Buying Adobe carefully
A new core position gets stress tested
I've been building up a core position in Adobe over the past 6 months around a core thesis:
Excellent management
Important 'must have' products: creative cloud (Photoshop suite), document cloud (Acrobat and PDF management), and experience cloud (managing marketing materials) are all must haves in the business suite. In the current creator and creative based economy, they're more important than ever.
Good capital allocation and future growth opportunities: company has great ROIC and good prospects for long term above average growth, with good places to redeploy that capital: organic growth and M&A. They also currently have a $25 billion buyback, and their current rate is buying back ~1-2% of the float per quarter.
Sell off provides a buying opportunity. The company is now 30% off all time highs, which over the past decade has proofed to be good buying opportunities.
The selloff has been due to a collection of fears and issues, none of which have showed up in the companies' numbers yet:
Generative AI fears: AI will remove the need for Creative Cloud or reduce subscription seats in the enterprise. Generative AI is also seen as a potential cost, reducing margins.
Figma acquisition not going through: admission of guilt that they don't have a good enough competitive offering in the collaboration space
Canva fears: Canva has been growing very strongly and is entering the enterprise market.
SaaS fatigue: SaaS as a business model has been struggling as tech companies slow their growth, which has led to slowing growth in the 'per seat' business model. This has caused a general selloff in many SaaS names this year and despite this, many SaaS companies still trade at rich valuations, meaning that they could easily continue to selloff as they're still 'priced to perfection'.
The selloff is perfectly understandable due to these concerns, and in fact overshadow the bullish thesis and my 'buy the dip' mentality here. There is a risk that this time is different.
So why am I adding here and making this a core position?
My bullish thesis above still holds. As for the bearish case, here are my thoughts, addressing these issues in order:
Generative AI should be a net positive for Adobe over time for a few reasons.
I view generative AI as a whole as net positive for incumbents over new players. That is to say that gen AI is a sustaining technology and not a disruptive one in many cases. It is much easier for Adobe to integrate the latest and greatest models into their existing products and distribution than it is for a new company to develop something outstanding and distribute it and acquire customers.
Unlike many AI products, Adobe's integrations of AI provide great value for customers that justify premium pricing. This will cause AI to be a revenue and perhaps gross margin benefit instead of a drag. AI has become table stakes in many products these days. Often without enough added benefit beyond 'my competition is doing it'. Many email providers, or writing tools now integrate some LLM. While this is a cool feature to add to a product, in most cases it's not a revenue driver, rather it's an anti-competition feature. This isn't the case for Adobe. Firefly has the potential to be a game changer for many companies, providing huge cost savings and efficiency as a designer can now do much more work than before. This justifies it becoming a revenue driver for Adobe and not just a cost, as most AI products are. Undoubtably this will take a few quarters to play out as the team deals with crafting, launching and tweaking the product and pricing offering, but in a years time my bet is that Firefly is a revenue generating line item.
It's a shame that the Figma deal didn't go through. Despite the huge price tag, I was long term bullish on this. However while Figma offers competition, they don't quite compete head on and this is an increase in TAM that was lost and not a headwind on current competition. The benefit is that Adobe now has $25 billion for the company buyback.
Canva is indeed a fierce competitor, but that's been the case for 5 years already. It's a competitive world out there and while Canva is a better low end product, Adobe has a much better high end product, has moats in the enterprise and it doesn't look like that's changing. As a whole the TAM for creative assets is increasing and I don't see anything new or material here.
SaaS fatigue is a real concern, especially in the near term since valuations haven't corrected enough to allay this concern in the sector - there's more room for downside. While Adobe's 30% drop has priced some of this in, the company is still richly valued. Seat growth should bounce back over time, I'd anticipate next year, as efficiency boosts increase competition overall. But this is a macro head/tail wind which I can't control or predict to a great extent. The micro bear case for seat growth is that AI is increasing efficiency and companies aren't hiring. This could certainly be the case for Adobe, as generative AI is especially useful for designers and visual artists. However over time (12-24 months) this effect should even out as increased efficiency will plateau and competition will increase once more, only at higher rates of productivity.
