Adobe Stock: Generative AI Software (NASDAQ:ADBE)

Adobe (NASDAQ:ADBE) is a leading software company that invests heavily in developing new AI tools that increase the productivity and efficiency of users working in the digital space. Adobe reports double-digit revenue growth in its two the most important segments, Digital Media and Digital Experiences, and the company has launched new products such as Firefly or Acrobat AI Assistant to make its products more attractive to users. Adobe is set to benefit from the overall growth of the generative AI software industry and has a broad product set to call on to leverage the power of new AI technologies. Adobe’s business is high margin and free cash flow is on an upward trend!

Double-digit revenue growth (subscriptions), high-margin business model

Adobe is best known for its catalog of productivity and creation tools, including: like Photoshop, Premiere, and Lightspeed, which have become household names in the creative industry. The beauty of the company’s business model and product suite is that Adobe collects an overwhelming portion of its revenue in the form of subscriptions. These subscriptions tend to be recurring and, as a result, generate a very high level of revenue and cash flow predictability for Adobe. In its fiscal second quarter (ended May 31, 2024), Adobe generated $5.31 billion in revenue, up 10% year over year. Of that $5.31 billion in revenue, 95% ($5.06 billion) came from subscriptions alone.

Adobe’s business is divided into three business segments: Digital Media, Digital Experience, and Publishing. In the first segment, Digital Media, Adobe is consolidating its Document and Creative Cloud services. Digital Media services include Adobe Firefly, a generative AI tool that can help creators, for example, populate images with AI-generated content. It therefore promises creators and agencies significant productivity gains by using automated image creation tools. This segment, not surprisingly, increased revenue by 11% year over year to $3.83 billion in Q2’24 and had the highest share of subscription revenue (76%).

Adobe’s Digital Experience segment provides insight into data and supports user workflows. This segment generated $1.33 billion in revenue (24% of subscription revenue), significantly less than Digital Media, but still saw 9% revenue growth. The last segment, Publishing and Advertising, generated $74 million in revenue and is not as important to Adobe.

Adobe is capitalizing on the rollout of new AI tools that are still somewhat in beta, such as Adobe Firefly. This tool is part of the Adobe Creative Cloud and is a generative AI software tool that has huge applications in creating photorealistic images. For example, Adobe recently introduced its Firefly Image 3 Model, which enables Generative Fill, Generative Remove, and Text-to-Image features to increase productivity in image creation and editing. Since AI clearly offers huge productivity gains for creators and simplifies workflows for digital marketing agencies (for example), the introduction of AI image creation tools could make Adobe’s core product suite much more attractive to users in the future.

In addition to catalyzing continued revenue growth through the introduction of AI products, Adobe has a very profitable software business. The software company has benefited from a strong, multi-year growth trend in gross profits as well as margins.

Strong Free Cash Flow Trajectory

Adobe’s high-margin software business, which is built on a small number of high-performance productivity tools, is posting strong free cash flow, and I think tools like Adobe Firefly promise such significant productivity gains for creators that Adobe is poised to accelerate product adoption in the future. Adobe generated $1.9 billion in free cash flow last quarter and is buying back a ton of its own stock (as you can see below).

In March, Adobe’s Board of Directors approved a $25 billion share repurchase. Adobe has entered into a number of accelerated share repurchase agreements with financial institutions, and the software company has repurchased 7.7 million shares. I expect Adobe will continue to repurchase more shares in the future and potentially exhaust its share repurchase authorization well before it expires (March 14, 2028).

Adobe Company Valuation

Adobe is an AI software company focused on productivity, so it can be compared to Microsoft (MSFT) or Salesforce (CRM). Adobe is currently trading at a price-to-earnings ratio of 28.1X, and its software business saw renewed growth following a well-received fiscal second-quarter earnings report in June that showed healthy revenue growth as well as strong subscription growth, particularly in digital media and digital experiences.

Over the long term, Adobe expects earnings per share to grow 17% annually, compared to 19% for Salesforce and 14% for Microsoft. While I think Adobe is a good bet in the generative AI software market and like the company’s Adobe Firefly product as a conversion magnet, Salesforce also represents a very deep value: Salesforce shares fell sharply after its recent earnings report, which I saw as a unique opportunity to double down on the CRM app vendor given its deep earnings value.

Adobe is trading slightly below its 3-year average P/E of 28.4X, but the introduction of AI-specific products could make the company’s core product suite much more appealing to users in the future… so I see catalysts for continued revenue growth here. For these reasons, I think Adobe, while not cheap, has the potential to re-price.

In my view, Adobe could be valued at 30.0X forward earnings given double-digit EPS growth, strong profitability (based on gross margins and free cash flow), and AI catalysts: 30.0XP/E implies a fair value of $617. This is a dynamic number and may change based on Adobe’s subscription revenue and free cash flow dynamics going forward.

Adobe Risk

Adobe is a software game that has a unique suite of products in the market that are aimed at the creative sector. As such, Adobe sees a very high percentage of recurring revenue from subscriptions, primarily in digital media. In my opinion, this drastically reduces the risk. However, what I see as a risk is the emergence of new imaging tools that may be better than Adobe Firefly. While Firefly offers Adobe a huge opportunity to enhance its existing suite of products for users, Adobe is not alone in investing in generative AI imaging software. If Adobe is surpassed in its AI imaging technology, the catalysts discussed in this article may not be realized.

Final Thoughts

Adobe is seeing double-digit revenue growth, including in the subscription segment, which is primarily driven by Digital Media and Digital Experiences. What I like about a software company is that 95% of Adobe’s revenue comes from subscriptions, and Adobe also has a high-margin business. The free cash flow trajectory is encouraging, and the company is buying back a ton of its own stock. Adobe is currently trading at a P/E of 28.1X, which doesn’t make it a bargain, but I see continued upward momentum in revaluation as the company leverages its current AI product strength!