• 9M23 revenue/PATMI was in line with expectations at 74%/76% of our FY23e forecasts. In 3Q23, revenue grew 10% YoY to US$4.9bn led by higher subscription sales of its creative software applications. PATMI rose 24% YoY to US$1.4bn driven by higher operating leverage and lower tax rate.
• For 4Q23e, Adobe expects GAAP EPS of US$3.12 on revenue of US$5bn (up 10% YoY). Net new Digital Media annualized recurring revenue is expected to be US$520mn with a modest contribution from generative AI tools. Adobe plans to hike pricing for some Creative Cloud products (Photoshop and Premiere Pro) by about 10% starting Nov. 1.
• We maintain a REDUCE recommendation with a higher DCF target price of US$441 (WACC 7.3%, g 4%), up from US$435. Our FY24e revenue/PATMI has increased by 1%/2% to account for new pricing and AI-related tailwinds. However, we believe ADBE is priced at a premium as its market cap is up about 43% or US$74bn over the last four months on an annual incremental profit opportunity of US$4bn assuming Creative Cloud revenue doubles with Firefly.

The Positives

+ Creative Cloud momentum remained robust. Adobe’s Creative Cloud business comprises 81% of Digital Media segment revenues. Creative Cloud revenue grew 11% YoY to US$2.9bn (14% YoY in constant currency). Net New Creative Cloud annualized recurring revenue, or ARR, was US$332mn during the quarter, with a total Creative Cloud ARR of US$12bn. The growth was mainly led by strong demand for its photography and video editing applications due to a surge in both the creation and consumption of digital media. Management highlighted that the company has integrated its generative AI offering Firefly into flagship products Photoshop and Illustrator, with more than 3mn beta release downloads. Key customer wins for Creative Cloud in 3Q23 include Amazon, SAP, and Take-Two Interactive.

+ Continued strength in Document Cloud. Document Cloud sales grew 13% YoY to US$685mn, accounting for 19% of Digital Media revenues. Net new Document Cloud ARR was US$132mn, exiting the quarter with Document Cloud ARR of US$2.6bn. The growth was primarily driven by continued demand for Acrobat PDF solutions across computing devices and e-signature capabilities. Management highlighted that Acrobat Web monthly active users spiked by 70% YoY led by growth in documents opened through Chrome and Edge extensions. Key customer wins in 3Q23 include Citibank, GlaxoSmithKline, and Morgan Stanley.

The Negative

- FX impacted revenue growth. Adobe generates 40% of its total revenue from international markets. The company’s revenue was negatively impacted by the strengthening of the US dollar relative to most other currencies, including the Euro, British pound, and Japanese yen. In 3Q23, FX headwind to revenue was about US$125mn (~10% of PATMI).

• 1H23 revenue/PATMI was in line with expectations at 49%/50% of our FY23e forecasts. In 2Q23, revenue grew 10% YoY to US$4.8bn led by higher subscription sales associated with its Digital Media and Digital Experience offerings. Adj. PATMI, which primarily excludes stock-based compensation expense, grew 13% YoY to US$1.8bn.
• For FY23e, Adobe raised its revenue guidance to US$19.3bn (vs US$19.2bn prior) and GAAP EPS guidance to US$11.20 (vs US$11.00 prior) taking the midpoint. The management raised its outlook on optimism that generative AI tools (Firefly) will increase demand for its creative software.
• Market cap is up about 30% or US$52bn over the last month on an annual incremental profit opportunity of US$3bn assuming Creative Cloud revenue doubles with Firefly. We downgrade to REDUCE from ACCUMULATE recommendation after the recent jump in its stock price. We increase our DCF target price to US$435.00 (prev. US$402.00) with a WACC of 7.3% and terminal growth of 4%. Our FY23e revenue/PATMI is increased by 1%/2% due to rising digital content creation and a shift to electronic document processes.

The Positives

+ Firefly beta adoption was robust. Creative Cloud sales grew 9% YoY to US$2.9bn (14% YoY in constant currency) led by booming content demand. Net new Creative Cloud annualized recurring revenue (ARR) was US$354mn, exiting the quarter with Creative Cloud ARR of US$11.6bn. In 2Q23, Adobe released a beta version of Firefly, its generative AI offering for creating content using text prompts. Management noted that Firefly-powered capabilities integrated into Photoshop and Illustrator have generated 500mn digital assets so far. While the focus remains on driving broad-based adoption, Adobe plans to publish additional information regarding AI monetization later this year. Key customer wins for Creative Cloud in 2Q23 include NVIDIA and Ernst & Young.

