Positives: Competitive Advantage & Moat

Summary: Industry-standard cash-cow software: Photoshop, Illustrator, Premiere and Acrobat. The Moat is legacy, muscle-memory and the subscription model.

Adobe is a global dominator in what it does – software for Design. But traditionally, it’s been the go-to standard for 2D creative design – like advertisements, magazines, book covers etc. Let’s call it “fun design”. It has never tried to excel at more “serious design” like machines, buildings or cars. Within the world of fun design, Adobe has been a stalwart.

Its competitive advantage can be boiled down to 4 main products – Photoshop, Illustrator, Premiere and Acrobat. These software packages have been around for a while and have become the industry standard for the following:

1. Photoshop – professional photo editing
2. Illustrator – professional graphics creation and editing
3. Premiere – professional video editing
4. Acrobat – immutable documents.

Adobe makes other software but these 4 are their main raison d’etre. They’ve survived the test of time because 1) first(ish)-mover advantage 2) they’ve kept pouring in money to improve these products, 3) designers using these products have too much muscle-memory or 4) All of the above. We suspect the staying power of these products is “all of the above”.

There is a 5^th reason why Adobe seems to have solidified its stranglehold in the domains that these 4 products dominate – a SaaS subscription model. Software-delivered-via-Cloud lays the groundwork for an incumbent to dominate. Money can be spent to improve products ad nauseum, making it very difficult for scrappy upstarts to catch up. The flywheel gets bigger when things are “softwarized” completely.

Judging by the numbers, the subscription model has worked wonders for Adobe. Check out its revenue and Free Cash Flow growth over the last few years.

Adobe has some dominant products that constitute as industry-standard. This is a rare asset. It’s trying to protect that competitive advantage by making it easy for users to run the software on any device, anywhere, and by making it hard to switch out to a competitor. The more designers stick with their product, the more muscle-memory they have over time, and the larger their “track record” on Adobe’s software is. That’s the Moat – legacy and muscle memory, fueled by a subscription model.

How long can this party last? If Adobe can repeat its recent performance, the stock is an easy buy even at current prices. But can it repeat this performance? That’s what we’re trying to investigate in the rest of this analysis.

In the rest of the Positives Section, we’ll run through Management Strategy and Growth Drivers. Then, we’ll turn our attention to Negatives – Competition, Strategy Risk and Key Risk. We’ll finish this thesis with our valuation of Adobe stock, which informs our decision – Buy or Watch.

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Positives: Management Strategy and Growth Drivers

Summary: Maintaining lead in its 4 cash cows and trying to build an ecosystem in concert with other products to increase customer retention. Management hopes that subscription volume and pricing will increase as they successfully execute on the “ecosystem value” of the Adobe product suite.

Adobe has 3 business lines now:

1. Digital Media
2. Digital Experience
3. Digital Publishing

On paper, these 3 segments have obvious synergies. Let’s say a designer designs a retail website and hands it over to the client, who then uses Digital Experience software to track and optimize their customers’ journeys. Somewhere along the line documents and whitepapers related to the sale will be created, which can also be tracked. It should all work in concert.

That’s Management’s goal – people buy Creative Cloud for one or two apps, but they stick around because they discover that many apps that work perfectly in concert. Management hopes that designers will realize that they can’t get this one-stop shop anywhere else, and that will therefore attract more fellow designers to the Adobe ecosystem. And finally, all this will give Adobe immense pricing power.

Great plan. But is it working? We can’t say for sure because we can’t get our hands on per-app data or designer behavior data. Adobe apparently has this data – Management uses something called DDOM – Data-driven Operating Metrics – to think about product enhancements and product launches. Judging by the numbers, something seems to be working.

There’s other stuff that management claims its work in on – AI (something called Sensei) and being truly multi-surface, meaning that eventually all apps should work on all devices (and operating systems) at all times. Worthy goals. From a macro standpoint, Adobe’s management is enjoying the “digital transformation” tailwind. As documents and work processes become increasingly digital, management wants Adobe’s fingerprints all over it – whether it’s as simple as secure PDFs or something more exotic like action buttons designed in Illustrator.

In summary, from the earnings calls, SEC filings and presentations made by Adobe’s Management, here’s their broad strategy:

1. Invest to maintain dominance of cash cows.
2. Keep trying to sweeten the deal – of a full-suite subscription – with other non-core apps that seamlessly work with the core apps.
3. Expand the stable of “sweetener” apps with organic R&D or tuck-in acquisitions (ex. Workfront, Marketo)
4. Expand a completely new business – Customer Experience – with a captive audience in the designer/creative community.

Among these pillars of strategy, #4 is hard to fathom. More on that in the Negatives section. But before that, let’s think about what can go right.

Growth Drivers: Management hopes that subscription volume and pricing will increase as they successfully execute on the “ecosystem value” of the Adobe product suite.

