Tom's Take: Adobe Q3 Results

A record quarter, so, why exactly is the share price down more than 10%?

For starters, it’s important to remember that share prices are a simple game of supply & demand.

If people feel that a share price will fall, based on annual reports, new product launches or CEO tweets, they’ll sell the stock to prevent losses. On the other side are buyers who feel that the sentiment around a stock is wrong & it’s actually worth more than it’s current value. They purchase, in the hope that they know something that sellers don’t.

Shares of most public companies are owned by large private equity firms, basically companies with lots of other people’s money who trust them to generate profit. So, when these PE firms sell a stock, it can move a market. In other words, create a panic where lots of other investors follow suit, driving down the value of a stock.

Think of a restaurant reviewer. They’ve got more influence on the success of a new restaurant than you or I because they’ve got a reputation of knowing more than most.

Sometimes they get it wrong. Are they? Let’s find out.

01.?? ?? What the PDF? How does Adobe make money?

Adobe started way back in 1983 with a product called Postscript, software that allows a computer file to be printed exactly as it appears on screen. A product that remains the industry standard still today.

Over time, Adobe have released a huge number of new products, with photoshop & of course the pdf becoming some of their most well-known products.

But Adobe does much more than this and its business is split into 3 areas as shown in this graphic that I made using Adobe Creative Cloud (teacher’s pet).

From this operating model (how the company is run), we can observe some good strategies:

01. Diversified Revenue Streams: This is a fancy way of saying that Adobe has a wide range of services to sell, so they can generate sales from lots of different offerings. In doing this, they also open up a broader target customer base.

So, they sell their services to influencers for content creation, agencies for running marketing campaigns, film studios for video editing, enterprise customers for digital document management & lots more. This means that they are not reliant on a single cohort for sales. Clever.

02.Predictable Revenue: In the early 2000s, Adobe moved from selling once off software programs (remember they used to come on a CD), to cloud based solutions. This enabled them to generate Annual Recurring Revenue. In other words, charging customers monthly for their services, usually tied to an annual contract. This is the standard in software, commonly referred to as SaaS (software as a service). But you already knew that.

This enables Adobe to lock in customers over longer terms, maintain constant cash flow (money coming in every month) & to plan for the future.

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03. Product Led Growth Strategy: Adobe benefits from a similar strategy to Stripe. In the beginning, Stripe targeted individual developers with a simple payment stack to help them accept payments for weekend projects & side hustles. Lots of these individuals also worked in large companies & as fans of Stripe, began to push decision makers to embed Stripe in their companies too.

Adobe does the same thing. Lots of their creative customers use photoshop & other tools in their daily lives, and the love them. Photoshop is even a verb in the Merriam – Webster dictionary. Like Stripe’s developer customers, Adobe advocates push the use of their software with their employers. This is called, product led growth. Hey, you learn something new every day.

???? Tom’s Take: Adobe is a very well insulated business with millions of customers across a wide range of industries. Not much else to say here, so we’ll jump into some financials instead.

02.?? ??The Numbers: Show me the moneyy.

Let’s take a look at the numbers Adobe posted for Q3. Just the high-level ones for now.

Revenue: The amount of money a company generated over a specific period of time. Adobe generated of $5.41bn and compared to this time last year, commonly referred to as YOY (year over year), it’s up 11%. Very nice.

If we break it down across their core services, it looks like this:

Net Profit: This is the money left over taking away all company expenses. In Adobe’s case this was $1.68 billion. This gives us a Net Profit of 31% (Net profit/Total Revenue). This is really healthy. For comparison, Microsoft has a Net Profit of 35.4% with Amazon at 7.8%.

Ok we’ve got the basics down. So, let’s dig in a bit deeper to not only see the numbers but also consider what they tell us about a company’s performance.

Gross Profit: Gross profit (also known as gross margin) is calculated by taking the price you sell something at and subtracting the cost to produce it. This is the money left over to pay overheads of running the business (think building costs, insurance etc).

