
These sales multiples are large as financing costs on the deal most certainly imply dilution (although not quantified), confirmed in the statement that non-GAAP adjusted earnings per share accretion is only seen in year three. The question is how quick and far the business will grow. Adobe has stated that ARR is seen at $200 million in the fiscal year 2022, and with an exit rate of $400 million, that suggests that the business is showing very strong growth.
Note that investors have real doubts on the deal. Adobe´s shares traded at $400 at the start of the week and ended at $300, with shares down $60 upon the announcement of the deal. This makes that the valuation of the firm has fallen between $28 and $47 billion this week, depending on if we consider a $60 or $100 price decline, with these value declines coming in excess of the value of the deal.
Assuming that some modest dilution will be seen, I still see earnings per share trending above the $10 mark, albeit that some debt has been incurred, as valuation multiples have compressed to roughly 30 times earnings.
Right now there are any moving targets. For starters, it is my personal opinion that shares of Adobe have been overvalued from the start, even after the pullback seen so far this year. The immediate reaction in response to the deal announcement seems like an overreaction, as the decline in the valuation far exceeds the deal tag.
The deal is very rich at “2021” or higher multiples, yet perhaps Adobe has feared the competitive impact on its core business from this emerging competitor, or it believes that it really can grow the business under its ownership in a stronger way. Some more color on the growth trajectory of the business would have been really helpful, as ambiguity has made investors understandably cautious in an uncertain environment.
On the other hand, Adobe has been an incredible value creator, and very dangerous company to bet against. Amidst all of this I think that valuations have improved and appeal consequently as well, although questions on the deal can be asked and valuations are still quite demanding. Hence, it is too early for me to go bottom picking just yet, as we are finding ourselves in rocky markets, albeit that any substantial further pullback from here could rather soon reveal potential appeal.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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