Even before the Brexit vote took its toll on the world's markets, Adobe (ADBE 1.43%) shareholders had experienced a nearly 6% stock-price hit the day following its earnings announcement on June 21. Clearly, Adobe CEO Shantanu Narayen and team dropped the proverbial ball in fiscal 2016's second quarter, right?
Turns out, not only did Adobe meet or exceed vaunted analyst estimates for both revenue and earnings per share (EPS) in Q2, it reported its best quarter ever. After sharing such a strong quarter, Adobe's guidance was alluded to by some pundits as the reason for its stock price easing, but that makes little to no sense, either. And therein lies the opportunity for long-term growth investors in search of value.
Image source: Adobe.
What's not to like?
It was about four years ago that Adobe began to materially change its business model with the introduction of its Creative Cloud. It may seem old hat today, but at the time the shift to a subscription-based service delivered via the cloud was fairly cutting-edge, and the move has paid off handsomely. As impressive as Adobe's record quarterly revenue of $1.4 billion was, it took a back seat to its Creative Cloud sales and the recurring revenue they bring.
The digital media segment jumped 26% last quarter to a record $943 million, driven by a whopping $755 million in Creative Cloud revenue, good for a 37% year-over-year improvement. A primary reason for Narayen's efforts to deliver subscription cloud services is the recurring revenue they generate. Ongoing, relatively stable sales are a fantastic means of building a business foundation, and Adobe has this nailed.
Narayen also pointed to Adobe's Creative Cloud, along with its Document Cloud, as a key to boosting Adobe's digital media unit's annual recurring revenue (ARR) to an impressive $3.41 billion in Q2. To put that into perspective, Adobe issued guidance of $5.8 billion in total sales for 2016, which means that as of today, nearly 60% of its expected revenue this year will come from ongoing subscription customers.
Adobe's move to an ARR model is hardly exclusive, as others in the sector including Autodesk (ADSK 0.77%) are quick to point to their own success in building an ongoing source of sales. Autodesk CFO Scott Herren attributed its solid, if not spectacular, fiscal 2017 Q1 results, announced on May 19, to "success we are having with our business model transition" -- namely, driving subscription sales to boost recurring revenue.
Where to from here?
It's worth noting another benefit of recurring revenue: It simply doesn't cost as much to generate those sales as relying on new customers to bolster the top line. Despite growing revenue by 20% last quarter, Adobe's cost of revenue increased just 9% year-over-year, as did operating expenses. That's a formula not only for future growth on Adobe's top and bottom lines, it's also a testament to Narayen and team's sound leadership.
Though hardly the sole reason to invest in any stock, Adobe analysts' consensus target of $111.73 per share is 20% above June 28's closing price of $92.46, and based on expectations for both the current quarter and fiscal year, pundits' expectations could prove overly conservative.
Adobe naysayers may point to its current lofty valuation given that it's trading at over 52 times trailing earnings, and at first glance they'd be right. However, with expected revenue growth of 20% both this quarter and this year, along with a more than 60% jump in non-GAAP (excluding one-time items) EPS forecast for fiscal 2016, Adobe's forward price-to-earnings ratio of just 24 makes it an absolute steal.
Down the road Adobe could see competition from the likes of virtual reality and augmented reality providers, but as it stands it's dug a fairly effective moat to defend its market of creative professionals. Autodesk has its place among structural designers, and virtual reality is still focused on gamers, so Adobe's competitive edge should remain intact for years to come.
Adobe's competitive advantage, combined with its impressive cloud-based ARR, total sales growth, and diligent management team, is why it warrants a prominent spot on most any value investor's buy list.
