Skip to Content
Stocks

Adobe Has Built a Wide Moat

Its products are the industry standard for creative professionals.

Wide-moat

First-quarter revenue rose 24% versus the prior-year period to $2.08 billion, modestly ahead of our expectations. Creative Cloud surpassed another key milestone as revenue grew 31% to $1.23 billion, and the company exited the quarter with more than $5 billion in Creative Cloud annualized recurring revenue for the first time. Management continues to tout the breadth of Creative Cloud’s portfolio as the key leverage that is enabling a broadening of the potential subscriber pool and says the company’s continued efforts in K-12 are paying off. The company is also succeeding in expanding its relationships with enterprises beyond traditional design users with products such as Stock and Spark.

Adobe’s adjusted operating margins continue to blow past our expectations, coming in more than 100 basis points higher than our prior estimate at nearly 42%. Management noted a one-time benefit stemming from a change in calculation of revenue in certain emerging markets from U.S. dollars to local currencies, providing a $20 million tailwind to annualized recurring revenue, but margins still would have outstripped our expectations on a normalized basis.

The self-service mechanics of Creative Cloud for individual subscribers has always been a boon for Adobe’s margins, but management also pointed to its robust partner ecosystem as a lever for margin expansion. We expect this will be particularly beneficial for Experience Cloud, which carries significantly lower contribution margins to the business than Creative Cloud. The upside of leveraging the partner community is twofold: First, Adobe can offload low-margin services work to these partners; second, the company can more effectively manage its investments in sales and marketing head count, something it has long excelled at. We now expect long-term adjusted operating margins to push into the high 40s by the end of our explicit forecast period.

Experience Cloud enjoyed a strong first quarter, with subscription revenue rising 22% year over year to $431 million. We continue to expect Digital Experience to undergo some lumpiness as a portion of revenue is tied to advertising services, but the increasing contribution of subscription revenue (roughly 78% of total Digital Experience revenue) should smooth out these effects over time. Management cited the company’s analytics expertise (including its artificial intelligence engine, Sensei) and deep multichannel campaign management portfolio as a differentiator in the enterprise setting. Management continues to expect roughly 20% growth in Experience Cloud subscription revenue and 15% growth in total Digital Experience revenue for the full year. However, we believe this outlook is conservative; we model just over 21% Experience Cloud subscription revenue growth and 16% total Digital Experience revenue growth.

Cloud Holds New Opportunities Adobe has long been the creme de la creme of creative software, as design programs around the world continue to rely on its products to mold creative minds. The company's seamless transition to the cloud has unlocked new opportunities as content becomes an increasingly valuable asset class.

User growth has been invigorated by Creative Cloud, which provides more-attractive price points, greater revenue visibility, and shorter upgrade cycles, further locking in customers from switching to less sophisticated rivals. Increased customer flexibility to pick and choose which apps suit their needs significantly reduces budgetary hesitations that once plagued Adobe’s software. Creative Cloud has total subscribers eclipsing 6 million today, and the company still has ample room to convert millions more from the legacy Creative Suite. As consumption for images and video content increases across devices, we believe this will expose more potential users to Adobe, stimulating long-term growth for Creative Cloud.

While Adobe was not the first mover in marketing software (now known as Experience Cloud), an argument can be made that it is the leader. Given Adobe’s prowess in the content creation realm, the synergies with marketing are apparent. As companies look to create unified, targeted ad campaigns, a multichannel marketing suite will become an increasingly mission-critical piece of software. Adobe’s robust platform spans campaign management, analytics, and advanced advertising embedding for video, among other features.

Adobe’s Experience Cloud is now a multi-billion-dollar business, and we think the company is solidifying itself as the best-of-breed vendor in digital marketing. We still have concerns about Adobe’s lack of sophistication in the broader realm of customer relationship management, where competitors like Salesforce.com CRM and Oracle ORCL can assert their products as superior in tying marketing with sales. While we believe there are some companies whose needs may not align with Adobe’s marketing value proposition, we think there is plenty of room for multiple large-scale winners in the marketing cloud, and Adobe appears to have an inside track.

