By Jacob Sonenshine
Adobe’s earnings report painted a pretty picture of its ability to turn artificial intelligence into paying customers. But the reaction to its disappointing guidance was anything but pretty. That has created a buying opportunity in its stock.
There was a lot to like about Adobe’s third-quarter results, with both earnings and sales easily topping estimates. The market, though, focused on management’s somewhat disappointing outlook, which included a forecast for “net new annual recurring revenue” — representing the sales Adobe expects to bring in from new customers or from increasing monthly subscription payments — to come in at $550 million in the fourth quarter, up 9% quarter over quarter. The fourth quarter usually sees double-digit growth, and the stock tumbled 13% after the report. It has since settled around $510.
The market reaction was understandable, if dubious. The lower-than-expected guidance could be a sign that competition from other AI offerings — such as Canva, a growing, privately held AI image generator, and OpenAI’s Sora — is intensifying, and that Adobe’s growth will slow substantially. As these products evolve, they could catch up to Adobe and continue to threaten its growth.
But there’s plenty of evidence to dispute that thesis. For one, Adobe’s management usually provides conservative guidance, which helps keep analyst estimates in check and is one of the reasons the company has missed consensus sales expectations just once in the past 20 quarters. Adobe also said on the third-quarter earnings call that a few new customer deals that normally would have closed in the fourth quarter closed in the third quarter instead.
Adobe generated net new annual recurring revenue of $504 million during the third quarter, $44 million better than guidance. Consistent with that, the company said that the total demand picture for the entire second half of this year, while more weighted toward the third quarter than usual, is on track to meet its demand expectations for the second half of this year.
“The disappointing guide is a combination of timing issues and conservatism,” writes Mizuho Securities analyst Gregg Moskowitz, who rates the stock Outperform and has a price target of $640, up 26% from Wednesday’s close.
Meanwhile, Adobe’s business looks as strong as ever. Third-quarter revenue grew 10.6% year over year as the company lifted prices on some of its offerings to reflect the new AI capabilities it is layering onto its Creative Cloud products, including its marquee Firefly tool, which is particularly misunderstood. It takes text prompts from the user and creates AI-generated art. Users can also export and share the final product. One way in which Adobe differentiates itself is that it uses its existing stock of rights-secured images to train its AI models — leading, perhaps, to less legal risk.
Those features are starting to capture customers’ attention. The third quarter saw three billion new image generations from customers, according to Bank of America’s Brad Sills, up from an average of below 2.5 billion in the past few quarters. Adobe is layering Firefly onto existing products such as Photoshop, allowing users to seamlessly add or remove parts of images.
Firefly also gives Adobe something few other companies bringing AI-powered products to their customers have: growing profit margins. That starts with pricing power, both from new customers and older ones, who are willing to pay more for the product. That has allowed Adobe to become more profitable itself. Its third-quarter operating margin rose a few tenths of a percentage point to 46.5%, even as it continues spending on marketing and research and development, as its revenue continues to outpace spending. Looking ahead, assuming business as usual, the growth story will go on — and please investors.
The stock, though, looks undervalued, given the AI-fueled growth potential. Shares trade at 25.5 times earnings estimates for the next 12 months, down from a peak of just over 34 times this year and below their five-year average of 33. That’s also below the 33 times average multiple for companies in the iShares Expanded Tech-Software Sector exchange-traded fund. Adobe could fetch that kind of multiple if it proves the market’s concerns wrong each quarter. But even if the market doesn’t reward it with such a high multiple, earnings growth should be enough to send it higher.
“Valuation also continues to look attractive to us, and we’re a buyer on this weakness,” writes Moskowitz.
It’s a good reaction to an overreaction.