+ Strong momentum in Document Cloud. Document Cloud revenue was US$659mn, up 11% YoY (14% YoY in constant currency). Document Cloud ARR grew by 17% YoY to US$2.5bn, adding US$116mn during the quarter. The growth was mainly due to strong demand for Acrobat with integrated Sign capabilities across the web, desktop and mobile. Management noted that Acrobat web monthly active users grew by 50% YoY driven by an explosion of PDF consumption through Chrome and Edge extensions. Key customer wins in 2Q23 include Boston Consulting Group, Novartis, and T-Mobile.

The Negative

- Negative impact of FX. Adobe’s revenue was negatively impacted due to the strengthening of the dollar against several key foreign currencies, including the Euro, British pound, and Japanese yen. In 2Q23, FX headwind to revenue was about US$150mn (~12% of PATMI).

Outlook

For FY23e, Adobe now expects GAAP EPS of US$11.20 on total revenue of US$19.3bn (prev. GAAP EPS of US$11.00 on revenue of US$19.2bn) taking the midpoint (Figure 1). The company also bumped its net new Digital Media ARR forecast to US$1.75bn from US$1.70bn driven by product-led growth initiatives, including Adobe Express and generative AI tools. Notably, we expect AI-driven revenues to be modest in 2H23e given they are still in the early stages. Meanwhile, the company lowered its Digital Experience segment revenue forecast to US$4.88bn (prev. US$4.98bn) due to cautious enterprise buying behaviour resulting in an elongated sales cycle, additional deal approval layers and deal size compression.

For 3Q23e, Adobe is guiding for revenue of US$4.85bn, up 10% YoY, and GAAP EPS of US$2.85, both at the midpoint of its guidance. Management also guided Digital Media and Digital Experience segment revenues to be US$3.56bn and US$1.22bn, respectively.

Adobe reiterated its belief that its pending US$20bn acquisition deal of design startup Figma should close by the end of FY23e. Cash flow generation continues to be strong, with the company generating about US$2bn in Free Cash Flow in 2Q23, ending the quarter with US$5.5bn in cash and cash equivalents.

• 1Q23 revenue/PATMI was within expectation at 24% of our FY23e forecasts. Total revenue grew 9% YoY to US$4.7bn, primarily driven by a 9% rise in digital media and 11% increase in the digital experience divisions. Adj. PATMI, which excludes its stock-based compensation and acquisition-related expenses, grew 9% YoY to US$1.7bn.
• For FY23e, Adobe raised its EPS forecast to US$11.00 (vs US$10.90 prior) and maintained its revenue guidance of US$19.2bn at the midpoint. The guidance was slightly below our initial forecast of EPS of US$11.38 on revenue of US$19.3bn.
• We downgrade to ACCUMULATE from BUY with a reduced DCF target price of US$402 (prev. US$408), a WACC of 7.5%, and a terminal growth rate of 4.0%. Our FY23e revenue was nudged lower by 0.4% to reflect ongoing macro challenges as cost-cutting customers delay software license purchases, while PATMI was cut by 3% due to higher expenses. Overall, Adobe enjoys long-term tailwinds from digital transformation of paper-based processes, explosion in digital content creation and continued shift to the cloud.

The Positives

+ Demand for Creative Cloud remains resilient. Creative Cloud revenue was US$2.8bn, up 8% YoY (13% YoY in constant currency). Creative Cloud annualized recurring revenue (ARR) grew by 8% YoY to US$11.3bn, adding US$307mn during the quarter. The growth was primarily driven by continued demand for its photography, imaging and video applications due to the surge in digital content creation. Key customer wins in 1Q23 include Accenture, Disney, BBC, and Nintendo.

+ Document Cloud strength continues. Document Cloud sales grew 13% YoY to US$634mn (16% YoY in constant currency) – the fastest growth of any segment in the quarter. Net new Document Cloud ARR was US$103mn, exiting the quarter with Document Cloud ARR of US$2.4bn. The growth was mainly due to its PDF capabilities and growth in e-signature transactions within Acrobat. Management noted that Acrobat is now the default PDF viewer in Microsoft Edge, which has an estimated 1bn users. Key customer wins in 1Q23 include HP, JPMorgan Chase, Samsung, and Verizon.

