Adobe Remains a Creative Software King

We raised our fair value estimate for

The company’s software-as-a-service-based products are bucketed into three segments: digital media, digital experience, and publishing. The first two serve as the growth engine of the business. Digital media houses Adobe’s creative software products for web designers, application developers, photographers, and animators, among others. We believe Adobe has an effective monopoly in the creative software market, which creates durable switching costs as its applications are mission-critical. We also believe a network effect exists in the company’s digital media products. The education system for creative minds relies heavily on Adobe’s products, which propagates a platform that is widely understood and used in the design community.

Adobe has transitioned from an on-premises business model to become a software-as-a-service heavyweight, and its Creative Cloud is the gold standard for creative professionals. Creative Cloud has benefited Adobe by offering customers more-attractive prices, locking in customers for longer periods, curbing piracy, and providing management with more visibility into future revenue. Customers can increasingly pick applications to suit their needs, and a subscription model removes the large up-front cost that existed with Creative Cloud’s predecessor. Through acquisitions, such as Macromedia in 2005, Adobe has built the most comprehensive suite of creative software.

Great software companies have more than one act, and Act 2 for Adobe has centered on analytics and digital marketing initiatives, which are currently housed in the digital experience segment. Adobe’s prowess in creative content has allowed it to nab synergies in the digital marketing space, cross-selling to enterprise chief marketing officers already using Adobe’s software. The product, now dubbed Experience Cloud, operates in a nascent and growing industry, but Adobe’s end-to-end functionality, built internally and through acquisitions such as Omniture, TubeMogul, Magento, and Marketo, has meant it is largely regarded as the leader in the space. As companies look to create omnichannel, targeted ad campaigns, Adobe’s marketing software has become a mission-critical offering for major brands and enterprises. Experience Cloud spans marketing, advertising, and analytics, among other features. It competes with the likes of Salesforce.com CRM and Oracle ORCL, which compete in the broader customer relationship management space, but we think a rising tide can lift multiple boats, with optionality for Adobe to cement itself as a digital experience leader.

In aggregate, we model an 18% revenue compound annual growth rate over the next five years. In terms of Adobe’s digital media offerings, while the transition is nearly complete, we expect uplift as the company continues to transition customers to the cloud. As Adobe builds new product packages around digital media, we expect it to increase its total addressable market. We project a 20% compound annual growth rate over the next five years for Adobe’s Creative Cloud. Adobe Document Cloud, built around the Acrobat family of products, is seeing a double-digit run rate, and we model a 10% compound annual growth rate over the next five years before a deceleration into the midsingle digits thereafter.

We model a 20% revenue compound annual growth rate for Adobe’s Experience Cloud and a 19% compound annual growth rate for the aggregate digital experience business over the next five years. We assume the company maintains its leadership in digital marketing and gains synergies from the 2018 deals for Magento and Marketo.

In terms of aggregate margins, Adobe’s mature digital media business helps the company achieve high gross margins, and while Adobe does not break out operating margins by segment, we believe the digital media segment accounts for the vast majority of operating profits. As the digital experience business grows and gains scale over its expenses, we believe Adobe’s cloud model will allow it to extract higher operating margins. While Adobe will certainly need to invest in selling, general, and administrative expenses and research and development head count, the asset-light business allows a significant portion of revenue growth to trickle to the bottom line. We believe that Adobe’s gross margins can expand from 86% in fiscal 2017 to 90% in fiscal 2027 and that upside remains for Adobe’s already robust GAAP operating margins, which currently sit near 30%.

Adobe underwent two large acquisitions in calendar 2018 to bolster its digital experience segment against competitors. We believe these enhance switching costs, particularly as Adobe’s already comprehensive marketing portfolio, coupled with these two acquisitions, will allow the company to have end-to-end functionality. We believe this discouraged customers from leaving for a competing product. In May, Adobe agreed to acquire Magento, which offers digital commerce capabilities, for $1.68 billion. We believe this is similar to Salesforce’s 2016 acquisition of Demandware in that there are advantages in tying together marketing and e-commerce capabilities. In September, Adobe agreed to acquire Marketo for $4.75 billion. Marketo’s specialty is lead management, which helps identify qualified sales leads in the business-to-business marketing sales process. Adobe Campaign once offered a stand-alone lead management module, but it was discontinued in March 2017. Marketo bolsters Adobe’s business-to-consumer capabilities with its expertise in B2B. Essentially, we believe the purchase helps fill a gap in Adobe’s product portfolio as it increasingly competes with the likes of Salesforce.