Creativity drives growth, is Adobe's moat deep enough?

Summary: Adobe has a competitive advantage through its Creative Cloud subscription bundle. The next phase of growth is likely to be driven by Adobe's Creative Cloud Express products for non-professionals and Adobe's Subscription 3D and Aero's Metavalse-ready products. However, due to the tight competitive landscape, Adobe's moat is shrinking. The next phase of growth can be challenging.

Adobe stock has been under selling pressure lately. The stock has fallen 33% from an all-time high of $699. Management's weak growth prospects are a major concern for investors. This weak outlook may be attributed to the increasing competition facing its creative tools.

Adobe still has a strong competitive advantage because its Creative Cloud subscription bundle contains more than 20 apps. Adobe's next phase of growth is likely to be driven by two key areas:

. Creative Cloud Express products help non-professionals become graphic designers.

. Substance 3D, an Aero product, helps businesses prepare for the metacosm.

For Adobe, however, the next phase of growth can be challenging. With fierce competition and many equal options for consumers, Adobe's moat seems to be shrinking.

Adobe's price at the time of writing seems quite reasonable, at $460. To get unexpected upside from these levels, investors will seek revenue growth of more than 13 percent per year, higher than Adobe management's guidance for fiscal 2022 ($17.9 billion).

Adobe Creative Cloud Family of Applications (adobe.com)

Adobe's Moat: Creative Design Portfolio

Adobe has three business units: 1) Digital Media (Creative Cloud and Document Cloud), 2) Adobe Experience Cloud, and 3) Publishing and Advertising(legacy products). Adobe's growth strategy focuses on: 1) digital media and 2) digital experience business units.

Adobe's Growth Strategy (adobe.com)

Within these business units, Adobe faces stiff competition for three key features: 1) comparable product features, 2) cheaper prices, and 3) popularity. Adobe doesn't have a single direct competitor, but there are many scattered competitors.

To thoroughly evaluate Adobe's competition, we need to divide the analysis into five categories: 1) graphic design, 2) video editing and animation, 3) UI/UX design, 4) PDF, electronic signature and document workflows, and 5) marketing and business automation.

1. Graphic Design:

There are two types of graphic design clients: 1) professionals who make a living from design, and 2) non-professionals who have creative needs for posters, youtube thumbnails, Instagram posts, icons, etc.

For professionals, Adobe Photoshop, Illustrator, InDesign, InCopy, Lightroom, and more are particularly well suited due to their advanced features and interoperability. No other software can compare, and Adobe products have more than 80% of the market share of graphics software companies.

However, these products are not easy to master. That's why non-professionals will look for simpler tools like Canva to meet their graphic design needs. Adobe recently launched an equivalent Creative Cloud Express product (formerly known as Adobe Spark) for non-professionals.

Google Trends analysis shows that Canva's popularity is even higher than Adobe's flagships, Photoshop and Illustrator. Adobe's Creative Cloud Express is a direct competitor to Canva, with very few searches.

From a feature and pricing standpoint, Adobe Creative Cloud Express has done a great job of catching up and staying relevant with non-professionals. It remains to be seen who advertises best among non-professionals to convert them into paying customers. Canva is the clear winner at the moment.

2. Video editing and animation:

Video editing and animation tools are becoming increasingly popular. In the creator economy, everyone has a story to tell, and they express it through beautiful videos. Adobe's Premiere Pro is a popular video editing tool. Adobe After Effects is used to add visual effects to videos. The competitor to Adobe Premiere Pro (23% market share) is Apple's (NASDAQ: AAPL) Final Cut Pro (25% market share). Adobe Premier Pro is more popular than Final Cut Pro.

From a functional point of view, both have their pros and cons. Both products have the potential to attract different types of customers based on their needs.

3. UI/UX design:

UI/UX design tools are mainly used for application and website development prototyping. This gives creators the opportunity to test their visual ideas before building. The most popular tools in the FIELD OF UI/UX design are Figma and Adobe XD. Figma is currently more feature-rich and popular than Adobe XD. Figma is known for its collaboration features.

4.PDF, electronic signatures, and document workflows:

Adobe Sign is an electronic signature tool for collaboratively signing documents. Adobe competes with DocuSign (NASDAQ: DOCU) and lags behind DocuSign in terms of market share and customer reviews.

