Clay Finck (03:09):

Fun fact about Adobe. According to the company’s website, about 90% of creative professionals use Adobe workshop, which says a lot about the value they are providing to customers. In general, when I think about software as a service companies, I think of a lot of positive things. Companies like this tend to have a very asset-light balance sheet, meaning that they probably don’t have a lot of physical assets that they need to purchase or invest in. And the company probably has a lot of recurring revenues, which can be a great business model for a company like Adobe. They can build out the software product one time and each additional customer they add just has really high profit margins. The profit margins on that customer will be just really high for the many years ahead. And the maintenance costs are spread out across a high number of customers, which really is beneficial for a software as a service company.

Clay Finck (03:59):

Recurring revenues are also great because the customers automatically charged for the service they are being provided. To use myself as an example, I use an Adobe product to edit my podcast. I purchase their annual subscription. Each year I will be automatically billed for their service. This means that since the majority of their revenues are recurring, they don’t have to continually sell to new customers as their existing customers tend to stick around and keep purchasing their products. So the market is going to value a company like Adobe very highly because those subscription revenues are likely to stick around for quite some time.

Clay Finck (04:34):

Years ago, Adobe sold licenses for their products so you only had to pay once and you had the software really forever. Then they would release a new version of the software with many improvements, and then you had to go buy the new version. They have been moving away from this model to a subscription model. And now, most of their sales are from subscriptions. To help illustrate how powerful a software as a service company can be, Adobe’s gross margins over the past 12 months are a whopping 87%. This gives them plenty of room to deliver long-term value to shareholders through the reinvestment in new products, spending on marketing to acquire new customers, as well as whether through economic downturns when the ability to race capital becomes pretty difficult.

Clay Finck (05:17):

In analyzing Adobe, I be using Adam Seessel’s framework for analyzing companies that he outlines in his book Where The Money Is. He uses what he calls a BMP checklist, which stands for Business, Management and Price. So I’ll walk through each of these items. Starting with the business side, we want to invest in companies that have a low market share of a large and growing market with a clearly identifiable competitive advantage that will allow the company to grow sales and profits for the many years to come. Now, the number one thing we want to look for in a company from a businesses perspective is for the company to have a strong moat. Now, Adobe probably doesn’t have as strong of a moat as Alphabet, but I believe that a strong moat is still there for Adobe. They don’t have the network effect aspect of their business that some of the larger big tech companies have.

Clay Finck (06:05):

My friends don’t see the value in getting Adobe editing software just because I have it. What they do have though is high switching costs. As people purchase Adobe software, they get used to using it. And if they were to switch to a competitor, they would need to take all this time and energy to learn the new software. It’s just a big headache and oftentimes not really worth that cost. So the only reason they would lose customers to a competitor if it was offered at a drastically lower price or that product is just far superior to Adobe’s. I believe that the brand that Adobe has built is also extremely valuable and adds to the moat they have. If you search for a specific software product that Adobe offers and you found two services and compared them side by side, you’d probably choose Adobe because they’re the largest and established player that we all know well and you’re pretty sure it’s going to provide a product that is going to give you what you need.

Clay Finck (06:59):

One concern I have with Adobe is their pricing power. I’m not exactly sure what is stopping a competitor from either offering a similar product at a lower price, or even offering a similar product for free. I’m much more comfortable with stating the fact that Google Search isn’t likely to be disrupted anytime soon because the customers use their product for free. But currently, the price of Adobe’s products are justified because of how much value the users and businesses receive in using their products as revenues have continued to march upward over the lifetime of the company. One thing is certain, and that is that the world is going digital. Adobe provides so much of the foundation for businesses that need to operate in a digital world.

Clay Finck (07:41):

So the business side looks pretty good for Adobe. Let’s move on to look at the management. Now, in assessing management, they have a really strong balance sheet with very little long term debt, which is always a good sign. Return on invested capital is also very high as the five year average for them is 24%, much higher than many other companies. And very, very good to see from a company we’re analyzing. High return on invested capital tells me that management is effective at taking capital and reinvesting it back into the business in a productive manner. It also tells me that Adobe is just a really good business and management has a really good business in their hands as they are just working with a cash making machine for investors. Insider ownership is also something you’d like to see from the executive team. It looks like the insider ownership is roughly 0.2% of outstanding shares or roughly $400 million. On a percentage basis, that’s not very high, but because the company is just so large, the dollar amount is acceptable from my perspective.

Clay Finck (08:43):

Management has been returning some capital to shareholders via share buybacks as the shares outstanding have declined from roughly 491 million shares to 472 million since 2018 18. This is roughly a 4% decline in the share count. Back in December 2020, management actually approved a share repurchase plan of $15 billion in shares through 2024. So that’s really good to see as well. I’m not seeing any serious red flags when it comes to the business in the management in particular. However, the price of the company today might lead some investors astray. Today, Adobe is trading at around $440 per share with a market cap of 205 billion, which is roughly 36% off its all time high of $688 per share.

