Adobe: A Possible Generative AI Winner; Insufficient Margin Of Safety

Adobe Systems (ADBE) reported fiscal Q3 non-GAAP earnings late Thursday of $4.09 per share, up from $3.40 a year earlier.

The software company said it expects fiscal Q4 non-GAAP EPS between $4.10 and $4.15 and revenue between $4.98 billion and $5.03 billion. Analysts are expecting $4.06 and $5 billion, respectively.

The digital media segment's revenue rose 11% year on year to $3.59 billion, driven by gains in creative and document cloud sales. Net new annualized recurring revenue, or ARR, for the division was $464 million.

Digital experience saw a 10% increase in revenue to $1.23 billion, with subscription gaining 12% to $1.10 billion.

Adobe has a broad portfolio of products and is an industry leader in the graphic design space (Creative Cloud), the marketing technology space (Experience Cloud), and the PDF space (Document Cloud). In the graphic design area, Adobe's global market share is 84%, ranking first in the world. In the graphic design field of the world's top 5 products, Adobe has three products: Photoshop, InDesign, Illustrator, in the field of marketing technology, Adobe's global market share of 9%, ranked second in the world. In the PDF field, Adobe's global market share of more than 96%, ranking first in the world.

Adobe's ample cash flow allows Adobe to continue to acquire its own potential competitors and consolidate the company's moat. Adobe has made ten acquisitions in the past five years, and despite the low probability of success and some regulatory risk, Adobe has widened its moat through acquisitions over the years.2022 In September, Adobe announced that it would spend $20 billion to acquire startup Figma, thereby significantly enhancing its online collaboration capabilities.Figma is one of the fastest-growing online collaborative design software in recent years; Figma's annual revenues reached approximately $75 million in 2020, and the following year it reached approximately $75 million in revenue. One of the fastest-growing online collaborative office design software in recent years; Figma's annual revenue reached about $75 million in 2020 alone, and doubled to $150 million in the second year.

Despite Adobe's slowing revenue growth in recent quarters, generative AI is expected to be a new growth cruve . Adobe's revenue growth has slowed in recent quarters as companies cut back on digital marketing spending in the wake of the outbreak. However, Adobe is investing in new AI capabilities through the new Adobe Express and Firefly, and AI investments will set Adobe up for future growth.

More than five months have passed since the launch of the generative AI paint model Adobe Firefly. To date, Firefly has had millions of users around the world, generated more than 2 billion images, and is one of the most successful beta tests in Adobe's history. On Wednesday, Adobe announced the commercialization plan for its AIGC tool, Firefly AI: a point-based fee, whereby users consume generative points when they use the AI to create drawings, and each point corresponds to one drawing per month. Free to get 25 points to generate points, at the same time you can pay to buy additional points. At the price of a separate Adobe Firefly purchase, the price per image is about 5 cents, which is much lower than OpenAI's AIGC service DALL-E. The latter costs 13 cents per generation.

Adobe recently launched the new Adobe Express platform, powered by the generative AI of Adobe Firefly, which now has millions of users. Adobe Firefly can generate images from text, perform generative fills, apply text effects, and recolor, among other features. According to management, the current Firefly capabilities are just the beginning, with plans to extend these AI capabilities to all digital media.

Generative AI is expected to put pressure on Adobe's margins, but Adobe is more focused on growing its revenue and users. Generative AI is very expensive to run, with large models for inference and training. Adobe Firefly currently generates more than 2 billion images, but from the financial results Firefly temporarily did not cause pressure on the gross margin in the third quarter. At the earnings meeting, Adobe management said that Adobe is more concerned about its revenue and user growth than the investment and operating costs of generative AI. Generative AI is expected to put pressure on Adobe's margins in the future. Considering that adobe has plenty of cash on the books and cash flow, it is expected that Adode will be able to bear the expenses related to generative AI.

To summarize, the slowdown in Adobe's digital media business after the epidemic is likely to be temporary. Adobe's revenue growth is expected to re-accelerate as the economy recovers and Adobe increases its investment in generative AI.

Adobe has not paid a dividend in recent years, but the company spends billions of dollars on buybacks each year, returning 1.5% to shareholders annually on average. Over the past four years, the company's operating cash flow was $4.42 billion, $5.73 billion, $7.23 billion, $7.84 billion, buybacks accounted for 57%, 49%, 51%, 80% of the company's operating cash flow. The company has averaged $3.81 billion in repurchases per year over the past four years. Based on the current market capitalization of $251.67 billion, the company's annual return to shareholders is 1.5%.

The current price-to-earnings (TTM) ratio for Adobe is 49.65x. In terms of PE-Band, the current valuation is at the median level of the past five years. Considering that companies cut back on spending on digital marketing after the epidemic and Adobe's revenue growth has slowed in recent quarters (Q3 revenue growth was only 10%), the current valuation is high.

Adobe is a very high-quality creative software company, with years of consecutive double-digit revenue growth and strong cash flow after transitioning to a subscription model. Although Adobe's revenue growth has slowed in recent quarters as companies cut back on digital marketing spending after the epidemic, Adobe's revenue growth is expected to re-accelerate as the economy recovers and Adobe increases its investment in generative AI.

On balance, the company's optimistic growth outlook has been price-in by the market, and the current share price does not provide enough margin of safety, so it is recommended to wait for a better buy point.