Adobe (NASDAQ:ADBE)'s stock has had a pretty volatile year, currently down approximately 19% YTDa stark contrast to the NASDAQ's roughly 23% YTD gain. This underperformance largely is driven from a market perception that Adobe may lose relevance in a world increasingly dominated by generative AI. The logic is that Adobe's tools, which are designed for creators, would be irrelevant as AI tools could (in theory) take over much of the creative process. However, generative AI tools like ChatGPT still produce results that fall short of perfection, and the same goes for visual content generated by tools like Midjourney. To truly bring creative projects to completion, human input still remains quite important (and it always will be). This dynamic, in my view, makes Adobe's product suiteparticularly its core creative offeringsbecome more valuable than ever.
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Understanding this key trend, Adobe has adopted the AI-enhanced creative landscape, integrating AI across its workflows to boost user productivity and create a distinct competitive edge. These innovations have given Adobe's customers unprecedented efficiency and control in the digital space. Evidence of this came through in Q3 FY24, where Adobe reported strong acquisition and retention among customers of all sizes, with notable adoption of its GenAI features, particularly among enterprise clients. I'm quite bullish on the stock for exactly these reasons and expect that Adobe's stock price will begin to reflect this shift over the next few quarters.
Adobe's Strong Quarter Fueled by AI and Customer-Centric GrowthIn Q3 FY25, Adobe achieved impressive 11% YoY revenue growth, bringing in $5.41 billion. This result beat the company's guidance range of $5.33 billion to $5.38 billion and was driven by strong performance across Creative, Document, and Experience Cloud segments, as well as high user acquisition and retention. Adobe's AI-centered approach has resonated with users and enterprises of all sizes, helping customers adopt and harness AI's value. Non-GAAP EPS also exceeded guidance, reaching $4.65, compared to the expected range of $4.50 to $4.55.
Out of the $5.41B in revenue, the company's Digital Media Segment that houses Creative and Document Cloud grew 12% YoY to $4.0 billion (~73% to total revenue), with the Document Cloud segment remaining the fastest growing segment, growing 18% YoY in the quarter. Within Document Cloud, Adobe significantly enhanced its offerings with AI, introducing an AI assistant across Acrobat and Reader. This assistant supports multi-document conversations and various document formats, transforming document interaction with efficiency gains and driving a notable 70% growth quarter-over-quarter, signaling widespread AI adoption.
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Additionally, Adobe integrated Firefly's AI image generation into Acrobat's Edit PDF tools, expanding applications for presentations, emails, and more. This suite upgrade has several blue-chip enterprise clients, including Amazon (NASDAQ:AMZN), Disney (NYSE:DIS), and the US Treasury Department. It's worth highlighting that this segment has a higher revenue run rate than e-signature competitor DocuSign (NASDAQ:DOCU), while still delivering faster growth. Although Adobe and DocuSign differ in product scope, I believe Adobe may be capturing some market share in the e-signature space as well.
Given that AI is clearly central to Adobe''s product vision going forward, and I expect that the increased capability of ADBE's core product suite will command a more inelastic price going forward for clients. Plus, the company's focus around commercially safe AI content should prove to be a huge differentiator going forward, especially given the legal risks. All in all, we think Adobe's revenue growth, which stands at around 10% YoY, may get a welcome bump as the company adapts its pricing scheme to monetize more effectively, which is a huge plus for shareholders. Another bump and point that I need to capture in terms of Adobe's revenue trajectory is its Generative Credits, which the company describes the use as it allows the use of generative AI features powered by Adobe's Firefly in applications, with the consumption of generative credits depending on the generated output's computational cost and the value of the generative AI feature used. During the earnings call, the management noted that as they have deeply integrated GenAI into their tools, they are seeing accelerated consumption of generative credits, with better retention metrics. However, what is important to note is that Adobe has not instituted any caps on generative credits yet, as they are focused on proliferation and usage across their customer base. As time progresses, the management noted that they will be instituting caps or selling premium AI plans that will enable them to better capture the monetization opportunity, which will also help revenue growth significantly over the next few quarters.
Top-line Drivers and Monetization StrategyWith AI being central to Adobe's long-term strategy, I think the improved capabilities of Adobe's core product suite will increasingly justify a more inelastic pricing model, adding some resilience to its revenue. With revenue growth currently at around 10% YoY, we could see further acceleration as Adobe adapts its pricing to monetize these advanced AI features more effectively. An important contributor to this trajectory is Adobe's approach with Generative Credits. These credits allow users to leverage Firefly-powered generative AI across applications, with consumption based on the computational cost and value of the AI-generated output. During the Q3 FY24 earnings call, the management noted an uptick in generative credits usage, mainly driven by GenAI's integration across the suite, leading to both greater retention and engagement. Adobe has chosen not to impose limits on these credits yet, aiming to maximize adoption across its customer base. However, management indicated that it plans to eventually introduce credit caps or premium AI plans. This move would unlock a substantial monetization opportunity, allowing Adobe to capture additional revenue growth over the next few quarters as well.
