The Rally In Adobe Systems Incorporated Stock May Be Pausing

Adobe has been a winning stock, but a $250 price tag is tough to justify

One of my favorite cloud stocks over the past several years has been Adobe Systems Incorporated (NASDAQ:ADBE).

At its core, Adobe is a giant creative solutions company that offers cloud-based and data-driven services and operates without much competition. The cloud and data slants give the business hyper-growth features, while the lack of competition angle means that big growth has a ton of clarity over the next several years. Plus, without viable competition, Adobe is free to hike prices without any user churn, thus adding significant firepower to the company’s margin expansion potential.

Big picture, this is a winner. That is why Adobe stock is up 500% over the past five years.

The strong growth narrative continues today. Adobe recently reported yet another double-beat-and-raise quarter that comprised 20%-plus revenue growth and healthy margin expansion. The guide also pointed to 20%-plus revenue growth again next quarter.

But Adobe stock failed to rally on those good numbers. Instead, it dropped.

Poor stock price action in response to positive news is usually a sure-fire sign of valuation friction. Indeed, I think that is what we have with Adobe stock. Despite the robust secular growth narrative, a $250 price tag is tough to justify for this company.

As such, I expect this rally in Adobe stock to start running into valuation friction. Shares will likely trade in a sideways choppy fashion into the foreseeable future until the fundamentals catch up to the stock price.

Here’s a deeper look.

The Adobe Growth Story Remains Robust

The Adobe growth story remains as strong as ever.

Ever since the company migrated its entire business to the cloud in 2013, it has been nothing but up, up, and away for Adobe stock. Because consumers are now buying subscriptions to Adobe products (versus a one-time purchase before), revenues have been growing at a healthy rate. The cloud business also operates at higher margins, so margins have been on a healthy upward track.

Plus, the company is building out its ecosystem to include enterprise-facing, cloud-hosted services catered towards leveraging data to optimize customer experiences.

As a result, this is a cloud-driven, data-driven growth company with huge margin drivers thanks to a big cloud shift and consistent price hikes.

The recent quarterly numbers affirmed that all this remains true today. Revenues again grew by more than 20%. Gross margins expanded. Operating margins expanded. Profit growth was robust.

But despite affirmation of the long-term growth narrative, Adobe stock failed to rally.

Why? Valuation.

Adobe Stock Is Fairly Valued, At Best

I’ve been a bull on Adobe stock for a while now. But no matter which way I look at the company, I cannot reasonably justify anything higher than a $250 price tag on the stock.

Yes, revenue growth is running around 24% right now. But that will inevitably slow over the next fvie years. Next quarter’s guide calls for just 22% revenue growth. Assuming this deceleration continues thanks to scale and tougher laps, Adobe is likely looking at 15% revenue growth prospects over the next 5 years.

Gross margins continue to march higher thanks to price hikes. The lack of competition gives this company clear runway to do another round of price hikes over the next 5 years. As such, I think gross margins can trend towards 90% over the next 5 years, versus high 80’s today.

Robust revenue growth is driving huge operating expense leverage. The opex rate has dropped dramatically over the past several years from upper 50’s to upper 40’s. Slower revenue growth going forward, though, means less opex leverage. Consequently, I think the opex rate can drop to somewhere between 40% and 45% over the next five years.

Under these assumptions for 15% revenue growth, 90% gross margins, and a 40%-45% opex rate, I think Adobe can grow earnings at a robust rate to around $11.75 in five years. Aggressively assuming Adobe can maintain its five-year average forward earnings multiple of 30, then that implies a four-year forward price target of $350. Discounted back by 10% per year, that equates to a present-day value of between $240 and $260.

Bottom Line on ADBE Stock

Adobe is a great company with a huge moat and exceptionally profitable business model. But even aggressive growth and valuation assumptions don’t support prices higher than $250 today.

As such, I think this secular growth stock runs into valuation friction into the foreseeable future, and that such friction will keep shares stuck in neutral.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2018/06/the-rally-in-adobe-systems-incorporated-stock-may-be-pausing/.

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