The Negative

- Pressure from foreign exchange rates. Adobe’s revenue was negatively impacted due to the strengthening of the dollar against several key foreign currencies, including the Euro, British pound, and Japanese yen. In 1Q23, the unfavorable foreign exchange rate movement negatively impacted revenue by approximately US$200mn (or ~16% of PATMI).

• 4Q22 results were in line with expectations. FY22 revenue/PATMI was at 100% of our forecasts.
• Creative Cloud sales rose 8% YoY to US$2.7bn, driven by continued demand for its creative design software tools. Document Cloud sales grew 16% YoY to US$619mn due to its PDF capabilities and growth in e-signature transactions within Acrobat.
• We lower our FY23e revenue/PATMI by 4%/6% due to macroeconomic uncertainty and FX headwinds. We maintain a BUY recommendation with a reduced DCF target price of US$408 (prev. US$420), a WACC of 7.1%, and a terminal growth rate of 4.0%. Adobe enjoys tailwinds from digital transformation of paper-based processes, explosion in digital content creation and continued shift to the cloud.

The Positives

+ Strong growth across business segments. In 4Q22, revenue grew 10% YoY (14% in constant currency) to US$4.5bn, which was in line with our estimates. The growth was driven by 10%/14% YoY increases in Digital Media and Digital Experience revenues to US$3.3bn and US$1.2bn, respectively. In the Digital Media segment, Creative Cloud revenue grew 8% YoY to US$2.7bn driven by strong demand for its design software tools (Photoshop, Adobe Express, and Frame.io) from creative professionals and smaller and medium-sized enterprises. Document Cloud revenue grew 16% YoY to US$619mn due to its PDF capabilities and growth in e-signature transactions within Acrobat. Digital Experience revenue, which includes analytics and marketing software, increased by 14% YoY to US$1.2bn. Key customer wins include Meta, Deloitte, and Delta Air Lines.

+ Maintained high margins. In 4Q22, Adobe reported an impressive gross margin of 87%. This is mainly because the company generates the majority of its sales (>90%) from recurring subscription revenue. Adj. operating margin (excluding stock-based compensation expense and amortization of intangibles) was 45%, which was in line with 4Q21. Adobe generated US$2.2bn in free cash flow in 4Q22. This translates to a 49% free cash flow margin.

The Negatives

- FX continues to be a headwind. Adobe’s revenue was negatively impacted due to the strengthening of the dollar against several key foreign currencies, including the Euro, British pound, and Japanese yen. In 4Q22, FX headwind to revenue was about US$175mn (15% of PATMI). Adobe projects nearly US$750mn headwind from FX in FY23e.

• 3Q22 results were in line with expectations. 9M22 revenue/PATMI was at 74%/75% of our FY22e forecasts. Total revenue grew 13% YoY to US$4.4bn, driven by 13%/14% YoY increases in Digital Media and Digital Experience revenues.
• Adobe agreed to acquire collaborative design software firm Figma in a cash-and-stock deal worth US$20bn. The company is acquiring Figma for 50x its FY22e annual recurring revenue (ARR) of US$400mn. The transaction is expected to close in FY23e and aims to expand tools for creative professionals. We believe that the deal would take out an emerging competitor as Figma poses a potential threat standalone.
• We nudge lower our FY22e revenue/PATMI by 1% due to macroeconomic uncertainty and FX headwinds. On a standalone basis, we maintain a BUY recommendation on ADBE with a lowered DCF target price of US$420.00 (prev. US$549.00), with an increased WACC of 7.1% and unchanged terminal growth rate of 4.0%. Overall, we believe that Adobe’s long-term secular tailwinds remain intact, including paperless workflows, explosion in digital content creation and continued shift to the cloud. Completion of the Figma transaction will cause a 7% downgrade to our target price due to operating margin dilution and additional shares in the diluted share count.

The Positives

+ Document Cloud strength continues. Document Cloud revenue grew 23% YoY to US$607mn and Document Cloud annual recurring revenue (ARR) grew 26% YoY to US$2.2bn. The main growth drivers include strong demand for PDF solutions across computing devices and momentum in AdobeSign. Key customer wins in 3Q22 include Amazon, Boeing, and ServiceNow. Document Cloud is accelerating document productivity and workflows with over 300bn PDFs opened and nearly 8bn e-signatures processed each year. Adobe also announced enhancements to Acrobat web experience such as High Contrast and Read Out Loud.

