3 Reasons to Buy Adobe, and 1 Reason to Sell

Adobe's (ADBE -0.84%) stock fell 3% on Sept. 22 after the cloud-based software giant posted its third-quarter earnings. Does that post-earnings dip represent a good buying opportunity? Let's examine three compelling reasons to buy Adobe -- and one reason to sell it.

1. It's generating robust revenue growth

Adobe's revenue rose 22% year over year to $3.94 billion in the third quarter, which exceeded analysts' estimates by $40 million.

Image source: Getty Images.

Its revenue growth decelerated in 2020 as the pandemic disrupted its enterprise-facing businesses, but its growth accelerated again throughout the first three quarters of 2021 as those headwinds waned.

Source: Adobe. YOY = Year over year.

Adobe expects its revenue to rise 19% year over year in the fourth quarter, compared to analysts' expectations for 18% sales growth. 

2. The core businesses are healthy

Adobe's digital media business, which generated 73% of its revenue in the third quarter, continues to expand. This core business consists of two parts. The Creative Cloud subsegment includes Photoshop, Illustrator, Premiere Pro, and other creativity tools. The document presentation and management software Adobe Acrobat, its e-signature service Adobe Sign, and other business-oriented tools and services reside in Adobe's Document Cloud partition.

Source: Adobe.

Adobe's conversion of those industry-standard software tools into cloud-based services over the past eight years locked in customers and generated stable recurring revenues from annual subscriptions. It expects its total digital-media revenue to rise about 20% in the fourth quarter.

The rest of Adobe's revenue mainly came from its digital-experience business, which provides cloud-based sales, marketing, e-commerce, and analytics services for larger enterprise customers. This segment's revenue rose 26% year over year, accelerating from 21% growth in the second quarter, and the company expects it to generate 22% growth in the fourth quarter.

That stable outlook indicates Adobe's digital-experience services are still keeping pace with resilient competitors like Salesforce, Shopify, and Twilio's Segment.

3. Stable margins and steady earnings growth

Adobe's gross and operating margins expanded year over year in the third quarter, and its non-GAAP earnings rose 21% to $3.11 per share and beat analysts' estimates by $0.09.

Adobe's margins held steady throughout fiscal 2021, and it repurchased about 5.7 million shares (just over 1% of its outstanding shares) over the past three quarters to further boost its earnings per share (EPS).

Source: Adobe. YOY = year over year.

Adobe's gross margins remain stable because most of its Creative Cloud services are considered essential tools for media professionals. That "best in breed" reputation gives the company significant pricing power against its smaller peers. As a result, Adobe expects its non-GAAP EPS to increase 13% in the fourth quarter.

The one reason to sell Adobe: Its valuation

Adobe is still firing on all cylinders, and analysts expect its revenue and non-GAAP earnings to grow 22% and 21%, respectively, this year. But Adobe's stock has also rallied nearly 30% over the past 12 months, and it looks a bit pricey at 45 times forward earnings and 19 times this year's sales.

By comparison, Salesforce expects its annual revenue to rise 23%-24% this year and more than double by fiscal 2026, but its stock trades at just 10 times this year's sales.

The market's tepid reaction to Adobe's solid third-quarter report indicates its high valuation could be limiting its upside potential. When a stock is priced for perfection, a company generally needs to hit a grand slam instead of a mere home run -- as Adobe just did -- to attract more investors.

Is Adobe's stock worth buying?

I believe Adobe's strengths still justify its higher valuation. It will likely generate stable gains over the next few years, but investors shouldn't expect it to skyrocket or outperform higher-growth tech stocks.