Artificial intelligence (AI) has been driving a lot of sales growth for businesses. But not every business has been booming. Up until recently, Adobe (ADBE 0.41%) had been a laggard among AI stocks.
The tech company doesn't make chips, and its sales haven't been tripling like they have for other businesses experiencing a flurry of demand. But its popular photo-editing software Photoshop is a must-have for many who are serious about photography, and the company has been using AI to enhance its capabilities, making it a potentially underrated play for AI investors.
Recently, the stock has been scorching hot. And there could be much more upside in the near term. What's behind Adobe's rally, and is now the time to buy the stock?
The company is coming off a strong quarter
On June 13, Adobe reported its most recent earnings, and it gave investors reason to be excited. The company hit record revenue, with sales rising above $5.3 billion for the period ending May 31. That represented a year-over-year increase of 11% when factoring out foreign exchange.
That's a slightly slower growth rate than in the previous period, when the company's sales rose by 12% (net of foreign exchange). Nonetheless, Adobe beat expectations for both earnings and revenue this past quarter, sending the stock higher in the days and weeks following the earnings report.
The stock is up by 22% in just the past month. And the surge has been so strong that it sent its 20-day moving average higher than its 50-day moving average, which is a bullish crossover for technical analysts. That can inspire more confidence in the stock's ability to go even higher, at least in the near term.
Why there could still be challenges ahead
Adobe isn't a stock without risks, however. The U.S. government launched a lawsuit against the company, which alleges that it tries to trap customers into its subscriptions with hidden termination fees. Subscriptions make up the vast majority of Adobe's revenue.
The other danger is that it may be more difficult for consumers to justify paying the $20 per month for a subscription for Photoshop, or $60 for all of its Creative Cloud applications, now that AI is making photo editing easier and more accessible than ever before. While Photoshop is enhancing its products, so are competing products. Users can now easily create 3D-generated images in ChatGPT. AI-powered phones are also making edits even easier.
The risk is that in the long run, Adobe may only appeal to a niche market that needs its cutting-edge software and which can justify paying those recurring subscription fees. And that may hurt its long-term growth prospects.
What also doesn't help is that with the surge in value, the stock trades at more than 50 times its trailing earnings -- investors may expect a persistently strong growth rate to justify that kind of valuation. Prior to this recent rally, Adobe's valuation was looking a lot more tenable, but the higher the stock goes, the more unappealing it may become, even for growth investors.
Is Adobe's stock a buy?
Adobe's stock has been taking off recently, but I'd hold off on investing in the company. In the long run, there are too many question marks surrounding how strong its growth rate will be, and the stock trades at too high of a premium to account for that risk, essentially giving investors little to no margin of safety. At such a high valuation, there are arguably much better growth stocks to consider than Adobe.
