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The Best Stock to Buy Now in a Growing Industry

This 20% undervalued wide-moat stock is our top pick in software today.

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Adobe Inc

Adobe ADBE developed what has become the leading software for creative professionals. The stock has stumbled this year, but we see plenty of momentum in product innovation, client interest, and revenue creation. In fact, we think Adobe is a top pick for long-term investors. This undervalued wide-moat stock was recently added to the Morningstar Wide Moat Focus Index and appears on our analysts’ list of the top 33 undervalued stocks this quarter; it’s also one of Morningstar chief US market strategist Dave Sekera’s 5 Undervalued Stocks to Buy During Q2 2024.

Adobe has come to dominate content creation software with its iconic Photoshop and Illustrator products, now both part of the broader Creative Cloud. The company has added new products and features to the suite through internal development and acquisitions to build the most comprehensive portfolio of tools used in print, digital, and video content creation. The 2023 introduction of Firefly marks an important artificial intelligence solution that should attract new users. Document Cloud is driven by one of Adobe’s first products, Acrobat, and the ubiquitous PDF file format created by the company. The rise of smartphones and tablets, as well as a mobile workforce, has made a file format that is usable on any screen more relevant than ever. Adobe believes it has an addressable market well in excess of $200 billion. The company is introducing and leveraging features across its various cloud offerings to drive a more cohesive experience, win new clients, upsell users to higher-price solutions, and cross-sell digital media offerings.

Key Morningstar Metrics for Adobe

Economic Moat Rating

For Adobe overall, we assign a wide moat rating arising from switching costs and network effects. By segment, we believe digital media has a wide moat from switching costs and network effects, while digital experience and publishing have narrow moats from switching costs. The digital media segment, which represents 70%-75% of revenue, contains Creative Cloud and Document Cloud. Both product groups generate strong revenue growth, but Creative Cloud’s is materially higher. High switching costs are the primary driver of the wide moat surrounding Creative Cloud. While there are many competing products, Creative Cloud is so pervasive in the creative world and in education that replacing it would be an insurmountable barrier, in our view. Creative Cloud also benefits from a network effect, in our view. By virtue of its widespread use, creative professionals have significant incentive to become well versed in its solutions. We believe Adobe’s creation of the PDF file format, first-mover advantage with Acrobat, and significant installed base have created a narrow moat based on switching costs for Document Cloud.

Read more about Adobe’s moat rating.

Fair Value Estimate for Adobe Stock

Our $610 fair value estimate implies a fiscal 2024 enterprise value/sales multiple of 13 times and an adjusted price/earnings multiple of 34 times. We model a five-year revenue compound annual growth rate of approximately 12%. We foresee solid growth in digital media and digital experience even as both steadily slow over time. Digital experience should benefit from 2023 price increases that should take effect over the course of several years and increasing penetration of an enormous market. We believe continued innovation, gathering new users, and upselling existing users in Creative Cloud should help drive strong growth for the next several years. We model non-GAAP operating margin, which was 46% in fiscal 2023, to expand modestly on an annual basis, given increased scale.

Read more about Adobe’s fair value estimate.

Risk and Uncertainty

Creative Cloud’s large market share means that a significant portion of high-margin revenue would be at risk if a competitor were to make inroads into the space. Cross-selling opportunities with digital experience would then be diminished, which would be problematic, as digital experience represents the larger growth opportunity over the next five years, in our view. Any integration missteps with recent acquisitions could cause delays in new contract signings or even substantial write-downs. The publishing segment largely comprises legacy products with very high margins. This cash cow could disappoint if it deteriorates more rapidly than we expect. Adobe faces strong competition to hire software engineers and potential risks arising from a breach of its data centers.

Read more about Adobe’s risk and uncertainty.

Adobe Bulls Say

  • Adobe is the de facto standard in content creation software and PDF file editing, categories that it created and still dominates.
  • The shift to subscriptions eliminates piracy and makes revenue recurring while removing the high upfront price for customers. Growth has accelerated and margins are expanding from the initial conversion inflection.
  • Adobe is extending its empire in the creative world through the expansion of its digital experience segment, which should drive growth in the coming years.

Adobe Bears Say

  • Momentum is slowing in Creative Cloud after elevated growth driven largely by the model transition to software as a service.
  • There is greater uncertainty in digital experience, since this is an emerging space and one that Adobe neither created nor dominates. Growth could be slower than we anticipate, or margin expansion may not materialize.
  • Digital experience has been built largely through acquisitions. This raises the possibility of disruption from inadequate integration efforts and lends credence to concerns that Adobe may overpay for increasingly larger deals.

5 Undervalued Stocks to Buy During Q2 2024

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This article was compiled by Susan Dziubinski and Sylvia Hauser.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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About the Author

Dan Romanoff

Senior Equity Analyst
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Dan Romanoff, CPA, is a senior equity research analyst on the technology, media, and telecommunications team for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He covers software.

Before Joining Morningstar in 2019, Romanoff spent 12 years in buy-side equity research covering the technology and telecommunications sectors, most recently at Holland Capital Management. Prior to that, he spent five years in sell-side equity research as an associate analyst at UBS and a senior analyst at Credit Suisse covering various areas within technology, including hardware, software, and semiconductors. Romanoff also has worked as an auditor and in valuation services for major public accounting firms.

Romanoff holds a bachelor’s degree in accountancy and a Master of Business Administration in finance, both from the University of Illinois at Urbana-Champaign. He also holds the Certified Public Accountant and Accredited in Business Valuation designations.

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