Every so often, the market will put a great stock on sale, and it's important to recognize whether that sale is a buying opportunity or a warning to investors.
The market may put a stock on sale because operations are deteriorating, competition is eating into its market share, or for several other legitimate reasons. Sometimes, though, the market ends up weighing near-term challenges much more heavily than a positive long-term outlook of a company. And that can be a great opportunity for investors.
Adobe (ADBE 0.34%) is one such company that's seen its stock beaten down recently. It's developing innovative solutions and features using generative artificial intelligence (AI) to support further growth in its market-leading software suites. Despite the market sending shares higher after a strong second-quarter earnings report and improved outlook, the share price is still down 24% from the all-time high it reached at the end of 2021. There's still an opportunity for investors to buy shares today.
Image source: Getty Images.
Injecting generative AI into everything it does
Adobe is a market leader in enterprise-level content-creation software (Photoshop, Lightroom, Illustrator) and document management (Acrobat, Acrobat Sign), as well as marketing and advertising solutions.
Its Creative Cloud and Document Cloud subscriptions provide a stable source of recurring revenue. The software suites are standards in the industry, which creates two advantages.
Since everyone else is using Adobe file formats, there's a network effect whereby people in the industry need Adobe software to interact with one another. A designer will send an Adobe file to a client or another designer. If they don't have Adobe's software, they might not be able to interact with the design as intended.
The second factor is that Adobe's software becomes very sticky. No manager is going to risk switching software suites just to save a few bucks. It would require retraining workers, and it could result in an inferior production. While freelance designers might only pay for a subscription when they have a need for Adobe's software, they're unlikely to leave Adobe for good.
Adobe is using AI to draw more users to its products and increase annual-recurring revenue. Its generative AI is called Firefly, and it's trained on Adobe's proprietary-data set. It powers popular features like Generative Fill and Generative Expand in Photoshop, Text to Vector in Illustrator, and Remove Object in Lightroom.
Adobe provides limited use of Firefly features for free, attracting new users to its products through its Adobe Express service. It's seen strong conversion to paid customers, and it's seen an increase in revenue per user and renewals as a result of Firefly.
It introduced Acrobat AI Assistant in April, which can summarize a document and answer questions based on the information in the document. It offers the AEP AI Assistant in the Adobe Experience Platform, which can help marketers automate tasks, simulate outcomes, and generate new audiences to target.
Trending back in the right direction
Management disappointed investors with its Q1 earnings release. The biggest red flag was a slowdown in average-recurring revenue (ARR) growth for its digital-media segment. It forecast just $440 million in new ARR for Q2.
As mentioned, Adobe's products are sticky, and it's drawing customers in with new AI features. It blew its forecast out of the water with $487 million in net-new ARR for its digital-media segment. It also provided a strong forecast going forward with $460 million in net-new ARR next quarter and $1.95 billion for the full year.
Management's commentary on the Q2 earnings call suggests the new AI features are driving higher conversion rates from free Express users, increasing revenue per user thanks to premium features, and increasing retention rates. That bodes well for long-term net increases in ARR.
Thanks to its subscription model, Adobe generates consistent free cash flow every quarter. A one-time expense for the failed Figma acquisition weighed on free cash flow last quarter, but it returned to normal levels in Q2. It's using that cash to fund its $25 billion share-buyback program authorized in March. It already bought back $2.5 billion in Q2.
It's not too late to buy Adobe stock
While you might not be able to get as good of a price as earlier this month, it's not too late to buy Adobe stock.
Even after the surge in price following its Q2 earnings report, Adobe shares trade for just 25.5 times forward-earnings estimates. (Some of those estimates could receive an upward revision after factoring in management's improved outlook.) That's a slight premium to the market average for a business that should be able to produce above-average earnings growth.
Adobe's a software business, and while it's investing heavily in AI development, it should be able to increase its operating margin as it gains scale and customers pay more for advanced AI features. The impact of FireFly and its AI Assistants should drive strong top-of-funnel interest in its software and higher conversion rates, leading to strong revenue growth. Analysts currently expect annual earnings to grow an average of 22% through next year, but that may be low considering management's revised outlook.
So, even after a slight recovery, it's not too late to buy shares of Adobe.