5. Marketing and Commerce:

Adobe Experience Cloud is a tool that automates customer insights and creates personalized marketing journeys. Adobe competes primarily with Hubspot (NYSE:HUBS) and ActiveCampaign, lagging behind in both market share and customer reviews.

In this article, I'll focus more on Adobe's Creative Cloud solution because it contributes nearly 60% of Adobe's revenue.

6. Adobe's masterpiece: The Creative Cloud Bundle

Adobe wisely bundles all of its products under one subscription plan. The Creative Cloud bundle offers the best features like 1) graphic design, 2) video editing and animation, 3) UI/UX design, and 4) PDFs, electronic signatures, and workflow tools, all at a price. It's great value for money, and Adobe is truly able to bring the best of all its products together under one roof.

If a person really wants to create content but hasn't yet developed loyalty to any product, Adobe's Creative Cloud bundle seems like a smart choice. As mentioned earlier, Adobe does not have one competitor, but many scattered competitors. Creating bundles is the best way for customers to take advantage of the many high-quality products Adobe offers.

Creativity drives sales growth, with upper and lower limits on Adobe valuations

Adobe has two key initiatives to delight existing customers:

Integrate AI with Adobe Sensei into all their tools to create delightful experiences. For example, create graphics from original sketches, change smiles in photos, AI-based search (e.g. find the Eiffel Tower in my photos), change the sky from day to night, smooth skin, PDF liquid reading mode, and much more. These small features improve the customer experience and help them achieve their creative goals smarter and faster.

Adobe and Behance have established a community that allows creators to showcase their work, engage, and be hired. Behance has also added NFT support to help creators showcase the authenticity of their work.

My paper notes that if Adobe stock needs favorable upside from here, Creative Cloud Express, Substance 3D, and Aero will have to do well. Adobe Substance 3D and Aero are tools to help businesses prepare for the metaverse. They focus on creating 3D scenes, textures, 3D objects for videos or games, and augmented reality experiences.

During the fiscal first quarter 2022 earnings call in March 2022, Adobe's management mentioned that Creative Cloud Express and Substance will be the main growth drivers in the near future.

In my later bull case valuation, I explained the likelihood that the stock would be if Adobe could achieve that goal. However, I think Adobe's moat is shrinking due to the tight competitive landscape. The next phase of growth can be challenging.

Before we get into Adobe's valuation, it's important to remind ourselves that sales growth is a key driver of long-term stock performance. Cash flow, multiples, are of course important, but over a decade, sales growth has had the greatest impact on stock performance.

Sales growth is a key driver of long-term equity performance (BCG Analysis, Morgan Stanley Research)

That's why it's crucial for Adobe to regain momentum in its sales growth. I'll analyze three of Adobe's cases: the basic case (management guide), the bull case (the next round of growth), and the bear market case.

For Adobe, I prefer to use a 5-year discounted cash flow model with a permanent growth rate rather than a relative valuation. This is because Adobe has a continuous and growing cash flow. I am willing to make some well-founded assumptions about future growth rates based on what I think the world is headed.

1. Basic Case: Management Guide

hypothesis:

Revenue CAGR of 11% in 2022-26

Free Cash Flow Margin 2026: 46%

Permanent growth: 3%

Discount rate: 8%

Intrinsic Value: $426

Basic Case Hypothesis Paper:

Adobe's Creative Cloud business units (Photoshop, Illustrator, Premiere Pro, Creative Cloud Express, etc.) face the daunting task of convincing new creators to choose Adobe products over competitors.

Competitors such as Figma, Canva, and other free tools have made it difficult for Adobe to attract new customers. I believe Adobe will continue to thrive with existing creators who have built loyalty to Adobe's products over the years and have become experts on those products.

However, if I'm a new creator, I have a lot of options, some for free. There's no compelling reason why I had to choose Adobe. As a shareholder, I'm a little nervous about that. While Adobe's brand name and products do have a strong moat, I certainly feel that its moat is shrinking due to the tight competitive landscape.

Adobe's Document Cloud and Experience Cloud business units face similar challenges. For example, Adobe, the creator of pDFs, should have seen the electronic signature market before DocuSign. But they didn't take advantage of their obvious options and are now behind DocuSign and catching up.

Given these challenges, I think an 11% COMPOUND annual growth rate is a reasonable assumption, considering that management guided revenue from $15.78 billion in fiscal year 2022 to approximately $17.9 billion in fiscal year 2022, resulting in a 13% year-over-year increase.