Moat From Monopoly We assign Adobe a wide economic moat rating, attributable primarily to its essential monopoly in creative software. Adobe's software has long been synonymous with content creation and management, and the company's solutions have become the gold standard for creative professionals and novices alike. While watered-down alternatives to flagship applications such as Photoshop have sprung up from the likes of Microsoft MSFT and others, we believe these applications ultimately lack the sophistication necessary for high-end content creation and editing that is a prerequisite for artists, photographers, videographers, and other creative minds. Higher-education design programs continue to rely heavily on Adobe's solutions to train students, and Adobe's products have extensive features and capabilities that can set apart the work of a power Adobe user from those deploying alternative software. As a result, new users are cultivated on a regular basis to create a network of designers who rely on Adobe's creative suite, which propagates a platform that is uniformly understood and used in the design community. Given the mission-critical nature of Adobe's solutions to these users and the level of training required to master the software, we believe the company has built a significant level of switching costs for its users. We expect Adobe's shift to the cloud will help eliminate customer hesitation over doling out a premium for an initial license or an upgrade to new versions, as more options are presented to users at various price points paid monthly; this should ultimately yield user growth. Adobe has routinely controlled upward of 60% of the market for graphic and image editing and 45% of the digital video authoring market, dominant shares that we expect will remain steady.

Adobe’s presence as a marketing cloud vendor is rapidly growing, and while we believe the company will be a formidable player, we do not believe it has carved out an economic moat in this market yet. The company competes with several heavy hitters in this space, including Salesforce.com, Oracle, and IBM IBM. While Adobe believes the link between the creative and marketing cloud creates obvious synergies, we have concerns that the lack of client relationship management functionality in Adobe’s solutions may ultimately push customers to competitors with more sophisticated CRM applications to tie marketing and sales functions together more closely while keeping design siloed. Still, the company’s growth in the marketing cloud has been formidable, and Adobe commands approximately 15% of the addressable market, according to Gartner, modestly ahead of IBM (13.9%), SAP SAP (11.3%), and Salesforce.com (10.5%). The marketing vertical is also rife with smaller players, headlined by Marketo and HubSpot HUBS, which will create competition for small and medium-size businesses in the near term and could feasibly target enterprises as these products mature in the longer term.

CRM Offerings a Weak Spot We think Adobe has cleared the hurdle of transitioning its flagship creative products to the cloud, mitigating a meaningful risk factor for the business. However, the company still has several million legacy Creative Suite users who have yet to migrate to subscription-based products, and it is counting on further conversions from this pool to help fuel growth. The company must maintain a meaningful rate of innovation across both desktop and mobile for its Creative apps, as competition at the lower, less sophisticated end of the market will remain constant from apps such as Instagram and Apple Photos on the mobile side and Microsoft and Corel on the desktop side. While open-source solutions remain a threat, none have materialized that can remotely challenge the completeness of Adobe's offering to date. Overall, we view the risks to the creative side of the business as minimal.

On the marketing side, Adobe’s biggest drawback is lack of sophistication when it comes to client relationship management applications, areas where competitors Salesforce.com and Oracle have a clear leg up. There is some risk that Adobe could lose out on deals to customers who are happy to keep any design needs siloed while deploying a marketing cloud product that ties in sales and marketing more closely. Further, there are a slew of point solutions on the market that may reduce the need for customers to turn to Adobe’s full marketing suite. On the other hand, we believe Adobe’s content-oriented, broad marketing suite should allow the company to compete for a substantial amount of business across a large swath of customers.

Adobe is in strong financial health. Share repurchases remain a significant part of its strategy, an avenue the company is likely to prefer over the next several years instead of reinstating a long-defunct dividend. We believe Adobe will continue to explore strategic acquisitions to further its already-broad product portfolio, particularly as it builds out its digital marketing platform, though we think the company will probably limit itself to small, tuck-in acquisitions.

More on this Topic

The Best REITs to Buy
These seven undervalued real estate stocks pay dividends and trade at attractive prices.

Sponsor Center