Adobe (ADBE -1.73%) is one of the largest and premier software-as-a-service (Saas) companies. It has a long record of solid execution, and smart acquisitions have made it a top stock to own, with Adobe outperforming the S&P 500 by about 30% over the past five years.
However, this outperformance figure used to be much higher, as Adobe shares fell about 17% when the company announced its acquisition of Figma earlier in September. While acquisitions aren't new for Adobe, $20 billion acquisitions are another matter.
Is this purchase a red flag for Adobe? Or is this a buying opportunity?
A high price to pay
Revisiting the $20 billion price tag, plenty of companies are worth that much. However, Figma only generated $400 million in annual recurring revenue, which applies a 50 times sales multiple to the business.
Although 50 times sales wasn't out of the normal in 2021, it's no longer the status quo, and almost no stocks trade at that range. For example, Snowflake (SNOW -1.99%), a business that traded for more than 150 times sales last year, is growing at a blistering 80% or greater pace every quarter since going public and only currently commands a 32 times sales valuation.
While Figma has an extremely high retention rate of more than 150% (which means customers spent $150 for every $100 they spent last year), Snowflake once again beats it out with a 171% retention rate.
While Figma and Snowflake are two entirely different companies, if Figma were publicly traded, it would likely be valued lower than Snowflake's 32 times sales. Because of this, Adobe likely paid at least double what the market would likely price the stock at: an estimated 25 times sales.
However, there are ulterior motives for this acquisition.
Better technology
Figma was eating Adobe XD's lunch before the acquisition. Both programs are used to prototype and design user interfaces and experiences for apps, websites, or games. However, two key features made Figma's product stand out.
First, Figma is free if you're designing alone. This ease of access makes it a prime choice for students or anyone operating on a strict budget. After a student learns the program or an individual hits it big, they don't feel like it's necessary to switch to Adobe, as they have already learned (and likely excelled) in Figma.
If you want to collaborate with others and work on the same project in real time, you need to pay for Figma. However, Figma's real-time collaboration tools are much more streamlined and powerful than Adobe XD's. As Figma's website puts it, files live on the cloud with Figma; with Adobe XD, you must sync to the cloud.
Going back to Adobe's reason for acquiring Figma, it may be taking out the competition before it has a chance to harm Adobe. But Adobe may have also acquired Figma to purchase its collaboration technology. This technology would be relevant for many of Adobe's other products and could be used as an additional pricing tier to unlock simultaneous edits. The real reason is likely some combination of the two, but investors will likely never know.
All that's left for us to decipher is whether Adobe's stock is worth owning.
Impact on Adobe's financials
Adobe anticipates paying for the acquisition in half stock and half cash. As of Sept. 2, Adobe had about $3.9 billion of cash, so it will also need to take out a loan. If Adobe uses about $2 billion in cash, it will need to take out an $8 billion loan, raising its long-term debt to $11.6 billion. However, over the last year, Adobe generated over $7 billion in free cash flow, so it could easily knock out this debt in two years.
But, Adobe was also using its free cash flow to fund share repurchases, which have now gone to waste with $10 billion in shares being issued. At Adobe's current $280 price, about 35.7 million shares will be introduced into circulation. This increase will bring its share count to about 502 million, nearly where Adobe began its share repurchases in 2016.
ADBE Shares Outstanding data by YCharts
To say this is poor capital allocation by management is an understatement. For years, Adobe repurchased stock at a valuation below 50 times sales. Then, in one fell swoop, it traded years of effort for one costly acquisition.
However, the acquisition may give Adobe the technology to sell more products, which would allow the company to repurchase shares even faster as it generates larger cash flows.
With Adobe trading for 28 times earnings (the lowest it has traded since it switched to a subscription business model), the stock has some uncertainty. The acquisition likely won't close until 2023, and investors may continue unloading the stock if Adobe's quarterly results don't go well. However, with digital design still an essential aspect of our lives (it affects advertisements, websites, and apps), Adobe will maintain its position as a top stock to own -- even though I think its credibility took a hit with this latest acquisition.
