After reaching an all-time high of just under $700 per share in November 2021, Adobe (ADBE -1.73%) stock is trading down over 35% from that high as broader market volatility has paired with slowing growth concerns for Adobe's business.
Adobe has now reported back-to-back disappointing quarters and weak revenue guidance, which has some investors on edge. However, Adobe continues to prove that it is one of the best-run tech companies out there -- a quality that more than makes up for its slowing growth.
Let's take a closer look and see if the recent reports and guidance really do justify the price drop. Or does the price drop signify an opportunity to buy in on this tech powerhouse at a relative discount?
Image source: Getty Images.
An investment in creativity
Content is king -- whether that's in the streaming sector, publications, podcasts, YouTube videos, Instagram Reels, TikToks, you name it. Adobe's business is massive. But it can be boiled down to its diverse yet integrated suite of applications that support digital media. It is not an exaggeration to say that Adobe's products are essential in modern marketing.
Adobe Photoshop is used to create digital artwork and professional photographs. Many of the icons, graphics, and logos you see in the world were made using Adobe Illustrator. There's a good chance that many of the ads you see broadcast or online and even the movies and TV shows you watch were edited with Adobe Premiere Pro. Digital and print publications all around the world use Adobe InDesign. The list goes on and on.
Adobe has so many software applications that it can be hard to keep track of them all. So, it solved that problem for customers and bundled them all together into one monthly or annual subscription called Adobe Creative Cloud -- which has 27 apps. Customers can still buy some of the major apps a la carte. But no matter the application, Adobe uses a subscription model -- making it one of the most powerful recurring revenue businesses in software.
Adobe's resilience will be put to the test
Adobe is a highly profitable and growing business in an excellent industry. Adobe has proven over the years that its business has a wide moat -- meaning it is relatively insulated from competition. This year will put that moat to the test.
Adobe just announced price increases that will go into effect on April 27. Creative Cloud (all apps) for individuals will increase from $52.99 per month to $54.99 per month for the annual billed monthly option and from $79.49 to $82.49 for the month-to-month option, but the prepaid annual plan will remain the same at $599.88 per year. Adobe also raised prices for creative cloud for teams and said that enterprise plan hikes vary based on the terms of each membership. The price hike will test the loyalty of Adobe's customers and the value of its products.
Adobe's fiscal year is unusual because it ends on the Friday closest to Nov. 30 each year (in this case Dec. 2). Therefore, the first full quarter of price hikes won't be until Adobe's third quarter of fiscal 2022 (June 3 to Sept. 2).
Adobe will probably lose some customers from the price hikes. But if it's a net win for the business and Adobe displays strong customer retention, then it would add to Adobe's investment thesis by proving it has inflation resistance and competitive advantages over rival products.
An efficient business
Adobe has displayed incredible pricing power for years despite the high costs of its software. That pricing power, combined with expanding the business has led to an explosion in its operating margin.
ADBE Operating Margin (Quarterly) data by YCharts
Operating margin is operating income divided by revenue. Operating income is revenue minus operating expenses such as sales, general, administrative expenses, cost of goods sold, depreciation, and amortization. Unlike net income, operating income doesn't include interest expenses, taxes, or nonrecurring items. In this way, it is a purer representation of a company's efficiency and profitability.
Large businesses can usually flex their size to make more revenue and profit. But it can be hard for a company to grow and retain the same level of profitability as a smaller business. In Adobe's case, its operating margin of 37% suggests that for every $1 it earns in sales, it pockets $0.37 after business-related expenses. For context, Microsoft has an operating margin of 43%, Nvidia has an operating margin of 39%, Meta Platforms' is 37%, Apple's is 33%, and Alphabet's is 29%. That puts Adobe's profitability in the same league as the most powerful tech companies in the world.
A big reason for Adobe's profitability is its adoption of a subscription business model. In 2013, Adobe launched creative cloud and converted its sales model from one-time downloads to a software subscription business. Adobe was one of the first large tech companies to convert almost exclusively to a subscription model. Looking at the operating margin chart, you'll notice that Adobe's profitability was struggling before the launch of Creative Cloud. Today, Adobe's operating margin is the highest it has been in over 15 years. But here's the real kicker -- Adobe is generating 400% more revenue today than it did 15 years ago.
More revenue in conjunction with higher profitability is better than just more revenue for the sake of more revenue. In this vein, Adobe's growth slowdown is not nearly as bad as it appears at first glance.
A relatively inexpensive valuation
Adobe's falling stock price but rising profitability has made the company less expensive than it used to be. Its price-to-sales, price-to-earnings, and price-to-free-cash-flow ratios are all well below their five-year median levels, indicating that Adobe is relatively inexpensive now.
ADBE PS Ratio data by YCharts
Finding exceptional businesses
Conviction in a company is invaluable. And to get it, it's best to separate a stock and its price from the company it represents. It's easier to have faith in a long-term investment thesis when you understand the underlying business and truly believe it will continue to be a great business for a very long time.
It sounds simple, but history has proven that it's better to invest in an excellent company at a premium price than a great company at a low price or even a good company at a bargain. By excellent company, we're talking about stable earnings and free cash flow, growth, industry leadership, a strong balance sheet, and upside potential. Excellent companies are hard to find. Adobe is one of them.
Therefore, even though Adobe stock may look expensive (even after its sell-off), it's simply too good of a business to pass up.