Adobe can prove my basic situation wrong, through new growth avenues like Adobe Substance, Aero, Creative Cloud Express, or new acquisitions. But unless otherwise proven, giving a compound annual growth rate above 11% would mean assuming something that management didn't expect either. I believe the basic picture of Adobe is the most likely, with Adobe's valuation close to fair, and at the time of writing, the stock is trading at $460.

Adobe FY2022 Guide (adobe.com)

2. Bull Market Case: Next Round of Growth

Revenue CAGR of 26% from 20 to 2022.Free cash flow margin in 2026: 49%.Permanent growth: 4%.Discount rate: 8%.Discount rate: 8%

Intrinsic Value: $719

Bull Market Case Hypothesis Paper:

To achieve a bull market, Adobe will have to demonstrate the next round of growth through Adobe Substance, Aero, and Creative Cloud Express. I find it going to be challenging for several reasons.

First, for 3D software, Adobe Substance Painter and Substance Designer are late entrants, and there are many incumbents and competitors such as Autodesk (NASDAQ: ADSK), Maya, Mari, Houdini, Blender, Cinema 4D, etc.

Blender is more popular than most other products. While Adobe Substance 3D has advanced texture painting features compared to other products, it is not a holistic 3D product. It needs to be used with other 3D software for filmmaking or similar content creation.

My well-founded guess tells me that the 3D market has a place in texture painting and isn't big enough for Adobe's next phase of growth.

Second, the augmented reality (AR) tool Adobe Aero is currently only available on iOS and has been publicly tested on desktops on Mac and Windows.

Judging by its reviews, Aero appears to be an entry-level AR tool for prototyping and fun, rather than real use cases. Aero was downloaded only 9,000 times worldwide in February 2022. Augmented reality does have clear use cases. It can help brands sell their products better, but Aero's capabilities are too limited to help brands do that.

Adobe is once again a late entrant to the market. With so many AR development products available, there's no compelling reason to choose Adobe over competitors.

Finally, Creative Cloud Express is a graphic design tool that is easy for non-professionals to use. Canva saw this market early on and captured it well with its simplicity, efficient pricing, and good brand image.

In my opinion, Adobe made a fundamental mistake here by renaming its product from "Adobe Spark" to "Adobe Creative Cloud Express." For everyone to use a product, it has to sound simple and engaging.

Canva grew very quickly and began to become a household name for new non-professional creators. Adobe should have seen this trend earlier than anyone else.

For all of the above reasons, Adobe's bull market case will be challenging. Here, I assume a 20% compound annual revenue growth rate starting in 2022-26, while Adobe expects revenue growth of 13% in fiscal year 2022. Personally, I prefer to be guided by a company or do valuations. So my basic case is a safer view.

3. Bear market case: lower than management expectations

5- 2022 Revenue CAGR of 26% 2026 Free Cash Flow Margin: 40% Permanent Growth: 3% Discount Rate: 8%

Intrinsic Value: $299

Bear Case Hypothesis Paper:

If a bear market occurs, it means adobe is starting to lose out to competitors like Figma and Canva from its existing loyal customer base. I feel like Adobe has a very strong brand and they will continue to innovate to keep up with the competition. As a result, Adobe is unlikely to start losing out on customers who are already subscribed and loyal.

Valuation Summary:

I gave Adobe a "reserved" rating because I believe the basic scenario of $426 is the most likely.

Adobe must demonstrate that it can grow above its guidance of 13% revenue growth in fiscal 2022. Things to look out for in the coming quarters:

Overall revenue growth: More than 13% in fiscal 2022. The management statement provided clues to future growth prospects beyond fiscal year 2022. Management's comments on Creative Cloud Express. Management comments on Substance 3D, Aero's revenue growth. Any new acquisitions Adobe has made to expand its TAM.

epilogue

Adobe's focus is on the Creative Cloud business, as it accounts for nearly 60 percent of Adobe's revenue. Other Adobe businesses such as Document Cloud and Experience Cloud continue to perform well, but face challenging competition.

The main dilemma Adobe faces is that its innovation is driven by competitors or acquisitions that seem to be catching up most of the time. Adobe's moat is shrinking and the competitive landscape is strained. But the brand remains strong and will continue to thrive once they regain their momentum.

All three valuations can only be used as a reference, and cannot be used as a reason to determine the strategy. Adobe's future growth is likely to depend on the evolution of the Creative Cloud business.