Adobe Stock Is an Undervalued, Long-Term Winner

ADBE stock - Adobe Stock Is an Undervalued, Long-Term Winner

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The recent market selloff has dragged all stocks lower, even long-term, continuous winners like Adobe (NASDAQ:ADBE) stock.

Over the past five years, since Adobe pivoted to a cloud-subscription business, ADBE stock has risen over 300%, and it has done so without much volatility. Although ADBE stock tumbled 20% over a brief period in early 2016, that decline blew over quickly. By April 2016, Adobe stock had reached new, all- time highs.

But recently, Adobe stock hasn’t performed too well. Since the big market selloff began in early October, ADBE stock has dropped 20% over the course of three months.

In normal times, a large, prolonged selloff like that would imply that something is structurally wrong with Adobe’s business. But there’s nothing wrong with Adobe’s business. In fact, Adobe’s cloud-based businesses are firing on all cylinders. The company’s revenue growth exceeded 20% in the company’s fiscal 2018 (which ended last month) and last quarter, and its top-line growth is expected to remain north of 20% next year and next quarter. Moreover, its margins continue to rise, and its demand drivers remain robust.

If nothing is wrong with the company’s business, then the valuation of Adobe stock must have triggered this recent selloff. But there isn’t anything wrong with the stock’s valuation, either. Although ADBE still has strong growth drivers, ADBE stock trades below its five-year average valuations, in terms of earnings, cash flow, and EBITDA.

If Adobe’s fundamentals remain strong and the valuation of ADBE stock remains reasonable, why has Adobe stock dropped 20% over the last three months? Worries about the broader market are making sentiment towards the whole tech sector weak. Adobe stock has fallen victim to this poor sentiment. Eventually, sentiment will improve. When it does, the stocks with strong fundamentals and reasonable valuations will rebound in a big way.

At the top of the list of such names is Adobe stock.

Three Clouds Illuminate the Bright Future of ADBE Stock

Many years ago, Adobe became famous for its unchallenged photo and video editing software. But that was the old Adobe. Back in 2013, Adobe pivoted its entire business to the cloud, moved to a subscription model, and expanded its suite of enterprise solutions. Today Adobe is an unchallenged visual-cloud giant with a rapidly growing presence in the enterprise-cloud market.

Over the past several years, this transition has powered consistent 20%-plus revenue growth and robust margin expansion. That combination has enabled ADBE to rapidly grow its profits, and, as a result, ADBE stock has been one of the market’s biggest and most consistent winners.

Continuous growth drivers imply that this operational momentum will persist for the foreseeable future. Specifically, Adobe has three big cloud businesses: Document Cloud, Creative Cloud, and Experience Cloud. All three businesses are the cream of the crop and are growing rapidly, have multi-billion dollar addressable markets, and are supported by continuous demand drivers.

Document Cloud provides market-leading solutions that are used to create, edit, and amplify next-generation digital documents. The business’ total addressable market has been estimated at $7.5 billion by ADBE. There really aren’t many competitors in the space, as Adobe owns the PDF world. Document Cloud’s revenues grew nearly 20% year-over-year in the company’s fiscal 2018 which ended in November. And it will continue to grow at similar rates because the world, especially enterprises, are becoming more dependent on digital documents than ever before.

In the Creative Cloud business, Adobe leverages its expertise in photo editing and video editing to create highly visually appealing cloud solutions for businesses and entrepreneurs. Estimated at around $30 billion, the addressable market of this business is also huge. There are no formidable competitors in the space, since Adobe is the only relevant name in photo editing and video editing. The top line of Creative Cloud grew nearly 30% in fiscal 2018. And its revenue growth will continue to increase by similar amounts because consumers and enterprises alike are becoming more visually-oriented than ever before.

The Experience Cloud may be the company’s most promising business. It’s an enterprise cloud solution that’s focused on enhancing the whole customer experience, from marketing to analytics to commerce to advertising. Its addressable market, estimated at over $70 billion, is massive. Competition in the space is fierce, but few match the features of Adobe’s experience-driven cloud platform. The revenues of Experience Cloud jumped 20% last year. And that growth will continue because we are gradually shifting towards an experience-driven economy in which Adobe’s experience-oriented solutions will prove to be extremely valuable.

ADBE Stock Is Undervalued

The core fundamentals underlying Adobe stock are rock-solid. It has three hyper-growth cloud businesses, all of which have market-leading positions and continuous growth drivers. As a result, Adobe should continue to rise rapidly for the foreseeable future.

At current levels, ADBE stock is undervalued, in light of its robust growth potential.

Over the past several years, Adobe’s revenue growth has exceeded 20%, and its top-line growth is projected to remain above 20% this year. In 2019. analysts expect the company’s revenue to rise just under 20%. Given the multiple, continuous drivers that Adobe has, it should generate 15%-20% revenue growth over the next five years.

At that rate, Adobe ‘s revenues will hit $20 billion within five years. As its revenues march towards $20 billion, its margins will move higher, with its gross margins inching towards 90%, thanks to its price hikes. Meanwhile, its operating expense rate will fall back towards 40% as its opex leverage increases. In five years, ADBE could have $20 billion-plus of revenues and 50% operating margins.

With all of those drivers, $20 in EPS seems like a reasonable projection for Adobe by fiscal 2024. Utilizing a forward price-earnings multiple of 20, which is average for growth stocks, I obtain a fiscal 2023 price target of  $400. After discounting back by 10% per year, I obtain a fiscal 2019 price target of over $270.

Adobe stock price currently sits under $220.

The Bottom Line on ADBE Stock

Adobe stock is a long-term winner that has suffered from market-wide, indiscriminate selling. But the fundamentals supporting Adobe remain rock-solid, while the valuation of ADBE stock is reasonable. As a result, Adobe stock should rebound in a big way.

As of this writing, Luke Lango was long ADBE. 

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