If you are working at an office today or as a content creator working from home, you are undoubtedly familiar with Adobe (ADBE 1.29%) products. Users opened more than 400 billion PDFs in Adobe products last year, and 90% of creative pros use Adobe Photoshop. The company's products are integral to many, which is why Adobe just reported another record-revenue quarter.
The business is on solid footing; the stock is not. It declined 52% from its 52-week high for three main reasons:
- The tech bubble in 2021 caused it to be overvalued.
- The bear market of 2022 swung the pendulum back.
- Adobe paid a premium to acquire Figma, and the market hated it.
Why did the market shun the Figma purchase?
We all probably know about No. 1 and No. 2 above, so let's focus on No. 3. Figma is cloud-based, design-software creators use for real-time collaboration on projects such as graphic design work for social media advertisements, app interfaces, and more.
It has become extremely popular and competes directly with Adobe XD. Many see it as superior to Adobe. Figma's website dedicates an entire page to this comparison. This is the first reason the market reacted negatively to the acquisition. Adobe purchased a product that will cannibalize sales of its existing product.
The second reason is straightforward: Adobe paid $20 billion for Figma. This amounts to 50 times Figma's estimated $400 million in 2022 sales. This price-to-sales (P/S) ratio is extraordinary. It makes fellow growth software-as-a-service (SaaS) companies like Snowflake and Cloudflare look downright affordable with P/S ratios of "only" 33 and 21, respectively. In fact, Cloudflare stock's biggest impediment may be its valuation.
Still, while the cost was undoubtedly high, the cost of doing nothing would be even higher. In its emotional daze, the market has missed the point entirely.
Is the market missing the forest for the trees?
In its rush to judgment, the consensus missed three significant considerations:
- The Microsoft factor.
- Figma's growth.
- Internal development costs.
CNBC reported in August that Microsoft designers, engineers, marketers, and data scientists were enamored with using Figma, even stating, "it has become like air and water for us." Adobe can ill afford to lose Microsoft as a customer. Microsoft could also have decided to make its own bid to acquire Figma. It's no stranger to blockbuster purchases like the recent planned acquisition of Activision Blizzard. The last thing Adobe needs is competition from a giant like Microsoft in the creative cloud.
Figma expects annual recurring revenue to increase 100% in 2022 to $400 million. This massive growth should continue with Adobe's resources behind the company. Even slowing to 50% compounded annually, yearly recurring revenue would reach $2 billion within four years. Suddenly, the $20 billion price tag doesn't look so outlandish. Adobe believes the total addressable market is $16.5 billion in annual sales.
Sometimes it is more practical to purchase a ready-made product than to develop it internally. Figma, founded in 2012, has been around for ten years, so Adobe is essentially paying $2 billion per year for someone else to do the research and development (R&D). Adobe has averaged just over $2 billion per year for its R&D the last several years, so this isn't an unreasonable sum.
Still not convinced? Ok, even if the Figma purchase was a waste of $20 billion, the market already discounted the market cap more than that since the announcement, as shown below.
ADBE Market Cap data by YCharts
It's not too late for long-term investors
If you didn't get in at the exact bottom, assuming it is the bottom of course, don't worry. Long-term investing isn't about timing the market perfectly. That's impossible to do consistently. Building wealth is about investing in high-quality companies and being patient. Short-term returns are about luck; fundamentals power long-term returns.
Adobe still trades at a price-to-earnings ratio well below its historical averages even after its recent rise, as shown below.
ADBE PE Ratio data by YCharts
Wall Street has a knee-jerk, visceral response to Adobe's acquisition announcement. But emotions and investing don't mix well, which may have opened up an opportunity for long-term investors to accumulate shares in a terrific and profitable company at a discount.