In their last Investor Day in December 2020, Adobe Management made a bold case for the future of the company. Essentially, the pitch was about digital transformation and role of Adobe is digitizing stuff like documents, pictures and graphics etc. Management’s optimism boiled down to their TAM expectations. And they’re huge:

The question for us investors is whether we can believe these numbers with high confidence. We’re split 50/50 on this. We’re optimistic because of Adobe’s track record and its clear dominance in a few products like Photoshop an Illustrator. But we’re also skeptical because of two potential risks that came up in our conversations with freelance designers.

When we showed them Adobe’s fantastic revenue growth since “cloudifying” its products, they immediately brought up the issue of “forced conversion” from physical products to subscriptions. They were skeptical about Adobe’s market share expanding too much. When asked about leading products like Photoshop and Illustrator, most of them attributed the continued success to legacy and muscle memory. They almost expected future challengers. More on this in the Key Risk section.

So, we should take Management’s TAM growth expectations with a grain of salt. But we’ll give them the benefit of the doubt with some caveats. So, we’ll assume the following:

1. Adobe’s TAM grows as per Manager expectations.
2. BUT - Adobe does not gain more market share than they already have.
3. So, Adobe will maintain its current market share, as suggested by current revenue and 2022 Management TAM.
4. We’ll extrapolate this market-share estimate to Management’s 2023 TAM expectations.

That will be our estimate for Sustainable Revenue. As far as costs are concerned, we’ll give Adobe the benefit of the doubt when it comes to scalability. And, we’ll assume no increases in Fixed Operating Costs such as R&D and SG&A. We’re really giving Management a lot of leeway here. Let’s see what happens.

The result looks like this:

We’ve made some assumptions below this line to arrive at a Sustainable Free Cash Flow estimate of about $7 billion. This translates to a per share price of $291. Adobe currently trades above $500.

For us to believe that $500 price tag, we’ll need to assume that revenue will more than double. That’s hard to swallow given that the company is not the global dominator we thought it was.

Negatives: Competition

Summary: Lost the plot on web/app design to upstarts like Figma, Webflow. Competition from Autodesk on 3D. Customer Experience software dominated by Salesforce and others.

We had started our exploration of Adobe with the idea that it’s a global dominator with little competition. It turns out that’s not true. Adobe has some industry-standard products but faces stiff competition in most of its product stable. The most interesting revelation about competition came from the web and app design world.

Not too long ago, Adobe Photoshop was the standard software for web design, along with another pesky upstart called Sketch. About 3 years ago, this dominance was challenged by other pesky upstarts like Figma and Webflow. Today, Photoshop is not the main website design application among in-the-know designers. These pesky upstarts are. This is true of App design and prototyping as well. Sketch used to be the main competitor to Adobe Photoshop, and now they tie up with upstarts like Figma, Webflow or Affinity to offer designers all they need to design a brilliant website or app. Adobe had responded with its own app called XD, but that’s been relegated to more of a hobbyist app than anything serious. None of the web designers we spoke to (5 of them) use XD.

For designing physical products and illustrations, Adobe Illustrator still seems to have the lead. Some of it is due to legacy and muscle-memory. But some of it is due to the quality of their product. One designer we spoke to designs illustrations for t-shirts and pet-wear. She uses Illustrator mainly because it allows her to store archetypes of designs that she can modify and use anytime in the future. She also mentioned that muscle-memory is a big attraction – why fix it if it ain’t broke? That seems to be a big part of the continued dominance of Photoshop, Illustrator and, possibly, Premiere – why fix it if ain’t broke?

But there’s no guarantee that dominance lasts. Incumbents get disrupted every day. An incumbent like Adobe must always widen the Moat, whether competition encroaches or not. Adobe does spend about $2 billion on R&D, so they are, presumably, always trying to innovate and widen the moat. The last few years have been about moving their entire business over the Cloud. The last 12-18 months have been about making products “multi-surface” – available on any device, any time. The next few years, Adobe’s Management says, will be about AI and expanding its product base.

We’re not sure Adobe can make huge strides into newer fields such as 3D-Imaging and VR/AR. They’ve got products for these – like Adobe Animate and After-Effects. We couldn’t find reliable data on their market share. However, we did try to find out how some of the recent miracles of animation. Lion King, for example, used Autodesk’s Maya and another specialized software called Unity. Pixar uses their own custom software called Presto. Popular mobile game Fortnite is made using something called Unreal Engine. Adobe can gain ground in these new graphical fields, but we can’t hang our hat on it. Can they beat these highly specialized incumbents?

With Adobe Digital Experience, we’re even more skeptical. We can’t, at the moment, see how they can compete with entrenched customer relationship management (CRM) software like Salesforce – especially now that it has combined forces with Tableau and Slack. Ultimately, good CRM is about good attribution of sales to a huge data lake of underlying variables. We’re not sure data attribution & analysis is Adobe’s core competency. But “Digital Experiences” is still a $3 billion business, so maybe we’re missing something. However, in comparison, Salesforce’s annual revenue is more than $20 billion. SAP’s annual revenue is more than $30 billion.

