Shares of Adobe (ADBE 3.53%) rallied sharply following a better-than-expected second-quarter earnings report, sending shares to a three-month high.
The update helped brush aside some market fears that the digital media software giant may be losing its step amid the emergence of competing artificial intelligence (AI) applications representing a threat to its core business. The stock is still down about 13% in 2024.
So, how should investors think about Adobe's latest trends? Is the stock a buy, sell, or hold right now? Let's dive in.
A solid start to 2024 with positive fundamentals
Adobe has built a leadership position over 30 years by constantly innovating. The company's diverse ecosystem of products from Photoshop, Premiere Pro, Acrobat, and Illustrator are industry staples for professionals and enthusiasts alike.
Revenue for its fiscal 2024's second quarter (ended May 31) reached $5.3 billion, an increase of 11% year over year on a constant-currency basis. Non-GAAP (adjusted) earnings per share (EPS) of $4.48 climbed by 15% from the prior-year quarter.
A major theme for the company has been its effort to incorporate artificial intelligence (AI) across its app ecosystem. Generative AI features are seen as simplifying and enhancing everyday tasks, with results suggesting customers are responding favorably. The trend has translated into a non-GAAP operating margin of 46% this quarter, up from 45.3% in Q2 2023.
Maybe the metric that best highlights Adobe's operating prowess is the remaining performance obligation (RPO) exiting the quarter at $17.9 billion, increasing by 17% from the period last year. RPO, reflecting the total value of subscriptions or services yet to be delivered to customers, offers good insight into the growth runway over the next several quarters.
In terms of guidance, Adobe expects 2024 revenue growth between 10% and 11% while non-GAAP EPS climbs between 12% and 13% to a range of $18.00 and $18.20. Overall, the solid headline numbers from Adobe provide good reasons for investors to buy or hold the stock.
Image source: Getty Images.
Competing AI applications pose a threat
By all accounts, Adobe's business remains as relevant as ever. Still, it's important to consider why shares of Adobe have been volatile and what the risks are moving forward.
One concern is that the outlook for revenue to increase this year by around 10.5% marks a slowdown compared to stronger trends in recent years. The company is doing a good job of pushing profitability, but growth teetering around the single-digit range doesn't make Adobe a particularly exciting stock. New artificial intelligence features have yet to drive an acceleration in the business that the market may be waiting to see.
In many ways, AI is a double-edged sword for the company. The challenge is that, beyond a new growth opportunity, there is also a layer of uncertainty as to what the rapid advancements in the field will mean for Adobe's competitive advantage.
Once highly valued skills, such as photo or video editing could become commoditized since complex tasks can be accomplished by AI through a simple command. Privately held OpenAi, which counts on Microsoft as a major shareholder and is recognized for its ChatGPT AI Chatbot, previewed Sora as a groundbreaking text-to-video tool capable of generating realistic animations.
Even with some indication that Adobe may open its doors to third-party AI developers, the threat is that Sora or one of many other new AI applications from various start-ups could one day undermine Adobe's digital media business. Even Apple announced advanced AI-driven photo and video editing tools with its latest iOS update, marking an expansion into the generative AI market.
A scenario where Adobe's leadership position comes under pressure would make a strong case to sell the stock.
The decision
I believe a hold rating for shares of Adobe makes sense, particularly following the correction from its 52-week high. The stock, trading at around 29 times the midpoint of management's 2024 EPS target, isn't cheap, but the premium valuation can be justified by what remains positive fundamentals.
Concerns about the company's competitive edge are valid, but Adobe also deserves the benefit of the doubt, given its long history of staying ahead of the curve. The company's ability to continue driving earnings higher should keep shares supported. I expect shares to remain volatile but have room to rally over the long run.
