Companies at the forefront of artificial intelligence innovations can see rapid swings in their share prices. Stocks can zoom higher on strong earnings, and that momentum can carry the stock for weeks or months. It's extremely tempting to wait for a pullback in the share price when that happens, but waiting could cost you.
One recent example of an AI stock that's soared higher in a short period of time is Adobe (ADBE 1.35%). Shares trade 27% higher than they did at the start of June thanks to a strong earnings report, a good outlook from management, and the continued rise in the overall stock market. But even after these latest gains, investors should still consider adding the stock to their portfolios.
The AI-powered future at Adobe
Adobe shares started climbing after a strong fiscal second-quarter earnings report last month. Revenue climbed 10% year over year, and adjusted earnings per share (EPS) was up 15%, ahead of analysts' expectations. What's more, management expects to generate between $4.50 and $4.55 per share in the current quarter, also ahead of expectations.
The latest report also put to rest investors' fears over slowing average recurring revenue (ARR) growth. First-quarter ARR growth disappointed, and management's guidance for just $440 million in net new ARR in the second quarter didn't help. But Adobe beat that outlook and brought in $487 million in new subscription revenue last quarter. Management is guiding for $460 million in ARR for the fiscal third quarter.
That's a sign Adobe's AI initiatives are starting to pay off. Its generative AI is called Firefly, and it's trained on Adobe's proprietary data set, including Adobe stock images. Firefly features include Generative Fill and Generative Expand in Photoshop, Text to Vector in Illustrator, and Remove Object in Lightroom.
NASDAQ: ADBE
Key Data Points
Adobe offers limited use of those features for free across all versions of its software suite. That includes the free-to-use Adobe Express. It's now seeing tremendous success in both attracting and converting those free users into paying ones. Express users are signing up for paid subscriptions, and paid subscribers are paying extra to use more Firefly features. All of that translates into strong ARR growth.
The company is now working to replicate that success with its Document Cloud and its marketing platform. It introduced the Acrobat AI Assistant in April, which can summarize a document and answer questions based on its content. It also offers an AI assistant that can automate marketing tasks, simulate outcomes, and generate new target audiences with natural language commands.
AI is Adobe's friend, not a foe
As AI-powered tools make it easier to create and edit digital images, some see the growth of generative AI as a threat to Adobe. But Adobe benefits from several competitive advantages that will make it difficult to displace and support its pricing power.
First, Adobe's software is an industry standard. That creates a network effect where everyone in the creative industry needs Adobe products to share files. If a designer sends a client a file, they better have an Adobe subscription to ensure they're viewing everything properly and can easily edit it and fine-tune it to their needs.
As the industry standard, Adobe's software suites are also very sticky. It's a big risk to switch your company's software just to save a few bucks each month. You'd have to retrain existing workers. New workers coming in are likely to be familiar with Adobe products but not others. Moreover, you could end up with inferior production capabilities.
Adobe's advantage in AI is its access to data nobody else has. That includes its Adobe Stock Image Library for training models. Its sizable user base also provides strong feedback it can use in the next iteration of its Firefly offering.
Both advantages are virtuous cycles, whereby they continue to increase in strength over time. That's hard for new competitors to overcome, even if they debut new AI features before Adobe.
It's not too late to buy the stock
Despite the recent run-up in the stock price, Adobe shares still trade for a fair price.
The combination of price increases and upselling Firefly features, plus strong conversions of free users, is driving revenue growth. Meanwhile, its operating margin has room to expand as it continues to scale, and management's using excess cash flow to buy back shares. Combined, that results in strong EPS growth.
Wall Street analysts are currently modeling 23% earnings growth this year and a more modest growth rate over the next five years. But analysts may be underestimating the long-term potential of Adobe's position and its AI features' ability to bring in new users that weren't previously in the market for its software. As such, Adobe could sustain much higher earnings growth over time, which would make its current forward price-to-earnings ratio of 31 look like a bargain.