For Adobe, their gross profit of $4.8 billion was up 12% YOY. This gives them a gross margin (Gross profit/Revenue) of 89%. This is high, even for software companies where the costs of producing a product remain relatively stagnant even if a product grows in popularity. By comparison, Salesforce has a GM of 76.85% whereas Apple comes in at 46.26%.

What’s interesting here is that gross margin increased by 12% while revenue increased by 11%. So, they are managing their costs very effectively. The more they sold, the less it cost them to produce the products they sold. Impressive.

Free Cash Flow & Market Cap: Free cash flow essentially relates to the amount of money a company has left to pay its bills & ideally have extra left over to fund its growth. For Adobe, in Q3 they had $1.9bn left over, up 18.75% on the same period last year.

Now, often FCF can be misleading. So, let’s take a look at Adobe’s debt to make sure they can afford it. Calculating this is relatively easy:

[Market Cap – Net Enterprise Value]

We’ve all heard of market cap, so let’s figure out what it means. Adobe has a market cap of $240bn. Now market cap is essentially the value investors put on a company. It’s the total $ value of a company’s outstanding shares (total outstanding shares x share price).

Net enterprise value reflects a company’s book value, essentially, it’s the value of everything under the company banner (customers, leases, office chairs etc. as well as some of it’s liabilities like loans).

Anyway, this gives Adobe a total debt of $7bn ($240bn - $247bn). Adobe could repay this $7bn in less than a year based on their FCF. So, safe to say the bank won’t be calling about missed repayments. Nice.

???? Tom’s Take: So, from a financial perspective, Adobe have had another strong quarter, breaking lots of their own records. But somehow, share prices is down ~10%, so what gives? It certainly isn't the numbers. We’ll take a closer look in the next section.

03.?? ??Nerds become jocks: Analysts takes & forecast misses.

The share price of a company is heavily influenced by analysts. These are the number crunchers at big banks & hedge funds who analyse companies and place a value on them. They are looking to evaluate if the current share price reflects the company’s reality. In school we called them nerds.

On Wall Street, analysts, at least for earnings calls, are the jocks. So, when they talk people listen. In Adobe’s case, despite the strong financial performance, the analysts had some concerns.

Public companies are obliged to forecast revenues for the upcoming quarter. This helps to set market expectations and reduce share price volatility. You don’t want to be wrong.

While Adobe beat analysts’ expectations for Q3, their Q4 revenue projects fell short of what was expected. They stated that they expected Q4 revenues of $5.5bn to $5.55bn, short of the $5.61bn expected on Wall Street. A relatively small differential, but a miss is a miss.

Gen Ai was also an analysts concern for Adobe. Now Adobe have successfully launched a suite of Gen Ai powered products under Firefly, (built on their proprietary LLMs) with over 12 billion images generated since launch last year. ?The issue lies in the monetisation of gen ai services. So, let’s take a closer look.

Adobe uses credits to charge for Ai, like everyone else, and has a $60 p/m unlimited credit band. As a starting point, this is unlikely to last, so price changes are likely coming.

However, they have also embedded Ai into lots of their product suite which comes at a cost. So, you can now use Ai to ask questions about a PDF. ?You’ll also have spotted a similar feature built into LinkedIn posts.

However, we don’t yet know if customers will be willing to pay a premium for these services. It’s still unclear if Ai embedded services become table stakes in software that are available for free or if they will cost a premium & give some companies a competitive edge? This is the concern for analysts. Big bets on Gen Ai as a service offering, as opposed to an internal cost saving measure, still remains a risk.

???? Tom’s Take: The Gen Ai concerns are valid & apply to a huge amount of software businesses. For Adobe, the bulk of their revenue comes from enterprise clients, with deep pockets, who in my view will likely see Gen Ai software as a way to make their staff more efficient. Consider the agency who could reduce content creation time, enabling teams to service more clients.

For me, I think the ~10% drop in share price is an overreaction. ?Adobe is in a very strong financial position & concerns on forecasts will be short lived. Adobe, like many others will navigate changes of Gen Ai, it just might take more time than originally expected.

See you in the next edition.