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Adobe Sets Its Sights on Marketing Technology

The wide-moat company is aiming beyond its dominance of content creation.

We believe Adobe ADBE is a blue-chip technology stock that offers great growth opportunities over the next several years. We are maintaining our wide moat and stable moat trend ratings but have lowered our fair value estimate to $296 per share from $300 to reflect slightly lower long-term margin assumptions. Even so, we still view the shares as modestly undervalued. Our fair value estimate implies a price/earnings ratio of 31 times fiscal 2020 non-GAAP earnings per share.

Adobe groups its Creative Cloud and Document Cloud in the digital media segment, which accounted for 70% of revenue last year. The company has come to dominate the content creation market with iconic products like Photoshop and Illustrator. Adobe also created the PDF file format and remains the leader in PDF editing software today. Now that the software-as-a-service transition for this segment is complete, we expect the digital media segment to grow by 15%-20% in each of the next several years.

The digital experience segment contains a variety of marketing technology solutions and was 27% of revenue last year. While Adobe does not own this market, it is considered a leader, along with several other large software companies. This segment has predominantly been built on acquisitions, with large deals for Magento and Marketo both closed in the second half of fiscal 2018. We believe this expanding suite of marketing technology solutions is increasingly attractive to customers because marketing professionals recognize Adobe’s excellence in content creation software, Adobe offers a solution independent of hyperscale Internet service providers’ analytical tools, and Experience Cloud continues to expand its solution set, making it a viable marketing platform. We believe the digital experience segment will be the main growth driver for Adobe over the next five years, and with subscale margins, it offers additional leverage for continued EPS growth.

Adobe’s Creative Cloud business, which includes its Photoshop and Illustrator solutions, made up 59% of total revenue in 2018 and addresses a $30 billion market opportunity, according to the company. New products and features have been added to the suite through organic development and bolt-on acquisitions to drive the most comprehensive portfolio of tools used in print, digital, and video content creation. The move to a SaaS model five years ago has led to improved visibility and is bringing in new users due to the suite approach in which all Creative Cloud products are available for one monthly fee, and various cheaper packages allow users Photoshop use for as little as $10 per month versus the previous boxed version for an $800 purchase. SaaS also eliminates piracy, which is an important source of new revenue.

Acrobat falls in the digital media segment too, as Document Cloud, and is a business that does about $1 billion in revenue annually. Adobe invented the PDF and continues to dominate the PDF editing software space today. For the digital media segment we model 20% revenue growth in 2019 and 15% growth in 2020. We believe Creative Cloud user adds will slow over the next several years, offset somewhat by moving users to higher-priced stock-keeping units.

Adobe jumped into marketing services with the 2009 acquisition of Omniture, which was a leader at the time in web analytics. Adobe used Omniture as a platform to create the digital experience segment, where the company continues to make acquisitions to bolster the suite of marketing solutions. Digital experience was 27% of revenue in fiscal 2018 and serves what Adobe believes is a $53 billion addressable market. In the second half of 2018, Adobe acquired Magento for its e-commerce platform and Marketo for marketing automation, for $6.4 billion in aggregate. These deals add more capabilities and continue to broaden the Experience Cloud, which makes the company more attractive to customers. We believe potential and existing customers want a broad suite of strong offerings, as well as a set of tools that is independent from hyperscale Internet service providers. We believe digital experience is the growth engine for the company over the next five years; we expect segment revenue to grow 35% in 2019 and 22% in 2020, driven by new customers wins and the upselling of solutions to existing customers. We also believe that at a 62% gross margin in 2018, the segment has a five-year runway for margin improvement to 75%-80%, which in turn will help drive strong EPS growth.

Publishing accounted for only 3% of revenue in 2018. This is a cash-cow business that Adobe continues to harvest to help fund growth in digital experience. We expect revenue to deteriorate over time and model 1% annual declines for the next several years.

We believe Shantanu Narayen has done an exceptional job since taking over as CEO in 2007. He led the effort to move the entire company to an SaaS model and drove the move into marketing technology. Beyond Narayen, we believe the company has a deep bench led by business unit heads. We note that Brad Rencher, the general manager of Experience Cloud, resigned in January 2019 but is remaining on in the near term to ensure a smooth transition. He came to Adobe from the Omniture acquisition. The reasons for the departure are unclear, but we believe new leaders from the Magento and Marketo acquisitions, or existing unit leaders within digital experience, can step up.

We are expecting our and the Street’s estimates to require some fine-tuning after Adobe reports earnings in mid-March, as the company will report results that include the adoption of ASC 606 even though guidance was provided assuming no adoption.

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