+ Demand for Creative Cloud remains robust. Creative Cloud revenue was US$2.6bn, up 11% YoY. Adobe added US$330mn of net new Creative Cloud ARR in 3Q22. Much of the Creative Cloud revenue growth was supported by significant growth in new users (particularly in Creative Cloud Express) and continued momentum in growth initiatives such as Frame.io and Substance. The demand for its photography, imaging and video applications was strong due to the surge in digital content creation.

+ Resilient Digital Experience. Digital Experience revenue grew 14% YoY to US$1.1bn driven by strength in the enterprise segment with large deal wins and continued momentum for Adobe Experience Platform applications. Workfront remained strong as well with revenue growing above 35% YoY. Key customer wins include T-Mobile, Morgan Stanley, and Qualcomm.

The Negatives

- Acquisition of Figma is expensive and dilutive. Adobe has signed a definitive merger agreement to acquire collaborative design software firm Figma for US$20bn. The deal values Figma at almost 50x its FY22e ARR of US$400mn. Adobe noted it could lower margins by 100-200 bps over the next two years. Management also expects the deal to be accretive to adjusted EPS only at the end of year three (FY26). The transaction will be funded by 50% cash and 50% stock, and is expected to close in FY23, subject to regulatory and shareholder approval.

Outlook

For 4Q22e, Adobe expects GAAP EPS of US$2.44 (adj. EPS of US$3.50) on total revenue of US$4.52bn. Adobe also expects Digital Media net new ARR of US$550mn for 4Q22e driven by price increases at renewals in both Creative and Document Cloud segments. Additionally, the company expects revenue growth of 10%/13% YoY in the Digital Media and Digital Experience segments. While acquiring fast-growing Figma may boost Adobe’s growth rate and give it a competitive advantage, the huge acquisition price is expected to have an impact on profitability.

• 2Q22 results were in line with expectations. 1H22 revenue/PATMI was at 48% of our FY22e forecasts. Total revenue grew 14% YoY to US$4.4bn, due to 15%/17% YoY increases in Digital Media and Digital Experience revenues.
• Creative Cloud sales rose 12% YoY to US$2.6bn, driven by continued demand for video content production. Document Cloud sales grew 27% YoY to $595mn due to strong adoption of Acrobat with integrated Sign capabilities within companies of all sizes and significant demand for PDF solutions on mobile devices.
• We maintain a BUY recommendation with a lower DCF target price from US$602 to US$549.00 (WACC 6.5%, g 4%). This is mainly because we reduced our FY22e revenue/PATMI by 1%/6% to account for the projected US$175mn incremental foreign exchange headwinds, US$75mn revenue hit due to the Ukraine conflict and higher tax rates. We believe that Adobe enjoys tailwinds from increased pricing, digitalization of document workflows, explosion in digital content creation and cloud migration trends

The Positives

+ Adobe reports record 2Q revenue with solid demand for its products. Revenue grew 14% YoY to US$4.4bn, beating consensus estimates for its top line by 1%, and was in line with our estimates. The growth was driven by 15%/17% YoY increases in Digital Media and Digital Experience revenues to US$3.2bn and US$1.1bn, respectively. In the Digital Media segment, Creative Cloud revenue grew by 12% YoY to US$2.6bn (Creative Cloud annual recurring revenue (ARR) grew 14% YoY to US$10.8bn), while Document Cloud sales grew 27% YoY to US$595mn (Document Cloud ARR grew 26% YoY to US$2.1bn) – the fastest growth of any segment in the quarter. The growth primarily came from new user acquisition and healthy retention. In 2Q22, Acrobat Web surpassed 50mn monthly active users, and doubled YoY. Additionally, Document Cloud revenue was driven by strong adoption of Acrobat with integrated Sign capabilities within companies of all sizes and significant demand for PDF solutions on mobile devices.

+ Maintained strong margins. Adobe reported an impressive gross margin of 88% as the company reports the bulk of its sales from recurring revenue. Operating income was 35% of sales compared with 37% a year ago. Non-GAAP operating margin, which excludes stock-based and deferred compensation expense and amortization of intangibles, was 45% compared with 46% a year ago. Adobe has stable operating margins despite the macroeconomic headwinds, representing a disciplined spending approach and a higher focus on profitability.

+ Creative Cloud price increases. In April, Adobe increased its subscription fees for certain Creative Cloud plans for the first time in five years. The new pricing was in effect for roughly a month but generated about US$10mn in additional revenue, in line with the management’s expectations. Meanwhile, the impact of the price increases is expected to be higher in 4Q22 as significant enterprise deals will be up for renewal.

