Adobe (ADBE) Stock: Time to Get Greedy (Valuation Upgrade)

Adobe Quotations (NASDAQ: ADBE) tumbled 9% on Friday after the software maker presented a weaker-than-expected revenue outlook for the current quarter. Overall, Adobe’s third-quarter results were generally solid as the company continues to expand its AI offerings, which it believes are strong momentum in its largest segment, Digital Media. Adobe also enjoyed a 1PP revenue acceleration compared to the previous quarter and increased its profitability to double digits on both an operating and net income basis. The stock is not entirely cheap, but cheaper than last week, however, which is why I recommend investors buy the drop here.

Previous assessment

We rated Adobe stock as a buy in July – Adobe: A Generative AI Software Play – because the software company released new products, including in AI, that indicated the potential to improve user productivity and because Adobe was seeing solid momentum in the top line. That momentum continued into the fiscal third quarter, and I don’t think the revenue outlook for the fiscal fourth quarter was all that bad. Adobe generated strong profitability last quarter, and investors, in my view, face a bearish buying opportunity following the Q3 earnings release.

Adobe beats estimates

The software maker reported better results on both the top and bottom lines for its fiscal third quarter: It posted adjusted earnings of $4.65 per share on revenue of $5.4 billion. The EPS figure beat the consensus estimate by $0.11 per share, while the top line came in $35 million ahead of the median prediction.

Strong core business results for Q3, improving profitability

Adobe reported strong financial results for its fiscal third quarter, indicating continued momentum in the company’s digital media segment. In its fiscal third quarter (ending August 30, 2024), Adobe generated $5.41 billion in revenue, showing 11% year-over-year growth. This growth represented an acceleration of 1 PP compared to the previous quarter, mainly due to the expansion of the business in the digital environment.

Digital Media includes Adobe’s Creative and Documents businesses, which are crushing it, in part due to the launch of new AI-specific products, such as the introduction of AI assistants in Adobe Acrobat and Reader. As a result, Digital Media revenues increased by 11% year-over-year. Both segments are also seeing a sizable boost in new annual recurring net revenue, as Adobe captures revenue primarily through a subscription-based business model. Total subscription revenue reached $5.18 billion in Q3’24, representing a revenue share of 96%.

In addition, Adobe significantly improved its profitability in the third quarter as more enterprise customers took up subscription offers. New and improved products, such as Adobe Firefly and various artificial intelligence offerings, continue to make the Adobe platform a magnet for creators, which also results in higher operating income. The software maker generated operating income of $1.99 billion in Q3’24, showing 17% year-over-year growth. At the same time, Adobe’s net income rose 20% year over year to $1.68 billion.

Adobe’s core profitability metrics are rising, mainly because the company is doing a great job growing its high-margin subscription offerings. Over the past five years, all major earnings numbers—gross profit, operating income, and net income—have improved dramatically, and the trends continue to be upward.

Poorly received outlook for Q4

Adobe expects fourth-quarter revenue to fall in a range of $5.50 billion to $5.55 billion, which fell short of analysts’ average estimate of $5.61 billion in revenue. Guidance for the current fiscal quarter (Q4) was largely the reason, in my view, for the negative price reaction to Adobe’s earnings report last week. With Adobe expected to generate $21.4 billion, I think the $85 million run on Q4 revenue guidance shouldn’t hold the stock back for long.

Adobe rating

Adobe isn’t necessarily expensive, given that the company runs a very profitable, subscription-based software platform at scale. Adobe is currently valued at a price-to-earnings ratio of 26X based on next year’s earnings, which compares to a P/E ratio of 28X for Microsoft ( MSFT ) and 23X for Oracle ( ORCL ). Both rivals are also highly profitable software companies that provide business productivity tools.

The industry group’s price-to-earnings ratio is 26X, while the average 5-year price-to-earnings ratio for Adobe is 30.0X. I think Adobe could return to its 30X P/E valuation average given that it is very profitable and is currently in the early stages of expanding its AI offerings. Content creators will continue to gravitate toward Adobe’s creative tools, particularly in Digital Media, which should translate into incremental growth in subscription revenue.

A P/E ratio of 30X, based on a consensus estimate of $20.55/share, calculates to a fair value near $617. That implies about 15% upside potential, but my fair value estimate doesn’t factor in an acceleration in Adobe’s top line and growing subscription absorption due to AI offerings. I also think last Friday’s pullback creates a unique buying opportunity for investors looking to invest in an AI software play for the long term.

Risks with Adobe

Adobe reported strong financial results in the third quarter, but there are risks. One risk is the potential erosion of its profitability and margins if other business software companies offer better and more efficient AI-powered authoring tools. Start-ups now also have the opportunity, harnessing the power of AI, to compete with large, well-funded software platforms such as Adobe or Microsoft.

Final thoughts

In my opinion, investors overreacted to Adobe’s fourth-quarter revenue outlook, as guidance missed the median prediction by only $85 million…which isn’t an amount to obsess over, considering that the software maker is set to earn around $21 billion in revenue this year. . I still like that the overwhelming majority of the company’s revenue comes from subscriptions, and that Adobe operates a high-margin business model. As a result, Adobe is broadly profitable, and its long-term (and short-term) profitability metrics all point to the upside. Abode shares have also been more expensive in the past, and the recent loss is a buying opportunity for investors. In fact, I think the best time to buy is often when investors panic and fear. In my opinion, this is one such opportunity.