Adobe (ADBE) - Get Report has been a volatile stock in 2020, like most of the rest of the stocks in the market. Meanwhile, as it navigates a global recession, Adobe is showing that its operations are more relevant than ever and growing.
Consequently, paying 57x times trailing earnings to become a shareholder seems expensive at first, but the lack of alternatives make this highly profitable industry-leading company more undervalued than it first appears. Here’s why:
Why It's Well-Positioned
With markets trading at close to all-time highs once again, finding investments that are cheaply valued is arguably the wrong approach. Why? Because what looks particularly cheap today is probably cheap because it's a business model that’s likely to face questionable prospects ahead. Put another way, cheap businesses today are on sale because investors are unsure of how their operations will navigate in our new low-touch economy.
On this front, Adobe is well-positioned. Even though Adobe relies on conferences to sign-up new customers these ultimately lead to a small portion of the sign-ups, the majority of its sign-ups go through its own self-serve website. Consequently, Adobe’s business model is not facing any significant disruption, and is even well-positioned to benefit from a digital economy.
Breaking Down Adobe's Revenue Streams
As a reminder, Adobe has two main segments: Digital Media and Digital Experience.
Adobe’s Digital Media is twice the size of its Digital Experience segment, at approximately 70% of total revenues compared with 30% of total revenue for its Digital Experience.
Adobe’s Digital Media holds Photoshop, Acrobat product family and Adobe Sign service. Indeed, Adobe's vision to allow its customers to be more expressive and creative through its digital solutions is more relevant today than at any time before.
Also, Adobe’s Character Animator recently won a technical Emmy Award for breaking new ground in television animation.
Altogether this reminds us that Adobe’s Digital Media is aimed at supporting companies on their digital journeys and is perhaps why Adobe’s largest segment was able to report for its quarter ending February (Q1 2020) revenue growth rates of 22% compared with the same period a year ago.
Meanwhile, for Q2 2020, which includes results up until the end of May, Adobe's Digital Media segment, is guided to be up 19% compared with the same period a year ago. Put another way, during this challenging quarter for many businesses around the world, Adobe's Digital Media segment is likely to finish with record revenues.
Adobe's other segment, Digital Experience, is aimed at offering insights by harnessing the power of data to offer a complete picture of the customer’s journey online and offline. Within its Digital Experience, last quarter Adobe launched its Adobe Commerce Cloud. This platform saw early signs ups from Coca-Cola (KO) - Get Report, Under Armour (UAA) - Get Report, and Morningstar (MORN) - Get Report.
Expensive On Surface, But Cheap Underneath
Adobe is a rare digital platform that continues to grow its revenues between 15% to 20% annualized, while at the same time reporting strong GAAP margins. Specifically, we can see that under GAAP accounting, which includes stock-based compensation, Adobe’s business model delivers operating margins of approximately 30%.
Putting its high margins into context, consider this: Adobe’s GAAP profit margins are higher than some of the best businesses on the planet, including Alphabet’s (GOOGL) - Get Report, Apple (AAPL) - Get Report, and Coca-Cola (KO) - Get Report.
Moreover, its ability to be more relevant and stronger over time together with its consistently growing earning power, reminds us that Adobe is showing no signs of slowing down.
Thus, while investors are being asked to pay 57x its trailing earnings appears expensive, investors are being offered a premium quality company that is unlikely to see its multiple meaningfully compress. Indeed, high-quality companies such as Adobe don’t stay undervalued for very long.
The Bottom Line
On the surface paying 57x its trailing earnings seems like a large premium at first, but given its high-margin, asset-light business, with its award-winning platforms, investors are likely to look back in a few years and see just how cheaply Adobe is being priced today.