This falling valuation offers opportunity

Adobe (US:ADBE) has long been the dominant design software product. Office workers know of it because it invented the PDF document, and almost every graphic designer will have used its products to design and edit pages, photos and videos. But for the first time in decades, its dominance is coming under threat.

Most people think of the big breakthrough in generative AI coming with the release of ChatGPT in December 2022. However, earlier that year a programme called Midjourney, which creates AI images from user prompts, was released. This technology had been around for a while, but the images produced tended to be mis-shapen and even disturbing. Midjourney marked the first time AI could reproduce the prompts accurately.

Adobe was clearly concerned: a few months later, it made a $20bn (£15.8bn) offer for cloud-based design tool Figma. Figma’s browser-based tool allows design teams to collaborate in real-time, and it had doubled its revenue in the previous year. But the offer represented a huge sum given the start-up made annual recurring revenue (ARR) of just over $400mn. Although Adobe investors (including Terry Smith) baulked, the company stood its ground. However, UK and EU competition regulators stepped in, and by the end of 2023 the deal had been abandoned.

The company has instead had to prioritise internal development to keep customers from defecting. In the last quarter it spent over $1bn on R&D for the first time ever. Its big bet has been on Adobe Firefly, its suite of generative AI tools. Similar to Midjourney, they enable customers to make videos and images from prompts. Since its launch, Firefly has created 12bn generations.

Adobe has also integrated an AI assistant into Adobe Acrobat and Reader, and management says that AI usage was up over 70 per cent quarter-on-quarter. However, despite these positive usage stats, Adobe is yet to monetise these new tools. The plan is to integrate them into the products and get customers used to them, before later launching premium AI plans at higher prices. 

This means recent guidance was a little disappointing. In the three months to August, net new digital media annualised recurring revenue (ARR) was $504mn. However, management has only guided for net new ARR of $550mn in the next quarter, below the $570mn analysts expected.

In other words, Adobe is adding more customers but at a slower pace than expected. This doesn’t look like a big concern, unless you consider this slowdown could be due to customers looking to other AI products. “Bears will say guide was very weak, numbers are not going to move higher, and competitive dynamics still a big headwind with Midjourney launching an editing tool and possibly another Chat GPT5 release,” argues Jefferies analyst Jeffrey Favuzza.

The alternative view is that although Adobe hasn’t monetised its AI products yet, this leaves the door is open for revenue acceleration in the future. Brokers at RBC think the guidance is “conservative” and that there are early signs of future revenue uplifts coming through.

Adobe shares surged in 2023, but haven't joined in the AI euphoria this year, and earnings expectations paint a mixed picture. In 2021, the company traded on a forward price/earnings ratio of over 40 times. This has consistently fallen since, to a current level of 24 times. Given the double-digit top-line growth, 36 per cent operating margin and 36 per cent return on equity, this valuation looks low, unless you believe Adobe will be terminally disrupted.

As it stands, growth hasn’t yet slowed dramatically, and its strong operating margin reflects a business that is entrenched and essential to its users. The falling valuation reflects a fear of a future where Adobe fails to adapt to generative AI. But there is also a future where Adobe’s scale and established relationships help it monetise its Firefly product, and confirm itself as an AI winner.

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