Why Adobe Is Worth $70 Per Share

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ADBE: Adobe logo
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Adobe

Adobe (NASDAQ:ADBE) has successfully transformed its business from perpetual licensing to a cloud-based subscription model. Investors have given a thumbs up to this transition as indicated in the stock’s performance over the past few years. While the rise in stock price has been meteoric over the past two years, when it rallied from $38 in 2013 to over $70, its performance has faltered over the past few months. However, the stock has rallied from $70 in January to its current market price of over $77. This translates into a return of over 10% in the last month alone. While we have recently revised our price target from $62 to $70, we believe that the current market valuation of Adobe is stretched, even though the company has significantly improved its Creative Cloud (CC) offering by extending functionality to mobile developers and strengthened its digital marketing portfolio through timely launches. In this note, we will discuss the factors that justify our price estimate of Adobe.

Check out our complete analysis of Adobe

Growth of Addressable Market for Creative Cloud Supports Our Valuation

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The Creative Cloud (CC) division together with the Adobe’s packaged division makes up 62% of Adobe’s estimated value. The key drivers for this division are the average revenue per subscriber and total creative software market. While Creative products (Creative Suite and Creative Cloud) contributed nearly 45% to Adobe’s revenue in 2014, the total number of licensees for Adobe’s creative products stood at 14.7 million, according to our estimates. In 2014, Adobe added 3.45 million subscribers to its CC services, which translates into a growth rate of 140% over 2013’s 1.43 million. We estimate that the subscriber base will continue to grow at a robust 75% in 2015 and add over 2.55 million subscribers during the year. We also believe that the company is on track to add 16.39 million paying subscribers by the end of 2021. This figure represents 64% of the 25.8 million point and suite licensees, which we estimate will grow at a CAGR of 8.6%. However, to justify Adobe’s current market price, the number of subscribers will have to grow to over 18 million, which in turn will require a higher growth rate in the total addressable market (TAM).

Average revenue per subscriber (ARPS) for the company consists of a blend of subscribers that have enrolled to different levels of cloud services. While access to the complete Creative Cloud suite costs $74.99 per month, access to standalone Photoshop is priced at $9.99 per month. We estimate that the blended ARPS for the company was $31.74 in 2014. The recent trend in subscriptions indicates that users are subscribing to the annual full version of Creative Cloud. The company has also reported good growth in its enterprise term licensing agreement (ETLA), which have tenure of three years. This leads us to believe that the ARPS will increase in the coming years as it converges to the sticker price of $74.99. However, since the company is adding products at lower price points, it will lower the blended ARPS for the company. We estimate that the ARPS will grow to $39 by the end of our forecast period. However, the market expects ARPS to grow at a much faster pace, which might be difficult to achieve if more products with lower price points are introduced within the cloud portfolio.

Market Share in Online Marketing Cloud

Adobe’s cloud marketing division is the second biggest division and makes up 17.3% of its value. Over the past few years, Adobe has built a comprehensive digital marketing platform that addresses most of the needs in digital marketing. This build up started in 2009 with the acquisition of Ominiture. Since then, the company has scaled up the functionality and product offering of its marketing platform through organic and inorganic growth. Currently, Adobe offers six products under its marketing cloud solution. The Adobe marketing cloud includes a complete set of analytics, social media optimization, consumer targeting, web experience management and cross-channel campaign management solutions. It generated around $1.2 billion in annual revenues in 2014. Having been built from the acquisition, the business has had a compounded annual growth rate (CAGR) of 83% over last five years. Well positioned in a growing market, this division is expected to witness robust growth in the coming years. Adobe is aiming to increase its revenues from cloud-based marketing solutions by expanding in new geographies and verticals.  Recently, the company has launched new data-driven marketing capability that delivers personalized mobile experience , thus supplementing its marketing cloud capabilities. According to the CEO of Adobe, Shantanu Narayen, the marketing cloud is easily a $10 billion opportunity. [1] Currently, we project revenues from its digital marketing division to reach $3.3 billion by the end of our forecast period. However, to justify the current market price of Adobe, the company will have to rake in over $4.5 billion in revenue for marketing division. We believe that this would be a difficult feat considering the intense competition in this space from companies such as IBM, Accenture, Salesforce and Oracle.

Acrobat Family Revenue To Grow

Acrobat family is the third largest division and makes up ~11% of Adobe’s estimated value. In the past few quarters, revenues from this division have been on a decline, primarily due to launch of document cloud services that have subscription fee spread over the period of usage. The company has amassed over 2.17 million subscribers for document cloud service. We expect this trend to continue and forecast the subscriber base to grow to 8.83 million by the end of our forecast period. Furthermore, as this service gains momentum, we expect the ARPS to increase from $8 in 2014 to $12.7 by the end of our forecast period. Despite this growth rate, we expect revenue to grow from $768 million to $1.35 billion by 2021.

Transition to Cloud Services to Negatively Impact Smaller Divisions

Smaller divisions of Adobe, which include Adobe packaged software, LiveCyle software and Print & Publishing, makeup 6% of its estimated value. The adoption of Creative Cloud will negatively impact Adobe’s packaged software, while up-selling to Adobe marketing cloud will pressure LiveCyle & Connect pro revenues. We expect revenues from these divisions to decline in the future. We estimate average selling price of packaged software and LiveCycle software will decline in the future to $165 and $85,160 respectively. We also expect the number of licenses sold for both the divisions to decline. Even if these metrics were to improve for both the division, it will have little impact on our stock price valuation, since the contribution from these divisions is small.

Changes To Discount Rate And Terminal Growth Rate

We have increased the terminal growth rate for Adobe from 1.5% to 2.5% based on the improvement in the U.S. GDP and expected hike in interest rate in the coming quarters. Furthermore, we have lowered the discount rate from 11% to 9%. While the equity risk premium for the U.S. market has increased from 5.45% in 2013 to 5.75% in the beginning of 2015, the Fed continues to keep interest rate (and the risk free rate) at record low. We have taken these factors into consideration to calculate the new discount rate. However, we believe that the market participants are factoring in an even lower discount rate to jutify Adobe’s current market price.

We currently have a $70.43 price estimate for Adobe, which is 10% below the current market price.

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Notes:
  1. Digital Marketing, Adobe and $10 Billion Worth of Opportunities, August 18 2014, www.mobilemarketingwatch.com []