Hi Reader

In weeks email I'll look at Adobe which is currently trading at a 52-week low of $367.25, down from its 52-week high of $586.55

Growth

If you want long term growth in a stock's share price you need long term growth in the company.

Over the past 5 years Adobe has grown revenue from $12b to $22b and normalized net income from $2.2b to $5.1b.

But if we look at the year over year (YoY) growth rates we can see that growth has slowed over the past 5 years. Revenues grew at an average of 14.37% over the past 5 year but now are growing at 10.5%. Normalized net income has grown at 20%+ but now grows closer to 15% a year. While for many companies they would be great numbers, investors expect a lot from Adobe as we'll see below in the valuation section.

Margins

Margins help you identify a business with a competitive advantage (moat). Declining margins often mean an eroding moat.

Adobe's gross profit margin (89.15%) has been highly consistent over the past 5 years barely diverging from its 5-year average (87.78%) and is currently above that average.

Earnings before interest and tax (EBIT) margins have shown more variation but is still highly consistent. Over the past 5 years it has a high of 36.76% a low of 31.36% and an average of 34.91%. EBIT margin is currently above that 5-year average.

Net income margin shows greater variability with a high of 40.88% a low of 24.08% and an average of 30.21%. Again, net income margin is above its 5-year average.

Given Adobe's high and consistent profit margins it clearly has a moat.

Return on Capital

Return on capital tells you how much profit a company is generating from its capital. The higher the better.

Over the past 5 years Adobe has had an average return on invested capital (ROIC) of 27.95%. While ROIC dropped between Dec 2021 and Dec 2023 it has since recovered and is back to 33.56% above the 5-year average.

Debt

Debt isn't a bad thing if used effectively and responsibly. It can enhance growth and is often a cheaper source of capital than equity.

Debt does become a problem however if it grows so large that it impacts the company's ability to maneuver or interest repayments threaten the company's solvency.

Some rules of thumb I follow

• Total debt to equity less than 100%
• Total debt to EBITDA less than 4
• Interest coverage ratio greater than 10x.

Adobe has a debt to equity of 50.1%. Meaning it has twice as much equity as debt. It's not high but it has increased over the past 5 years from an average of 34.7%

Total debt to EBITDA basically tells you how many years it would take the company to pay off its debt. Adobe has a debt to EBITDA ratio of 0.7 meaning it could pay off its debt in 0.7 years. This is on par with the 5-year average.

The interest coverage ratio or EBIT/Interest Expense ratio tells you how many times the company could pay its interest expense. Adobe has an interest coverage ratio of 39.6x meaning it could pay its interest expense almost 40 times over. This has declined from a 5-year average of 49.2x

Value

We can get a rough estimate of a company's value by looking at its current multiples and comparing them to its historical multiples.

The Price to Earnings (P/E) ratio tells you how much you are paying for $1 of a company's earnings. The higher the ratio the more you are paying.

Adobes price to earnings (24.2x) is at its 5-year low, almost half its 5-year median (46.1x) and nearly one third of its 5-year high (70.4x).

We have to go back to 2013 since Adobe has traded at such a low P/E.

The Price to Book (P/B) ratio tells you how much you are paying for $1 of the company's book value or shareholder equity.

Adobe's Price to book of 12x is above at its 5-year low (8.9x), slightly below its 5-year median (15.9x) and almost half the 5-year high (23.5x)

The Price to Free Cash Flow (P/FCF) ratio tells you how much you are paying for $1 of the company's free cash flow.

Adobe's price to free cash flow (17x) is at its 5-year low, less than half of its 5-year median (35x) and less than one third of its 5-year high (57.7x).

Like the P/E ratio you'd have to go back to 2013 since the P/FCF ratio has been this low.

So why is Adobe down?

Adobe is down 47% from its 5-year (and all time) high of $688.37 back in November 2021.

The S&P 500 is only down 12% and that's all been in the last couple of months. Since November 2021 the S&P 500 is up 39% so we can't blame the general market for Adobe's woes.

Adobe's margins, return on capital and debt profile are all similar to where they were back in 2021. The biggest change I can see is the reduced growth rate. In the early 2020s Adobe was growing net income at 35% per year. That's reduced to less than 15% per year.

Adobe has historically traded at much higher multiples. This means the market expects excellence from Adobe. Given the growth rate has slowed the market is not impressed and so the share price has fallen. That's the danger with buying high P/E stocks. They usually have high PEs because they are performing spectacularly. But as soon as the results slow down you see the P/E get slashed.

What is Wall Street Saying?

"We think that Adobe will continue to ramp up investment in new product extensions, particularly around generative AI, as it pursues a rapidly expanding total addressable market". - Argus analyst Joseph Bonner,

"ADBE has been a frustrating stock for much of FY24," said Mizuho analyst Gregg Moskowitz. "Having said that, today's disclosures indicate that ADBE is beginning to meaningfully monetize its Generative Al innovations, and we continue to expect solid upside to the FY25 ARR/revenue guidance as the year unfolds."

"Believe that ADBE is an AI winner and that AI is not replacing existing revenue streams, investors need to be able to observe longer-term trends.” - Bernstein’s Mark Moerdler

"New disclosure of GenAI contribution is a step in the right direction, but investors need to see a clearer roadmap". - Keith Weiss, an analyst at Morgan Stanley

"The opportunity for Adobe is to stitch together the workflows across its Creative, Document, and Experience clouds using commercially-safe AI to automate how content is created, scaled, activated and delivered, while the biggest challenge in our view is the competitive threat from Canva (which has disclosed its F3Q24 ARR of $2.55B) on the graphic design side and Figma for workflows as we see more and more organizations using those two products together very effectively," said Citizens analysts, led by Patrick Walravens

Video: Making the case for and against Adobe - CNBC

What are your thoughts on Adobe?