The Negatives

- FX headwinds impacting revenue growth. Adobe is factoring in an incremental FX headwind of US$175mn across 2H22 revenue. This year, the US dollar has gained strength against the Euro, the Japanese yen, and other currencies as the Federal Reserve has raised interest rates to combat inflation. Adobe generates about 40% of its revenues from international markets.

Outlook

For FY22, Adobe now expects earnings of US$9.95 per share on total revenue of US$17.65bn (prev. EPS of US$10.25 on revenue of US$17.9bn). Non-GAAP EPS is expected to be US$13.50 compared with the prior forecast of US$13.70. This guidance reduction was driven by the projected US$175mn incremental foreign exchange headwinds, US$75mn revenue hit due to the ongoing Ukraine conflict, increased tax rates, and summer seasonality in 3Q22.

Adobe expects Digital Media net new ARR of US$1.9bn for FY22. Additionally, the company expects revenue growth of 12%/14% YoY in the Digital Media and Digital Experience segments.

Cash flow generation continues to be strong, with the company generating about US$1.9bn in Free Cash Flow, ending 2Q22 with US$3.4bn in cash and cash equivalents.

• 1Q22 results in line with expectations. 1Q22 revenue/PATMI at 24/25% of our FY22e forecasts.
• Document Cloud remains Adobe’s fastest growing segment with 17% YoY revenue growth, driven by paper-to-digital transition. Document Cloud segment ARR (annual recurring revenue) was US$2.0bn, up 29% YoY.
• Adobe revealed its intention to increase prices on its Digital Media offerings, which we expect will strengthen 2H22 ARR growth in Creative Cloud.
• We maintain a BUY recommendation with a reduced DCF target price from US$658.00 to US$602.00. Valuations based on DCF with a WACC of 6.4% and terminal growth of 4.0%. We reduced our FY22e PATMI by 2% due to an estimated US$75mn revenue hit from the business disruption associated with Russia’s invasion of Ukraine.

The Positives

+ Document Cloud continues to be Adobe’s fastest growing segment. Document Cloud revenue grew 17% YoY to US$562mn and Document Cloud ARR grew 29% YoY to US$2.0bn. Much of the Document Cloud revenue growth was supported by strong customer demand for Acrobat subscriptions; momentum in AdobeSign, with significant YoY increase in e-sign transactions within Acrobat; and high demand for PDF solutions on mobile devices.

+ Strong operating margins. Strong margins have been an important aspect of our Adobe investment thesis, and 1Q22 was no exception. The company posted operating margin of 37% in 1Q22, which was in line with 1Q21. Margins benefitted from lower travel/facilities costs amid a peak in Omicron cases in December and January.

+ Price increase for Creative Cloud products. Adobe has revealed its intention to increase pricing of its Digital Media products late in the second quarter. This could boost Creative Cloud revenues in 2H22 as price hikes take effect at renewal for existing customers and for new customers. Adobe believes that it has delivered significant value to customers by introducing several platform innovations and products, including mobile and web-based Creative Cloud Express offerings. While no specifics are available, the last price rise was announced in 2017.

The Negatives

- War in Russia and Ukraine impacts Digital Media segment. Adobe has stopped selling products and services in Russia and Belarus due to the ongoing Russia-Ukraine conflict. The company has announced that it is decreasing its Digital Media ARR balance by US$87mn, consisting of US$75mn relating to sales in the Russia/Belarus region and an additional US$12mn pertaining to Ukraine (although the company will continue to provide Digital Media services to the latter). Further, Adobe's FY22 sales will be reduced by US$75mn due to these adjustments.

- Higher tax rate. In 1Q22, Adobe reported tax rate of 18% compared to the company’s guidance of 16%. This was mainly because of the lower-than-expected tax benefits related to stock-based compensation. Further, the tax rate outlook for 2Q22 increased to 20%. Assuming everything else is constant, the increased tax rate reduces EPS by US$0.06 each quarter.

Outlook

Adobe expects 2Q22 revenue of US$4.34bn and earnings of US$2.44 per share. The company expects Digital Media net new ARR of US$440mn. Additionally, Adobe anticipates revenue growth of 13% and 15% for the Digital Media and Digital Experience segments, respectively.

Adobe did not provide an update to its FY22 prior guidance. For FY22, Adobe expects earnings of US$10.25 per share on total revenue of US$17.9bn. Among the other guidance metrics are 14% as-reported revenue growth for Digital Media and Digital Experience segments.