Adobe’s Management has prioritized the Adobe ecosystem – that’s their competitive edge and they want people to pay for the one-stop-shop facility that only they can provide. But it’s no point being a one-stop-shop if most of your products are second-rate.

Negatives: Strategy & Key Business Risk

Summary: Unlikely that Adobe will regain lead in website design, app prototyping or gain in 3D Imaging or VR. Makes it hard to orchestrate an ecosystem to retain subscribers. They lose their lead in cash-cow products like Photoshop and Illustrator to pesky upstarts, thereby negating any “ecosystem” advantages, thereby decreasing ARPU.

Currently, the orchestration is working. Customers subscribe to Creative Cloud because, why not? A designer may only use Photoshop but buys the optionality on using the others. Some designers may actually use Photoshop and Aftereffects. Some may use 3 apps. We tried to dig around to find out the percentage of users that are using 2 or more apps on Adobe’s Creative Cloud, but we couldn’t find any reliable data. Even more surprising was that it’s hard to find reliable data on how many total subscribers Creative Cloud actually has. A Google search says 15-20 million.

But we can sort of back into it. Adobe’s LTM Revenue ending February 2021 was $13.7 billion. Nearly $10 billion of that was attributable to Digital Media. If we assume that Creative Cloud subscriptions accounted for virtually all of Digital Media revenue, we back into a user-base of roughly 16 million subscribers – IF all these users bought the whole $53/month Creative Cloud package. Many don’t. So, if we lower the average revenue per user number from $53/month to, say, $40/month, the user count goes up to 21 million. At $20/month, it’s 42 million. Maybe, the actual number is 25 million, give or take 10%. So, the question is, how much upside is there to that number? It’s hard to say. How many people in the world are designers? 1 in 100 prime-age adults? 1 in 200? It’s safe to assume volume won’t grow by leaps and bounds unless Adobe steals market share.

If volume can’t grow by leaps and bounds, then maybe pricing will. The key to that is that ecosystem value-add. If Management can convince enough people that the entire Creative Cloud ecosystem is worth $53/month or more. If Photoshop, Illustrator and a couple of more apps remain design staples, can Adobe charge, say, $60/month? We suspect there is an upper limit to this because if Adobe comes across as a shameless gouger, it may open up a minimum viable market for a pesky upstart selling “Photoshop Lite” for, say, $10/month.

Based on our scuttlebutting among designers we know, it’s possible that Adobe will face competition in their core cash cow products like Photoshop and Illustrator. At the moment, there are other alternatives but there is no compelling reason for photographers and designers to switch out of these incumbents. It’s probably appropriate to use the Word and Excel analogy – they’re not exactly a pleasure to use but the alternatives aren’t great either.

The risk is that the incentive for a designer or firm to pay Adobe a subscription fee decreases significantly if they find alternatives to Photoshop or Illustrator or Lightroom or Premiere. As we mentioned before, we can’t automatically assume that Adobe will strike it big in 3D or VR. It’s safe to say that most designers are quite specialized in their own little niche – photos or video or animation or websites/apps or apparel etc. It’s not 100% clear to them why they should subscribe to the whole ecosystem if they don’t have a big use-case for Adobe’s other apps.

The Key Risk can be summarized as follows:

1. Adobe loses its status in core products, which is mainly why designers subscribe.
2. Once that happens, there is no ecosystem to defend.
3. If most designers switch from a full $53/month Creative Cloud subscription, to a single-app $20/month subscription, ARPU (average revenue per user) can get hit big time.
4. If, as we suspect, there isn’t much room for volume growth, then revenue takes a hit.
5. For a high-fixed-cost business like Adobe (which is great when revenue grows) the impact on Free Cash Flow will be even more severe.

The risk to our estimate of Sustainable Revenue is that Management fails to convince the designer community that they need 2 or more Adobe apps and, therefore, the Adobe ecosystem. This brings us to Valuation.

Valuation: What is Sustainable?

Our main assumption is that we’ll give management the benefit of the doubt on their 2023 TAM expansion argument. We’ll assume that TAM will increase substantially in the next couple of years. But, for all the risks mentioned above, we won’t assume any market share growth.

Here’s what we’re assuming:

Here is what it shakes out to - our valuation summary:

For more details on our valuation of Adobe, please check page 10 of our thesis summary by clicking the picture below.

It’s disheartening for us to conclude that Adobe’s too expensive for us to buy. We like the business, but we don’t want to overpay. Margin of Safety is one of our core values. If we invest in Adobe at these prices, we'd just be speculating on their subscriber growth. We're not prepared to do that. This is why we dig in. Great story. Very high price.