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Morningstar | Adobe Remains a Creative Software King; Raising FVE to $300. See Updated Analyst Note from 10 Oct 2018

We are raising our fair value estimate for Adobe Systems to $300 per share from $245 after incorporating new assumptions into our model. We are maintaining its wide moat, stable trend, medium uncertainty, and Standard stewardship ratings. Adobe remains a cash machine, benefiting from 20%-plus revenue growth, and GAAP operating margins are near 30%. The firm approved an $8 billion buyback this year. With shares trading at a discount, we think this remains an attractive point of entry.

The firm’s software-as-a-service-based products are bucketed into three segments, digital media, digital experience, and publishing, with the former two serving as the growth engine of the business. Digital media houses Adobe’s creative software products for web designers, application developers, photographers, and animators, among others. We believe Adobe has an effective monopoly in the creative software market, which creates durable switching costs, as its applications are mission-critical. We also believe a network effect exists in the firm’s digital media products. The education system for creative minds relies heavily on Adobe’s products, which propagates a platform that is widely understood and used in the design community.

Adobe has transitioned from an on-premises business model to become a software-as-a-service heavyweight, and its Creative Cloud is the gold standard for creative professionals. Creative Cloud has benefited Adobe by offering customers more attractive prices, locking in customers for longer periods, curbing piracy, and providing management with more visibility into future revenue. Customers can increasingly pick applications to suit their needs, and a subscription model removes the large, up-front cost that existed with Creative Cloud's predecessor. Through acquisitions, such as Macromedia in 2005, Adobe has built the most comprehensive suite of creative software.

Great software companies have more than one act, and act two for Adobe has centered around its analytics and digital marketing initiatives, which are currently housed in its Digital Experience segment. Adobe’s prowess in creative content, has allowed it to nab synergies in the digital marketing space, cross-selling to enterprise CMOs already utilizing Adobe’s software. The product, now dubbed Experience Cloud, operates in a nascent and growing industry, but Adobe’s end-to-end functionality, built internally and through acquisitions, such as Omniture, TubeMogul, Magento, and Marketo, has meant it is largely regarded as the leader in the space. As companies look to create omnichannel, targeted ad campaigns, Adobe’s marketing software has become a mission critical offering for major brands and enterprises. Experience Cloud spans marketing, advertising, and analytics amongst other features. Experience Cloud competes with the likes of Salesforce.com and Oracle, who compete in the broader CRM space, but we think a rising tide can lift multiple boats, with optionality for Adobe to cement itself as a Digital Experience leader.

In aggregate, we model an 18% revenue CAGR over the next five years. In terms of Adobe’s digital media offerings, while the transition is near complete, we expect uplift as Adobe continues to transition customers to the cloud. As the firm builds new product packages around digital media, we expect Adobe to increase its total addressable market. We project a 20% compound annual growth rate over the next five years for Adobe’s Creative Cloud. Adobe Document Cloud, built around the Acrobat family of products, is seeing a double-digit run rate, and we model a 10% CAGR over the next five years before a deceleration into the midsingle digits thereafter.

We model a 20% revenue CAGR for Adobe’s Experience Cloud and a 19% CAGR for the aggregate digital experience business over the next five years. We assume the firm maintains its leadership in digital marketing and gains synergies from the 2018 deals for Magento and Marketo.

In terms of aggregate margins, Adobe’s mature digital media business helps the company achieve high gross margins, and while Adobe does not break out operating margins by segment, we believe the digital media accounts for the vast majority of operating profits. As the digital experience business grows and gains scale over its expenses, we believe Adobe’s cloud model will allow it to extract higher operating margins. While Adobe will certainly need to invest in selling, general, and administrative expenses and R&D headcount, the asset-light business allows a significant portion of revenue growth to trickle to the bottom line. We believe Adobe’s gross margins can expand from 86% in fiscal 2017 to 90% in fiscal 2027 and that upside remains for Adobe’s already robust GAAP operating margins, which currently sit near 30%.

Adobe underwent two large acquisitions in calendar 2018 to bolster its digital experience segment against competitors. We believe these enhance switching costs, particularly as Adobe’s already comprehensive marketing portfolio, coupled with these two acquisitions, will allow the firm to have end-to-end functionality. We believe this discouraged customers from leaving for a competing product. In May 2018, Adobe agreed to acquire Magento, which offers digital commerce capabilities, for $1.68 billion. We believe this is similar to Salesforce’s 2016 acquisition of Demandware in that there are advantages from tying together marketing and e-commerce capabilities. In September 2018, Adobe agreed to acquire Marketo for $4.75 billion. Marketo’s specialty is lead management, which helps identify qualified sales leads in the business-to-business marketing sales process. Adobe Campaign once offered a stand-alone lead management module, but it was discontinued in March 2017. Acquiring Marketo bolsters Adobe’s business-to-consumer capabilities with Marketo’s expertise in B2B. Essentially, we believe the purchase helps fill a gap in Adobe’s product portfolio as it increasingly competes with the likes of Salesforce.