Maintain BUY with lower TP of US$602.00 (prev. US$658.00)

We lower our FY22e PATMI by 2% to reflect an estimated US$75mn revenue hit from the business disruption associated with Russia’s invasion of Ukraine. Digital media creation tools and cloud document management systems are in high demand globally across several industries. Despite the war-based revenue reductions, we maintain BUY with a lower target price of US$602.00. Valuations based on DCF with a WACC of 6.4% and terminal growth of 4.0%.

• Creative Cloud revenue expanded at 21% CAGR in the past three years. We expect Creative to see significant growth (total addressable market of US$63bn by 2024) ahead due to shift to digital, explosive content creation, and rising e-commerce penetration.
• Document Cloud business momentum was strong in FY21, with 100% YoY growth of Acrobat Web monthly active users and 85% YoY growth in Adobe Sign transactions in Acrobat. We model Document Cloud revenue growth of 19% YoY in FY22e driven by expansion of digital document use cases, e-signatures, and collaboration features.
• Adobe's margins (gross and operating margins of 88% and 37% in FY21) are impressive and generate massive amounts of FCF. We initiate coverage with a BUY recommendation and DCF-based target price (WACC 6.2%) of US$658.

Company Background

Adobe (ADBE) offers software for creative content and marketing purposes, with an emphasis on user experience. Its revenue segments are Digital Media (73% of FY21 revenue), Digital Experience (25%), and Publishing and Advertising (2%). While most people are familiar with Adobe's Acrobat product, Adobe's Creative Cloud segment includes more than 20 photo and video edit applications, including Photoshop (Figure 1) and Illustrator.

Investment Merits

1. Digital content creation is rising. Adobe’s Creative Cloud caters to the demands of creative professionals. The Creative Cloud segment grew its revenue by a CAGR of 21% over the last three years. It reported an impressive US$10.2bn in annual recurring revenue (ARR) in FY21. Adobe’s management expects its Creative Cloud total addressable market (TAM) to reach US$63bn by 2024. The main drivers for this expected growth are rising demand for content creation by consumers (i.e Facebook, Instagram, and TikTok), digitization (fueled in part by the COVID-19 pandemic), expansion of non-professional creatives, upskilling, and greater individual usage (particularly with rise of mobile). We expect Creative Cloud to continue strong revenue growth of 13% YoY in FY22e.

2. A strong player in digital signatures. The COVID-19 pandemic enhanced the digital signature industry and cloud document management. Adobe’s Document Cloud boosts document productivity by fueling the paper-to-digital transition and enabling all document activities seamlessly across web, desktop, and mobile. The company witnessed significant growth in Acrobat Web, with monthly active users up over 100% YoY in FY21. Also, Adobe’s strategy of combining Adobe Sign and Acrobat is paying off, with Adobe Sign transactions in Acrobat up 85% YoY. Document Cloud ARR grew to US$1.9bn in FY21, representing 31% YoY growth. Even when the economy recovers, we believe paper-to-digital movement will continue to be a strong tailwind for ADBE for several years to come. We expect Document Cloud revenue growth of 19% YoY in FY22e.

3. Adobe generates incredible margins. Adobe’s subscription revenue grew 25% YoY in FY21 and reported an impressive gross margin of 88%. Operating margin also expanded to 37% as lots of new customers signed up for Adobe's myriad of services. We expect operating margins to track above 35% in FY22e and FY23e.

We initiate coverage with a BUY rating. Our target price is US$658 based on a DCF valuation with a WACC of 6.2% and terminal growth of 4.0%.

REVENUE

Adobe has three revenue segments: Digital Media (73% of FY21 revenue) comprising revenue from two major business units Creative Cloud and Document Cloud; Digital Experience (25%) including revenue from Experience Cloud Subscription; and Publishing and Advertising (2%) consisting of revenue from a diverse range of legacy products and services. Main markets are the Americas (57%), EMEA (27%), and the APAC (16%).

Total revenue expanded at 22% CAGR in the past five years (Figure 2). Growth was driven by Digital Media and Digital Experience which grew at 22% and 23% CAGR respectively in the past three years (Figure 3). We expect these two segments to continue strong growth driven by digital transformation initiatives, solid demand for cloud document management (Figure 4), and enterprise momentum with Digital Experience. Acquisitions like Frame.io and WorkFront, as well as new product launches, might contribute incrementally.