While AI is a short term headwind, my main concern is for point #4. SaaS multiples are still high, and Adobe isn't trading at cheap levels yet, despite the pullback (there are many articles that cover Adobe valuation, for example here and here). Despite not being classically cheap, the core of my bullish thesis still remains, and the company is definitely a quality one, giving me confidence that this is a good buying opportunity for my portfolio.
Upside can come from:
Hitting this years targets, which have come in doubt on last quarters call. Management is very confident in this year’s goals. Anything where the company shows that AI isn't eating their lunch will be a net positive for the company and the stock.
1 to 2% buyback each quarter this year and over the next 2 to 3 years.
Early signs of AI monetization.
This upside, if executed, which I believe will be the case, should lead to outperformance, justifying my core position. This is part of my thesis for driving overall outperformance in my overall portfolio during H2 2024 and 2025.
Due to the downside risks and key uncertainties around Adobe's business and the SaaS sector as a whole I'll be more cautious with Adobe. I'll be looking into the quarters results closely and putting a larger scale around Adobe buying going forward this year. Barring more information and certainty, my next significant levels of purchases will be in the $380 level where I'll look to start increasing again.
Before wrapping up, let's review my investment checklist:
Competitive advantage / moats / durability of the advantages: How strong are the moats that the company has? How material are those moats to the businesses success and long term value and growth? How durable are the moats? Are these moats getting stronger over time or weaker?
Competition is the main concern for Adobe and the key question of the business going forward. Will AI benefit or disrupt? If AI benefits, as I believe, this is a further enhancement of their competitive moat. Some specific aspects of generative AI suit Adobe even further such as letting brands control and tweak their AI models, use unique branding assets and safely trained models. Additionally, the more creative assets live in the Adobe cloud the stronger and more sticky the moat. We'll find out the answer to this over the next 2-4 quarters.
Is this a top notch management who can execute? What's their track record? Do they have skin in the game? What's their incentive plan and how does that affect key success metrics?
Yes. This is a top notch management that has successfully navigated the shift to cloud, new business models and products.
Why invest now? What's the time horizon for this investment?
Stock drop has created an attractive buying opportunity in a world of increasing moats (if the bull case plays out). The time horizon for this investment is very long term - multiple years or more - as Adobe has the potential to compound capital at a high rate in this business environment.
What's the upside? Is there an exit price or exit metric? What is it? What is the end game for this investment?
There is no specific upside target, rather to find and hold a long term quality business.
How is the market pricing this? Is this a contrarian bet or not?
At the moment this feels like a contrarian bet to me as the market has sold off Adobe due to AI fears. This is something to be careful of - the market could be right!
How confident am I in all these answers?
I am confidfent in management but not as confident as I'd like in the future of the business model around AI, as there are too many variables around how this will play out. I could be right on the thesis and Adobe could still mismanage the shift, or I could simply be wrong on the thesis and AI will improve dramatically and cause Adobe products to lose relevancy.
Risk factors and how to mitigate them:
Contrarian bet? » Where do I admit I'm wrong? How long or what do I need to see play out or not?
If growth underperforms their historic benchmarks or dropss below ~10% without good cause this would give me concern that the headwinds they are facing are significant. Additionally if they can't monetize Firefly and AI within 2-4 quarters.
Volatility? » Larger steps between purchases (more percentage difference or time)
Adobe is a relatively volatile stock, as evidenced by 50%+ sell offs every several years. I will mitigate this with larger scales between buys.
How big can this position reach? Is this a resilient position? If it’s fragile, how much can it affect my portfolio and overall returns? The fragility of Adobe as a core position aren't around the viability of the business - they're free cash flow generative and have excellent financials. Rather it's due to a rerating of the stock. This can be a relatively large position, but until certainty clears up I will keep it at it's current level.
Based on all of the above: what's the capital allocation summary for this investment? What's the starting position size and when will I increase it and by how much?
Based on the above and my confidence in the thesis around AI and Adobe's positioning in the market, but taking into account the uncertainties, I'm comfortable with Adobe at ~5-6% my portfolio and plan to buy more on large pullbacks if the core thesis holds true. Should AI be a headwind or the core businesses weaken, I will sell out and redeploy.