Strong Margins and Operating Leverage Signal Bullish OutlookAdobe's margin profile is another area why I'm bullish on the stock. Known for outstanding execution, Adobe consistently ranks among the most profitable companies in the industry. Over the past decade, the company has shown remarkable control in stabilizingand even growingits margins despite scaling to meet increasing user demands. Since FY14, Adobe's gross margins have risen by over 500 bps, and its operating margins have more than doubled, from around 15% in FY14 to roughly 37% by Q3 FY24. This trend highlights Adobe's effective cost management and strong operating leverage, with operating income still growing at a higher rate (+17.3% YoY) compared to the 11% YoY revenue growth rate, even amid significant AI investments.
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Looking ahead, I expect Adobe's operating leverage to remain strong, particularly given that it remains strong even with the high annual R&D and S&M spend of around $10 billion. If Adobe chooses to curb its variable costs, it could drive substantial bottom-line growth, even if the top-line growth slows down. In the near term, as Adobe continues to expand revenue, I anticipate stable margins, which should translate into better returns for the investors.
Softer Q4 FY24 Guidance Raises ConcernsDespite a strong quarter with continued growth in GenAI adoption, Adobe's softer-than-expected guidance for Q4 put some pressure on investors, leading to the recent mid-September dip. For Q4, management projects revenue of $5.5 billion, with $4.1 billion expected in the Digital Media segment and $1.4 billion in the Digital Experience segmentslightly below analyst expectations by about 1.3%. To reach their goal of $30 billion by FY27, as outlined in Adobe's latest investor presentation, the company will need to achieve a CAGR of roughly 12.6% between FY25 and FY27. Given this target, the softer guidance and future revenue projections have raised some concerns. However, looking closer at the guidance, the slight shortfall is due to certain deals closing earlier in the current quarter rather than Q4 as initially expected. Additionally, Adobe's remaining performance obligations (RPO) give some encouragement for investors. By the end of Q3 FY24, Adobe's total RPO reached $18.1 billiona solid 15% YoY increase, which signals potential revenue acceleration ahead as Adobe continues to acquire and retain customers across its suite of solutions.
Valuation PerspectiveAdobe currently trades at a notable discount compared to its 3-year forward price-to-earnings (P/E) higha reasonable entry point, in my view. This isn't to suggest Adobe will quickly return to those peak valuation levels, but it's worth highlighting the significant pullback in its historic premium. With a current forward P/E multiple around 34x, Adobe's price tag looks attractive, especially considering the EPS growth potential from stable margins and steady top-line expansion. I believe a 40x-43x multiple is fair for a company like Adobe that maintains recurring revenue, mid-single-digit top-line growth, and consistent profit margins. This estimate might even be conservative, given the company's net cash position and its ongoing share repurchase program.
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Even without any assumed multiple expansion, I see Adobe generating double-digit returns through its top-line growth and earnings yield, even if revenue growth comes in below consensus. If Adobe manages to increase its operating margins, this could create further upside or provide a cushion if long-term valuations shift lower. Targeting the lower end of that range with a 40x multiple gives a target price of $570, offering a comfortable 18% upside.
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To add an alternative perspective to Adobe's valuation, I conducted a discounted cash flow (DCF) analysis, which supports my bullish view on the stock as well. The base case in this model assumes a 12% CAGR in revenue over the forecast periodconsistent with Wall Street expectations and management's $30 billion revenue target by FY27. This DCF also factors in shorter-term margin stability and projects conservative margin expansion later (although I expect a much-stronger margin expansion than forecasted in the DCF) as Adobe leverages operating efficiencies and tapers down its R&D and S&M spending. For this analysis, I applied an 8% discount rate, aligned with the company's WACC, and used a 3% terminal growth rate to account for Adobe's ongoing growth from its AI-enhanced products over the long term. Under these assumptions, the DCF produced a fair value of $583 per share, implying an upside potential of around 17%.
Closing ThoughtsThe way that I see it, Adobe's recent quarter was solid, showing investors the meaningful steps the company took in the customer-centric AI innovation space. Previously, the company's exposure to GenAI was seen as a risk, yet its strategic AI integrations are allowing broader adoption and retention across a range of clients. While GenAI hasn't impacted Adobe's financials as it has for hyperscalers and chipmakers yet, I believe the potential is on the horizon. With Adobe expected to soon introduce caps on generative credits or implement AI-specific pricing, new revenue channels could emerge, further improving Adobe's growth profile and supporting and expanding its valuation over the next few quarters.
This content was originally published on Gurufocus.com