EXPENSES

Cost of sales and total operating expenses grew 18% CAGR in the past five years. Cost of sales was 12% of FY21 revenue, while Research and Development (16%), Sales and Marketing (27%), General and Administrative (7%), and Amortization of Intangibles (1%) made up operating expenses. Total Operating Expense as a percentage of revenue has been reducing over the last 5 years, from 61% in FY16 to 51% in FY21, leading to improved operating and gross margins.

MARGINS

Gross margins hit an all-time high of 88% in FY21, up by 160 basis points (bps) from FY20. Gross margins appear to be on an upward trend over the past five years, and we expect this to continue because of the increased scalability of the business.

Net margins (reported) in FY21 were 31%, down from 41% the previous year. The change is primarily because of the one-time tax benefits completed during FY20. Adobe anticipates margins to fall slightly because some savings (such as T&E) are expected to be rolled back into the model in FY22e.

BALANCE SHEET

Assets: Cash and cash equivalents decreased by about US$0.6bn YoY in FY21 to US$3.8bn, largely due to share repurchases and acquisitions. Plant, property and equipment for FY21 was US$1.7bn, an increase of US$156mn from the previous year, largely due to ongoing CAPEX spending. The company’s current ratio for FY21 was 1.2x.

Liabilities: Current liabilities for FY21 were US$6.9bn, almost US$1.4bn more than FY20. This increase was mainly due to a rise in accrued expenses and deferred revenue. Non-current liabilities saw a jump of US$4mn in FY21. Adobe had a net debt position of US$279mn in FY21 (Figure 5). ADBE’s debt-to-equity ratio remains low at only 0.3x.

CASH-FLOW

Cash-flow from operations has steadily grown at 27% CAGR to US$7.2bn (Figure 6) from FY17 to FY21. CAPEX stood at US$0.3bn in FY21, at 11% CAGR over FY17-21. In FY21, Adobe generated US$6.9bn in free cash flow. This translates to an enviable 44% free cash flow margin. Adobe's ability to generate large amounts of cash allows it to acquire firms or return cash to shareholders (repurchase). The software company has a share repurchase authorization of up to US$13.1bn expiring in 2024.

BUSINESS MODEL

The rise of digital content has been the secular tailwind driving Adobe’s growth story over the last few years. As of FY21, about 92% of ADBE’s revenue is recurring and derived from subscription models.

Digital Media (73% FY21 revenue). ADBE reported Digital Media revenue of US$11.5bn, representing 25% YoY growth. Products in this segment fall under two categories:

1) Creative Cloud – This provides applications and services for photography, video/film, animation, design; and

2) Document Cloud – This offers solutions to create, edit, approve, share, scan, and sign secured digital documents.

Creative Cloud is the core of ADBE’s business, as it has consistently accounted for ~60% of total revenue over the last few years. It grew from US$5.3bn in FY18 to US$9.5bn in FY21 (Figure 7). And on an ARR basis, Creative Cloud accounted for 84% of total Digital Media ARR in FY21. Creative Cloud revenue growth was driven by new user acquisitions on the ADBE website, strength in the Creative Cloud Teams product offering, and focus on co-selling Frame.io with its Creative Cloud enterprise offerings. Frame.io is a cloud-based video collaboration platform that enables editors and key project stakeholders to collaborate using cloud-based workflows. Furthermore, content creation and consumption across devices is growing. We expect that Creative Cloud adoption will continue to rise at a healthy rate even when the economy recovers.

Within Creative Cloud, Adobe has developed a robust and comprehensive platform that eliminates the need for users to have external sources for fonts, storage, and stock photos. In addition, we think Adobe could capture market share across several emerging technologies like 3D and augmented reality. Adobe has identified a US$63bn TAM for Creative Cloud in 2024, up from US$41bn in 2023. This TAM comprises US$25bn from creative professionals, US$31bn from communicators, and US$7bn from consumers. We expect Creative Cloud revenue to grow 13% in FY22e.

ADBE reported Document Cloud revenue of US$2bn in FY21, representing 32% YoY growth (Figure 8). The COVID-19 pandemic drove business operations online from offline at an accelerated pace. Business operations that were previously done on paper had to be converted to a digital format overnight. This has fueled the company's Document Cloud business, and we expect it to continue to do so. Adobe estimates its Document Cloud business to represent a US$32bn opportunity in 2024, up 52% from US$21bn in 2023. We expect Document Cloud revenue to grow 19% in FY22e.