Clay Finck (09:32):

Since it’s IPO, the stock has been a consistent outperformer relative to the S& P 500. Over the past five years, Adobe has achieved an average annual return of 24.4% while the S&P 500 has had an average annual return of 12.0%. Seeing that consistent outperformance over time is definitely something I love to see because trying to pick a losing stock and predicting that it’s going to turn into a winner is something that’s very difficult for me, at least.

Clay Finck (10:00):

Adobe is also a key component of the Nasdaq-100 as it’s the 12th largest holding in the index and has a 2% waiting in the Nasdaq. Despite the recent drawdown in the stock price, the company looks to be trading at a hefty premium. The price to earnings ratio is sitting at around 43. The market is really pricing in a lot of growth ahead for the company in the future. With that, Adobe has also been a company that has really always traded at an expensive multiple. Prior to February 2020, the market cap to free cash flow ratio has generally been in the 25 to 30 range since 2017. After COVID, it rose all the way to 48. And today it’s all the way back down to 26. So relative to its recent history, the current multiple is definitely within historical standards.

Clay Finck (10:50):

Despite the contraction in the stock price, the business is actually still growing. The most recent quarter had nearly $4.4 billion in revenue, which is a 14% increase year over year for the quarter. And the operating income was 1.5 billion, which was up almost 9% year over year. Management expects the company’s revenue to grow 14% over the next year and earnings per share to grow roughly 7% next year.

Clay Finck (11:15):

If you guys tuned into my intrinsic value analysis of Alphabet a couple weeks ago, you know that the expected return I calculated for Alphabet was 9.9%, which I expect to be a good amount higher than what we’ll find for Adobe due to the difference in the multiples of the two companies, but we’ll see what we end up calculating here for Adobe. When pulling up the intrinsic value calculator in TIP Finance, we’ll first need to determine an expected growth rate of their free cash flows for Adobe over the next 10 years.

Clay Finck (11:46):

Adobe’s revenues have grown at an average rate of 21.9% over the past five years, and in 2021 grew by 22.7%. I expect their growth to continue unless we see a very deep recession, then I would expect the revenues to potentially even decline in the stock to really drop significantly due to the high multiple they have. Free cash flows grew at an average rate of return of 28% over the past five years, but we shouldn’t put too much weight on that as they were really starting from a low base five years ago. If Adobe is really hitting on all cylinders and is able to continue to widen their moat and fend off their competitors, I would assume that the company can grow at 14% per year over the next decade, which may be slightly optimistic at this point for how mature the business has become. But I’m going to go with 14%.

Clay Finck (12:37):

The free cash flows for the previous 12 months are $6.8 billion so I’m going to use that as our starting point for the free cash flows. Inputting those numbers into the calculator, this gives us an expected return for Adobe of 7.3%. Like I expected, it is lower than Alphabet’s at 9.9% because Alphabet is trading at a much lower multiple, but still growing at a very high rate as well.

Clay Finck (13:02):

As always, I like to tweak the assumptions and see how that changes our expected return. If Adobe were to encounter a deep recession or two over the next decade, let’s say they grow free cash flows at just 8% per year instead of the 14%, this would lower our expected return from 7.3% all the way down to 4.3%. So still growing a little bit, but not near as much as our original assumption.

Clay Finck (13:28):

And finally, I’d like to lower the market price and see how that would change our return as well. Let’s change our expected growth rate back to 14% and say that the market price actually declines by 30% from where it’s at today. So starting at $440, a 30% decline would bring it down to $308. This would increase our expected return from 7.3% to 10.4%. So assuming that the competitive advantage and business position stays intact for Adobe, long term investors should welcome any declines in the price of the stock.

Clay Finck (14:03):

For a company like Adobe, I believe it’s a company that has a pretty good chance of beating the market over longtime horizons. However, it would likely drastically underperformed during a market downturn. This is where long term investors like myself can take advantage of opportunities like what is presented with a company like Adobe today. I’m willing to weather through those economic storms in order to achieve that higher outperformance in the end.

Clay Finck (14:29):

When I compare Adobe to Alphabet, which I covered a couple weeks ago, I’d say Adobe has a little bit more risk just due to the uncertainty around the moat and how much competition Adobe is facing relative to Google. However, since Adobe is a much smaller company, this also gives them a lot more room for long term outperformance, as well as they potentially have more room to grow relative to Alphabet.

Clay Finck (14:52):

All right, that’s all I had for today’s episode. I sincerely hope you found this episode valuable and you learned something new. If you guys aren’t connected with me yet on the socials, you can find me on Twitter, @clay_finck. That’s @C-L-A-Y_F-I-N-C-K. I’m also on Instagram, @clay.finck. Feel free to shoot me a message on either of those platforms. Or if you have any feedback, I’d be happy to hear from you. And feel free to give me a follow as well. Thanks for tuning in and I hope you enjoyed today’s episode.

Outro (15:23):

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