By Valuentum Analysts
The fast-growing software companies that generate the lion’s share of their revenue from subscription sales with original budgets are very attractive entities. Adobe (NASDAQ: ADBE) She also has something else going on for her. While other capital-intensive companies have huge capital expenditures (property and equipment purchases) that affect the cash they can return to shareholders, Adobe’s asset-light business model ditches free cash flow. We define conventional free cash flow as cash flow from operations minus all capital expenditure. Let’s take a look at Adobe’s free cash flow generation through the recently released results for the three months ending December 3, 2021.
Adobe continues to be the powerhouse of free cash flow generation. It’s sometimes easy to overlook big-cap companies because we might think they’re too big or they might be the best years behind them. However, the market reminds us that great companies are great for a reason: They are able to continue to multiply capital and returns at high rates, and a lot of that has to do with how effective they are at generating free cash flow. That’s why Apple (NASDAQ: AAPL) and the alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) Two strong companies with free cash flow that are light in assets – despite being huge stockholders, they have made huge returns in recent years.
In fact, the big-cap growth stylistic area, in which Adobe is located, has been one of the strongest performers over the past five years when it comes to price returns, doing significantly better than almost every area of the market, from economic trenches to portfolios. Balanced Finance/Bonds for Biotech Stocks and Mastering Limited Partnerships. Sometimes, as investors, we think big stocks can’t do as well as small stocks because they are really big. But the past five years have proven this view wrong. Payouts from a large base can be more impressive than those made from a small base. We still love Adobe and the big capital growth areas!
Adobe business model overview
As mentioned above, Adobe is one of the largest software companies in the world. The company was founded in 1982 and is headquartered in San Jose, California. Its main offerings include Adobe Creative Cloud, Adobe Document Cloud, and Adobe Experience Cloud, all geared toward enabling the digital economy (including offerings geared toward media and content creation, offerings that enable digital document processing and processing revitalization, and offerings that support e-commerce and marketing activities digital).
By 2024, the company sees Adobe Creative Cloud serving a total addressable market of approximately $63 billion. [‘TAM’], Adobe Document Cloud to about $32 billion from TAM, and Adobe Experience Cloud to nearly $110 billion from TAM. We appreciate Adobe’s promising growth prospects and believe that it will be able to meet its target expectations. The company’s enormous free cash flow generating capabilities give it great flexibility in being able to achieve its goals.
Adobe also continues to gain traction with Creative Cloud subscriptions, and we love this recurring subscription-based model. Adobe Marketing Cloud has become a favorite among major marketers, as digital marketing bookings continue to expand with a great clip. The company is also investing in its AI capabilities to help its customers by providing enhanced automation features across its offerings.
In summary, we believe that Adobe is well positioned to benefit from the continued spread of e-commerce activities around the world, particularly across the suite of Adobe Experience Cloud products and services. Their impressive financial sources and cash-based intrinsic value help form a strong basis for our estimation of the fair value of the shares, which we talk about later in this article.
Update and Financial Guidance
Perhaps the most impressive part of Adobe’s business model is that nearly 90% of Adobe’s revenue comes from recurring sources. Asset-light operations allow for significant free cash flow generation in the company, as we demonstrated in its latest press release near the top of this article. But Adobe has been a solid source of free cash flow for some time.
For example, Abode averaged free cash flow (defined as net operating cash flow minus capital expenditures) about $4.6 billion per year from fiscal year 2018 to 2020, considering that fiscal year ends in late November (November/early December). In fiscal year 2021, Adobe generated approximately $6.9 billion in free cash flow (according to the 10-Q SEC filing covering the first three quarters of fiscal year 2021 and its press release covering the fourth quarter of fiscal year 2021).
We love Adobe’s potential margin expansion as well as its sales growth forecast as well, especially as recurring revenue sources continue to grow. Adobe increased GAAP revenue 23% and GAAP operating income increased 37% year-over-year in fiscal 2021, as the coronavirus (“COVID-19”) pandemic accelerated the global shift to digital business solutions daily. Economies of scale enabled Adobe to significantly increase its operating margins in GAAP in fiscal year 2021 (which were up more than 380 basis points year over year).
We’re also fans of the original Adobe balance sheet. At the end of fiscal year 2021, Adobe had approximately $1.7 billion in net cash on hand with no short-term debt on the books. The company has been buying back its stock steadily in recent fiscal years at a moderate pace (Adobe has managed to maintain the strength of its balance sheet), and the company does not currently pay a joint dividend. We love rich net worth, free cash flow generating stations! Looking ahead, Adobe provided promising guidance covering fiscal year 2022 during its fiscal fourth quarter earnings update as you can see in the following graphic below.
Adobe’s fair value estimate
Do you think stock prices mean something? We do.
By adding the net cash on a company’s balance sheet to the present value of future projected free cash flows and then dividing that amount by the shares outstanding, one arrives at the company’s value on a per share basis. After calculating the value per share of the company—which includes an analysis of net cash on the balance sheet and projected free cash flow in the future—and then comparing this value per share to Adobe’s stock price, we can make an informed judgment about whether the stock is a good deal. The higher the value for the price, the better the deal! Think of it as getting a discount at the grocery store. As Warren Buffett once said, “Whether it’s socks or stocks, I like to buy quality items when they are set at a low price.”
Based on our discounted cash flow model, we believe Adobe Systems is worth $576 per share. Our company valuation model reflects a compound annual revenue growth rate of 15.6% over the next five years, a pace lower than the company’s 3-year compound annual growth rate of 20.8%. Our valuation model reflects a 5-year expected average operating margin of 43.6%, which is above Adobe Systems’ 3-year moving average. After the fifth year, we assume that free cash flow will grow at an annual rate of 6.5% over the next 15 years and 3% forever. For Adobe Systems, we use an 8.5% weighted average cost of capital to discount future free cash flows.
Although we estimate Adobe’s fair value at approximately $576 per share under our “baseline” case scenario, each company has a range of potential fair values created by uncertainty from key valuation drivers such as future revenue or earnings, for example . After all, if the future was known for sure, we wouldn’t see much volatility in the markets because the stocks would trade accurately at their known fair values.
Understanding how changes in future expectations affect stock values is essential to understanding how the capital markets work and what causes market volatility. For example, if future expectations regarding revenue growth or margin expansion change, the value of the company will change, and thus the buying and selling decisions that drive price will change.
In the following chart below, we show the potential range of Adobe’s fair values. We think the company is attractive at less than $461 per share (green line), but expensive above $691 per share (red line). Prices falling along the yellow line, which include our estimate of fair value, represent a reasonable valuation of the company, in our opinion. Please note that the lower score represents our ‘bear’ case scenario and the upper score represents our ‘bull’ case scenario for Adobe. At ~$515 per share at the time of writing, we believe there is a higher potential for downside risk in Adobe stocks at the moment.
There is a lot to like about Adobe. We are huge fans of the recurring revenue stream because it provides a lot of clarity regarding Adobe’s future cash flow performance, which has been excellent. We also like Adobe’s large net cash position, which also supports a cash-based intrinsic value estimation. We cannot say that enough. We admire net cash affluence, and the free cash flow that generates power.
The company’s guidance for fiscal year 2022 indicates that Adobe’s growth story is expected to continue in earnest after the company has set a remarkable performance in fiscal year 2021. Adobe is targeting a significant and growing market opportunity across all three of its core offerings, and it has an original balancing sheet to boot. While ADBE shares have faced meaningful selling pressure recently, their long-term growth story remains largely intact, and we love the company very much. This large stock could become even larger.