The Investment Case for Adobe
Originally published on Linkedin
In this article, I will explain why I am a shareholder in the wonderful creative software business, Adobe.
Disclaimer: For the avoidance of doubt, this article is not a personal recommendation. You should hire a financial adviser or do tonnes of research before making any investment decisions. Investing in individual stocks is very high risk and statistically speaking you are likely better off diversifying among thousands of companies through collective investment funds. This is also why I was very pleased to learn that my favourite equity fund, Fundsmith Equity, added Adobe Inc to its £24bn, 29-stock portfolio earlier this year.
7 reasons why I love Adobe
Adobe's programmes are truly superb and its market leading position in creative software reflects this. Try googling the best software and you will find that Adobe is either the top-rated or not far from the top in the following categories: Photo-editing, drawing, web design, video-editing, animation, PDF editing/reading, e-signatures, vector graphics, publishing, audio-editing and mobile app design. Adobe has also become a major competitor in online marketing and web analytics software, which makes up around 25% of its total revenues.
Demand for good-looking digital content is only going to increase as technology continues to advance and populations grow. Adobe is well-positioned to continue benefiting from this long term trend.
Adobe's pricing model is subscription-based, which provides an excellent cash flow stream for the company. It is also structured in a clever way so that, when looking at their annual packages, you can pay £10-£20 per month for an individual product or you can pay £52 per month for all 27 of their creative apps plus cloud storage, commercial-use images, fonts and more. So if you create digital content for a living, why not just choose the leading provider that gives you all the tools you need in one competitively-priced package? Why bother having products from lots of different companies that probably do not integrate with each other as seamlessly?
Adobe is embedded in the graphic design sector - its programmes are the industry standard. University courses teach graphic design students how to use the Adobe Creative Suite and employers expect designers to be proficient with the software. Moreover, because Adobe's programmes can take months or years to master, all of this time invested contributes to brand loyalty. Thus it would take a lot of convincing for professionals to step outside the Adobe ecosystem.
Adobe's business model is relatively defensive. During an economic downturn, graphic designers would probably be shooting themselves in the feet if they stopped renting the creative tools that enable them to make a living.
Owning Adobe for the long term could be a hedge against the 'threat' of Artificial Intelligence (AI). Artistic creativity is arguably one of our most uniquely-human traits, which is why the field of digital design may have more longevity than most careers that are more prone to being displaced by automation/AI. The most common prediction of AI is a pessimistic one of 'us and them' whereby machines and humans are seen as separate and at odds with one another. On the other hand, a more optimistic view is that AI integrates with us and empowers us on an individual level, which we already experience with our smartphones to some degree. Adobe is currently using AI and machine learning to power its software, which enhances the abilities of content creators rather than making them obsolete.
Last but not least, Adobe's economic numbers are brilliant:
87% per annum gross margin (4-year average).
33% per annum operating margin (4-year average).
25% per annum return on capital employed (4-year average).
Reasonable debt levels: Long term liabilities represent 37% of equity and only 20% of assets (at 30/11/2021).
Such high profit margins are an excellent defence against inflation. For example, Rolls Royce has a gross margin of 20% and Adobe has a gross margin of 87%. If both companies experience 10% inflation in their Cost of Goods/Revenue, the business with the higher input costs suffers the most: Adobe's gross margin takes a 1.49% hit whereas Rolls Royce better start charging its customers more because its gross margin gets slashed by a whopping 40%.
What about the risks of owning Adobe?
For better or worse, I cannot think of many risks that are particularly unique to Adobe but more so to software developers and businesses in general:
While graphic designers are likely to remain committed to Adobe, there are many creative apps, which non-professionals can use that are completely free of charge.
Piracy has always been a problem and Adobe has to stay on top of this.
Adobe's management could start making bad decisions, such as taking on too much debt to finance acquisitions that turn out to be failures. Thus it is the responsibility of shareholders to keep an eye on who is running their company and how.
The intensity of future competition is less predictable and hence more risky for software developers than the concerns of simpler companies like Coca Cola, for instance.
Because Adobe is so successful, its stock price trades a premium and therefore the risk of overpaying on a relative basis is unlikely to go away. However if previous profit rates persist, a long term position ought to more than compensate for buying the stock at a relatively high price - especially following the recent declines in the stock market. Although if interest rates have much higher to go, premium-priced stocks in particular may well have further to fall.
The future is uncertain. Even if you think you have found a perfect investment, something completely unexpected could come along and shatter your predictions. This is brutal nature of business.
I hope you found this article interesting. If you find it persuasive, please let this be a small fraction of your overall research and preferably discuss it with a professional.
Investing is risky, complex and a big test on one's emotions. As Warren Buffett's business partner, Charlie Munger, puts so bluntly,
"If you can't stomach 50% declines in your investment, you will get the mediocre returns you deserve."