Many tech stocks had epic runs in 2023 and have sustained the momentum this year. But not Adobe (ADBE -0.82%).
The software-as-a-service (SaaS) giant is down 22% year to date at the time of this writing and tumbled 13.7% on Thursday in response to its fourth-quarter fiscal 2024 results and fiscal year 2025 guidance.
Here's what's driving the sustained sell-off in the growth stock and if it is worth buying in December.
Image source: Getty Images.
A primer on Adobe
Adobe was a SaaS pioneer, launching its subscription service in 2012. Today, it still generates nearly all of its revenue from subscriptions. Users can pay for a bundled offering of its suite of apps, known as Creative Cloud, or they can turn to a la carte options.
Adobe's business model is straightforward and highly effective. It upgrades core products and develops new products to retain existing users and attract new ones. By providing more value and empowering its users to get more out of a subscription, Adobe can justify price increases over time.
Adobe dominates the digital media industry with tools for videos, images, documents, and more at different levels of sophistication, including professionals, students, and mainstream users. Its foothold in the industry and established product lineup gives it pricing power. Adobe is an ultra-high-margin business that generates a ton of cash flow. Its gross margin tends to be around 85% to 90%. In comparison, its operating margin hovers around 45% to 50% -- because its main expenses are research and development (R&D), sales, marketing, and administrative -- not maintaining existing products.
In sum, Adobe is a phenomenal business, but there are concerns that Adobe may not be as dominant in the future.
Adobe's innovation has yet to translate to sales growth
The last couple of years have been arguably the greatest surge in innovation Adobe has experienced since launching Creative Cloud 12 years ago. Artificial intelligence (AI) is leading to significant product improvements at Adobe, including text-to-image and video generation, GenStudio for Performance Marketing (AI-powered content for delivering cross-channel content and running market campaigns), improvements in Adobe Document Cloud (including AI-driven search and summary functions with PDFs), easy content creation using Adobe Express for mainstream users, and more.
The problem isn't a lack of new ideas; it's that Adobe's innovation has so far failed to translate into meaningful revenue growth.
In first quarter fiscal 2024, which ended March 1, 2024, Adobe reported $5.182 billion in revenue, representing 11.3% growth compared to the same quarter in fiscal 2023. Adobe is guiding for just 9.1% in revenue growth at the midpoint of its first quarter of fiscal 2025 (which is the upcoming quarter).
For full-year fiscal 2025, Adobe is guiding for $23.3 billion to $23.55 billion in revenue, a non-GAAP (adjusted) operating margin of 46%, $15.80 to $16.10 in GAAP earnings per share (EPS), and $20.20 to $20.50 in non-GAAP EPS. If it hits the midpoints of these targets, Adobe would grow revenue by 14.2% and non-GAAP EPS by 10.5%. For context, Adobe grew revenue by 11% and non-GAAP EPS by 15% in fiscal 2024 versus fiscal 2023. So the growth rate remains roughly the same.
It would be understandable if Adobe's margins came down as it ramps up spending on R&D. But the continued lack of revenue growth shows that Adobe's innovation has yet to be a game changer for the performance of its business, which is concerning considering Adobe is essentially entering year three of its AI journey.
Wall Street's frustration with Adobe's inability to monetize AI is reflected in the stock price. Adobe soared 77.3% in 2023 as investors cheered AI's potential to accelerate growth. But that gain was amplified because Adobe had a terrible year in 2022. Zoom out, and the stock price is only up 55.1% over the last five years, lagging the S&P 500's 91% gain and drastically underperforming the tech sector's monster 168.7% run.
Experimentation versus monetization
Adobe remains in the experimentation phase rather than the monetization phase of its AI growth. On the first-quarter fiscal 2024 call from March, Adobe CEO Shantanu Narayen explained the company was focused more on developing new tools to see what sticks with users rather than maximizing near-term profits.
Arguably one of the most important parts of Adobe's latest earnings call was when President of Digital Media David Wadhwani drilled into the specifics of Adobe's growth algorithm, which is a balance of gaining new users, new products, delivering value, and justifying higher pricing. Wadhwani explained that Adobe isn't focused on price increases right now, but rather, attracting new users and measuring engagement with its AI tools. Later in the call, an analyst pressed management on why it wasn't as willing to raise prices given the amount of value creation. Wadhwani reiterated that the game plan is to bring in more web and mobile users rather than squeeze profits out of users:
And we believe that proliferation ... maintains as one of the top priorities because we know that if people start using our products today, we have the opportunity to continue to deliver value for a long time to come. And so, that balance is what we try to do. And it's a management judgment call that we think we're getting it right.
To buy Adobe stock now, I think it's important to agree with management's approach to AI and pricing, which is focused on the long term.
Adobe is a great value in an expensive sector
Adobe has made a splash with AI product developments but has yet to prove that AI will be a major contributor to its sales growth. But this is still a highly profitable company that continues to grow sales and earnings steadily.
Adobe has become a better value as its stock price has languished and its earnings have increased. Adobe has just a 23.3 forward price-to-earnings (P/E) ratio based on the midpoint of its fiscal 2025 non-GAAP earnings guidance and a 29.8 P/E based on forward GAAP guidance. The main difference between the calculations is that GAAP accounts for stock-based compensation, which Adobe arguably over-relies on to retain and attract top talent.
Adobe sports an inexpensive valuation for being a high-margin business with more cash and cash equivalents than debt on its balance sheet.
Investors who believe that Adobe will eventually be able to transition from experimentation to the monetization phase with AI are getting an excellent opportunity to buy the stock at a relatively cheap price. Adobe has set the bar fairly low for fiscal 2025 from a revenue and earnings perspective. If AI adoption improves, Adobe could gain some momentum. But if the year drags on and fiscal 2026 starts to look like a continuation of the low-double-digit revenue growth pattern, it wouldn't be surprising for investors to lose patience and drive a further sell-off.
