When it comes to tech, Adobe (ADBE 1.49%) isn't exactly the most exciting name. The old software firm is exhibiting many characteristics of a value stock: Its core proficiencies (document editing and creative software) are far from a high-growth industry, and revenue is steady and predictable. As boring as Adobe is as a business, though, the returns are far from dull. The stock is up over 140% over the last three-year stretch, compared to just a 58% return for the S&P 500.
After the company's most recent quarterly earnings, this stock looks dirt cheap. Here are three reasons why.
Image source: Getty Images.
Supercharging creativity, digital documents, and customer experience management
Businesses and organizations of all kinds are in need of software tech. From marketing to data processing to managing customer relationships, the digital era is unlocking new ways for companies to streamline their processes, increase employee productivity, and improve upon their services.
Adobe, along with salesforce.com (CRM +0.51%), is at the heart of this movement to digitize business operations -- collectively referred to as "digital transformation." Adobe has built a suite of software covering creativity (everything from graphic design to movie and TV show production), document editing (basic digital document viewing to digitizing workflows, a realm that rubs elbows with DocuSign (DOCU 0.69%)), and customer experience management (tools to help a business manage marketing, website content, and customer interaction). Adobe ranks as a top-tier solution for all of the above, offering a solution for virtually every need in the digital era.
Software productivity tools like this have been around for decades, but the advent of cloud computing (and effects from the pandemic like remote work) has accelerated the move to bring business processes up to date for the 21st century. Research firm Gartner (IT 0.65%) expects global spending on cloud-based business process and application services to be well over $160 billion this year, and the greater cloud-computing industry could reach $1 trillion a year by the end of this decade (expected to be just over $300 billion in 2021 by Gartner's estimation). With just $14.4 billion in revenue over the last 12 months, Adobe is still a relatively small part of this growing industry and has a clear path of steady expand in the years to come.
When boring financial results equal incredible stock returns
Adobe has already been benefiting from this transition to the cloud. As already mentioned, this is no high-flying name in the software universe. Adobe has been putting up high-teens to low 20% year-over-year growth for years. But steadily growing at that pace is a fantastic situation for a software provider.
The reason why is all about scalability. Once a software service has been built, the costs associated with expansion are minimal. Any incremental gains in users and revenue are highly profitable once a few basic costs of maintaining the service have been paid for.
To illustrate, Adobe grew total sales 23% year over year during its fiscal 2022 second quarter (the three months ended June 4, 2021) to $3.84 billion, but free cash flow increased 73% to $1.89 billion -- a free cash flow profit margin of 49% in Q2. Free cash flow profit margin was 46% over the last 12 months. All of the new revenue it has hauled in did little to increase Adobe's expenses, thus the far greater increase in the bottom line.
The company expects this situation to continue. The outlook for the third quarter calls for another year-over-year revenue increase in the low 20% range, and Adobe will remain a cash-generating machine. This is the primary driver of the share price these days, giving impetus to more strong double-digit percentage returns for Adobe's stock this year and beyond.
A powerful tech platform poised for steady long-term expansion
There's ample room for this software leader to make a bigger splash at some point down the road. Adobe finished April with $5.77 billion in cash, equivalents, and investments offset by $4.12 billion in debt. Add in the steady stream of free cash flow generation each quarter, and Adobe has plenty of ability to develop new capabilities for its platform, or to go shopping (like its $1.5 billion takeover of Workfront in 2020 and $1.68 billion acquisition of Magento in 2018, both of which were added to the customer experience cloud).
At 43 times trailing 12-month free cash flow, this is one dirt cheap software stock given its steady financial performance, its strong balance sheet, and the growing cloud industry it participates in. Adobe remains a rock-solid company to start building your portfolio around.