Digital Experience (25%). Digital Experience provides tools to analyze marketing spend, optimize advertisements, and manage ad campaigns. The Experience Cloud platform includes four product categories:

• Content and commerce – This provides tools to assist both mid-market and enterprise organizations in creating and managing e-commerce experiences (Adobe Experience Manager and Adobe Commerce).
• Data insights and audiences – This provides real-time analytics (Adobe Analytics, Real-time Customer Data Platform, and Audience Manager).
• Customer journey management – This enables businesses to manage marketing and advertising campaigns across B2B, B2C, and B2E use cases (Adobe Campaign and Marketo Engage).
• Workflow management – Through the acquisition of Workfront in 2020, Adobe offers work management software to assist businesses in managing their marketing and creative workflows.

ADBE reported total Digital Experience revenue of US$3.9bn in FY21, representing 24% YoY growth (Figure 9). Experience Cloud Subscription revenue was US$3.4bn with a growth of 27% YoY. This was driven by a seasonally solid quarter for Enterprise activity with subscription bookings increasing by more than 50% YoY in the fourth quarter of 2021. Also, Adobe Experience Platform customers increased by 300% YoY in FY21.

In Experience Cloud, we believe Adobe is well-positioned to benefit from the significant surge in e-commerce and rising demand for enhanced customer experiences anytime, anywhere. We also see Adobe’s strategic acquisition of Workfront as a significant growth driver for this segment. Adobe projects Digital Experience TAM to be US$110bn by 2024, a 29% increase from the 2023 estimated TAM. We expect Digital Experience revenue to grow 14% in FY22e.

Publishing and Advertising (2% FY21 revenue). The publishing and advertising segment is the legacy portion of ADBE’s business. It includes printing technology, e-learning solutions, and web conferencing applications. This business’ revenue has been falling, but only makes up 2-3% of the company's total revenue.

INDUSTRY

The surge in digital content over the last decade is a long-term growth driver to Adobe’s numerous businesses, and we believe that trend will not slow down anytime soon.

Creative Cloud. The market for Creative Cloud remains significant and growing. According to Statista, the global creative software segment is expected to see a CAGR of 5% between 2022 and 2026 to reach US$10.8bn. The growth in creative jobs, adoption of latest mediums, high-quality innovative communication, and surge in people posting on social media platforms are all broadening the customer universe. ADBE’s key competitors in the Creative Cloud market include CorelDRAW, Affinity, Autodesk, and Getty Images.

Document Cloud. According to MarketsandMarkets, the global e-signature market is expected to see a CAGR of 33% between 2021 and 2026 to reach US$16.8bn. The primary reasons that are expected to fuel the growth of the e-signature market include increased spending on digital documents by government agencies and companies, improved security with a regulated and seamless workflow, and enhanced end-to-end customer experience.

Notably, research firm IDC recently recognized Adobe as the leading provider of e-signature software, though DocuSign is ahead (Figure 10). ADBE’s other competitors in the e-signature market are Box and Dropbox.

Digital Experience. According to Grand View Research, the global digital experience platform market size, valued at an estimated US$10.2bn in 2021, is set to reach US$22.9bn in value by 2028, which indicates a 12% CAGR. The US digital experience market size is expected to see a CAGR of 13% (Figure 11). The main drivers for this expected growth are increased preference of companies to deliver personalized and optimized user experience and engagement across several marketing channels. ADBE’s key competitors in the market include Salesforce.com, Microsoft, and Oracle.

Risks

1. Weak advertisement and marketing spend could hurt Adobe. Adobe’s business is closely linked to the marketing spending and the macro economic situation. If the spending environment significantly slows, either as a result of the impacts of COVID-19 pandemic or an economic downturn, ADBE's business across the board could get hurt.

2. Piracy poses a significant risk. Adobe defends its intellectual property rights, but the company loses revenue as a result of the illegal use of its software. Adobe’s business can suffer if piracy rises.

3. Fierce competition. The level of competition in the marketplaces in which ADBE competes (mainly for Digital Media and Experience) is increasing, with the opportunity for new entrants to win market share through modern technology.

Valuation

We initiate coverage on Adobe Inc. with a BUY rating and a price target of US$658.00. Our valuation is based on DCF valuation, using a 6.2% WACC and 4.0% terminal growth rate (Figure 12).

Rule of 40

The Rule of 40 is a metric that measures the balance between growth and profitability. It considers revenue growth and EBITDA margin, the total of which must be more than 40% to satisfy the criteria.

The sum of ADBE’s three-year average revenue growth of 20% and EBITDA margin of 42% equals 62%, which fulfils the Rule of 40 criteria.