Adobe Stock: Time to Buy The Dip (NASDAQ:ADBE)

Adobe (NASDAQ: ADBE) shares fell 9.1% in after-hours trading after reporting fiscal Q3-2024 results. However, digital media and design software stock probably isn’t worth dropping that much. The main reason for the drop was the lower than expected orientation, but this it was hardly a miss. Now, you have a growing, industry-leading company that has returned to a reasonable valuation that suggests long-term upside here. As a result, I rate the stock a Buy. If ADBE stock declines further in the future, I would be willing to change the rating to a Strong Buy.

A quick overview of Adobe’s earnings results and what caused the decline

Adobe’s Q3-2024 results beat both revenue and EPS expectations. Revenue of $5.41 billion beat estimates by $40 million and rose 11% year-over-year, while non-GAAP EPS of $4.65 beat estimates by 11 cents. Meanwhile, cash flow from operations came in at $2.02 billion, up up from $1.87 billion in the same quarter last year, performance obligations remaining at the end of the quarter were $18.14 billion, and the firm bought back 5.2 million shares in the quarter. So far, so good.

Guidance miss

Here’s the part investors didn’t like. For the fourth fiscal quarter of 2024, Adobe estimated revenue of $5.5 billion to $5.55 billion — $5.525 billion in the middle. That missed analysts’ estimates for revenue of $5.6 billion. Also, non-GAAP EPS is forecast at $4.63 to $4.68 — $4.655 in the midpoint. However, analysts were expecting EPS guidance of $4.67.

Basically, revenue guidance was 1.34% lower than expected and EPS guidance was 0.32% lower than expected.

Analysts worry about slowing growth

On the earnings call, Wolfe Research analyst Alex Zukin asked the following question about the new ARR guidance for digital media, as he was concerned that Q4 guidance is the lowest it’s ever been sequentially:

The quarter itself, especially on Digital Media ARR looked very strong. It looked abnormally strong because you haven’t grown sequential net new ARR in the third quarter in, I think, almost four years. So maybe just comment like what caused this unseasonal force. Is it pricing, AI traction, and especially the new Document Cloud net ARR? But at the same time, given all the product momentum that you’ve gone through in the scenario, it’s a little confusing to understand why the Q4 guidance is the lowest it’s ever been sequentially for Q4 on the new Digital Media ARR, which I think that makes people a bit. nervous about can go ahead, next year’s performance. And so maybe we’re addressing that dichotomy, because it looks a little bit different, seasonally, than what we’re used to. And I think it weighs the stock after hours.

Adobe responded, and part of the response came from David Wadhwani, president of Digital Media Business. He said the early closing of some deals boosted Q3 at the expense of Q4, affecting the sequential growth pattern.

In terms of timing details, Q3 was a bit stronger than you’d expect, and for good reason given the seasonality. I think a lot of that can be explained by a few trades that may have just historically closed in Q4, closing earlier than expected in Q3, and that changed the dynamic in terms of the linearity that you typically see between Q3 and T4.

Before that, he said that the combined performance of Q3 and Q4 met Adobe’s expectations and that they are on track for the second half of the year.

Is the drop justified?

I think Adobe has handled this question well, so I see no problem there. So we now turn to the main issue of lower-than-expected guidance. Did such a small miss justify a 9.1% drop? Probably not, but maybe the valuation was too high before. I don’t really care about that, though, because we’re looking at what the price is now, not if it was too high before. Now, the assessment is reasonable, which I will address below.

Adobe’s valuation has now become reasonable

I will evaluate Adobe using an inverse DCF calculator that I created. Essentially, it calculates an implied growth rate that the market expects, and then you can decide whether the stock can beat that implied growth rate (which would make it undervalued) or not (which would make it overvalued). A more comprehensive guide can be found here.

Here are the evaluation inputs:

• FCF per share: $14.62, which I manually calculated from the earnings report
• Cost of equity capital (taken from Finbox, which calculates it using the CAPM model): 9%
• Terminal Growth Rate: 3%
• Share price after schedule: $533

I used a terminal growth rate of 3% for a few reasons. First, global GDP growth is expected to be around 3% for the next few years, and that seems like a reasonable growth rate in perpetuity. But aside from that, assuming the Fed’s 2% inflation rate target is met, Adobe’s pricing power (which can be easily proven by its very high and stable gross margin of ~88 %) could at least allow it to raise slightly overpriced prices. inflation.

As for manually calculating FCF per share, here’s how I got it (just to show you that the figure is relatively reliable, as it’s not yet updated on most financial sites). We took the $2.02 billion in cash from operations in Q3 and subtracted the $57 million in CapEx to get $1.964 billion in free cash flow. To that, we added FCF from the last 3 quarters and got $6.55 billion in TTM free cash flow. We then used the number of shares outstanding of 448 million provided in Adobe’s Q3 report and divided the $6.55 billion by that figure to get $14.62.

evaluation

Looking at the screenshot below, we can see that the market is currently pricing in ADBE to see its FCF per share grow by 12.826% per year over the next 10 years and then grow by 3% per year thereafter in perpetuity.

This seems very reasonable to me, especially given that Adobe’s free cash flow is expected to grow to $10.73 billion by fiscal 2026 (ending November), according to analysts at simplywall .st. That’s 2.25 years away and the 2.25 year CAGR from a $6.55 billion base would be around 24.5%.

It is possible that these estimates could be revised downward, but probably not by much, given the very low rate of guidance. Also, the 24.5% CAGR does not include the positive effect of share buybacks, so factor that in as well. For reference, Adobe’s FCF for the past five years is 16.75%. The per share amounts should be slightly higher due to the decline in the number of shares of the stock over the years, which you can see below.

Additionally, analysts expect Adobe’s EPS growth over the next few years, helping to prove to me that the stock can reach its implied growth rate of 12.826%.

What happens if you adjust FCF for stock-based compensation?

In my last article, I went a bit on Palantir (PLTR) for its high stock compensation, so I didn’t want to leave it out of this article. If you deduct trailing 12-month SBC of $1.819 billion from $6.55 billion in FCF, you get $4.731 billion ($10.59 per share) of what I call “real” free cash flow.

In this case, the implied growth rate jumps to 17.082%, but frankly, this still seems achievable to me based on future free cash flow estimates. Let’s be real though. Many people don’t bat an eye at SBC and evaluate stocks based on adjusted numbers anyway, so make of that information what you will.

The Takeaway

Adobe reported solid earnings that beat both revenue and EPS estimates. However, the stock fell more than 9% in after-hours trading, even as it only missed revenue and EPS guidance by 1.34% and 0.32%, respectively. Additionally, while new Q4 digital media ARR guidance looked weak to analyst Alex Zukin, the company assured investors that the reason was due to deals that were recognized in Q3 that would normally have been recognized in Q4.

After reading the earnings report, I concluded that the low guidance rate did not justify a 9.1% decline. The stock now trades at what I believe to be a reasonable valuation, implying free cash flow growth per share of 12.826% over the next 10 years (17.082% if you strip out SBC) and 3% per year thereafter. Based on the company’s historical growth and future growth expectations, it could exceed or meet these implied growth rates. When I see an industry leader trading at a reasonable price, I become bullish on the long term.