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Adobe (ADBE) just reported its Q4 FY22 earnings report (ending November 2022).

Today, we’ll cover the following:

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Adobe is a big deal in the tech world, and you've probably heard of them before.

They make all sorts of software for creatives, like Photoshop and Illustrator, which are widely used for editing and designing purposes. It has become a $150 billion software giant through steady growth and a shift to a subscription model.

Adobe's products and services are designed to help people create, collaborate, and communicate more effectively, and to drive innovation and growth in their personal and professional endeavors.

The company has been acquisitive over the years, a trait comparable to Salesforce.

Here are the ones you should know:

2022: Figma ($20 billion).
2018: Marketo ($4.8 billion).
2005: Macromedia ($3.6 billion).
2009: Omniture ($1.8 billion).
2018: Magento ($1.7 billion).
2020: Workfront ($1.5 billion).
2021: Frame.io ($1.3 billion).

Recently, they made their biggest acquisition (still pending approval) in the form of Figma, which is a really cool real-time collaboration tool for designers. The Figma acquisition is a testament to Adobe’s dedication to innovation and staying ahead of the curve. Once the acquisition is completed, it could be a game changer, But it does come with some caveat on the price paid (more on that in a minute).

Before we start, let’s discuss how Adobe makes money.

More than 93% of Adobe’s overall revenue comes from subscriptions, a shift more than 10 years in the making.

App Economy Insights @EconomyApp

$ADBE Adobe's shift to subscriptions since 2010. Figma will add ~$400M of annual revenue.

Because Adobe is primarily a subscription business, the key performance metric is ARR (Annualized Recurring Revenue). For example, if you subscribe to a service for $10/month, the ARR is $120. It gives a better indication of the trajectory of the overall business with the projected revenue for the full year of all existing subscribers.

Revenue has three main segments:
- Digital Media (~73% of overall revenue).
  - Creative Cloud (~59% of overall revenue), including Adobe Express.
  - Document Cloud (~14% of overall revenue), including Adobe Acrobat.
- Digital Experience (~25% of overall revenue), data insights and audiences, content and commerce, customer journeys, and marketing workflows.
- Publishing and Advertising (~2% of overall revenue).

Note that the majority of revenue comes from the Americas (~60%), followed by EMEA (~25%) and APAC (~15%).

All segments have been growing consistently in the low teens in recent years.

Costs and expenses include:
- Cost of revenue: Primarily the cost of subscriptions, including third-party hosting services and data center costs (network infrastructure costs). operations, implementation, technical support, software costs, and amortization of certain intangible assets. Cost of revenue also includes the cost of product revenue (royalties and localization costs) and cost of services (contracted costs incurred to provide consulting services, training, and support).
- Sales & marketing expenses: Sales and marketing headcounts, commissions, advertising, trade shows, event, public relations, and other market development programs.
- Research & development expenses: Software development headcounts and infrastructure costs.
- General & administrative expenses: Finance and accounting, legal, human resources, and management information systems personnel. Also includes computer equipment and software used in the administration of the business.
Margins:
- The gross margin is among the best you’ll find in public software companies, in the high 80s. Hosting and infrastructure costs are a relative small part of the revenue generated by subscriptions.
  Adobe gross margin (Macrotrends)
- The operating margin has been above 20% in the past six years and even above 30% in the past four years. It’s a profile comparable to Microsoft.
  Adobe operating margin (Macrotrends)

Let’s look at the most recent quarter!

1. Adobe Q4 FY22

Income statement:

Here is a bird’s-eye view of the income statement.

Main highlights:

Revenue grew +10% Y/Y to $4.5 billion (in-line).
- Digital Media grew +10% Y/Y to $3.3 billion.
- Digital Experience grew +14% Y/Y to $1.2 billion.
- Publishing & Advertising declined -18% Y/Y to $0.1 billion.
Gross margin was 88% (unchanged).
Operating margin was 33% (-4pp Y/Y).
EPS was $3.60 ($0.10 beat).

Cash flow:

Operating cash flow was $2.3 billion (51% margin, +1pp Y/Y).

Balance sheet:

Cash and cash equivalent and short-term investments: $6.1 billion.
Long-term debt: $3.6 billion.

FY23 Guidance:

Revenue to grow +9% Y/Y to $19.2 billion (unchanged since analyst day).
Digital Media net new ARR ~$1.65 billion.
Digital Media segment revenue +9% Y/Y to $14.0 billion.
Digital Experience segment revenue +13% Y/Y to $5.0 billion.

So what to make of all this?

Revenue was in-line with expectations, and earnings were slightly ahead. So there were no major concerns despite the challenging environment.
Digital Media's net new ARR was $576 million, which was ahead of the ~$550 million guidance provided last quarter.
The FY23 guidance assumes a 4pp currency headwind. So the FY23 guidance is for revenue to grow +13% Y/Y fx neutral, which is healthy in this environment.
There were no major surprises since the guidance was unchanged from the financial analyst meeting that occurred a few weeks prior.

Is the business sustainable?

The company has a positive net cash position and is gushing cash through its business operations, so the sustainability of the business is not at risk in the near term.

Adobe repurchased approximately 5.0 million shares during the quarter ($1.8 billion) and 15.7 million shares during the year. As of this writing, buybacks have not been the best use of capital this year, but we’ll have to revisit in a few years.

2. Recent business highlights.

Creative Cloud

The leading segment grew +13% Y/Y in constant currency. An important driver has been the success of the Creative Cloud All Apps offerings, which include Photoshop, Illustrator, Acrobat Pro Premiere Pro, InDesign, and Adobe Express.

The majority of Creative Cloud ARR comes from the All Apps bundle.

The strategy has been focused on four pillars:

Keep the creative apps at the bleeding edge of technology with high precision,
Deliver Adobe Express (content creation for social media) across web and mobile.
Leverage Adobe’s unique data sets with Adobe Sensei (AI-driven output).
Enable collaboration between creators (share for review, co-editing).

Document Cloud

Experience Cloud

3. Key quotes from the earnings call

David Wadhwani - President of Digital Media:

“Q4 was a record quarter for Creative Cloud. We achieved net new Creative Cloud ARR of $453 million and revenue of $2.68 billion, which grew 13% year-over-year. This strong performance was a result of: demand for our flagship applications, including Photoshop, Lightroom, Illustrator, Premiere Pro and Acrobat; expansion in SMB and enterprise […] accelerating growth in Substance 3D and Frame.io […] momentum in Express.”

He also mentioned key customer wins for Creative Cloud, including Electronic Arts, Meta, NBC Universal, Publicis, Roku, Target and United Nations.

“Our announcements included: powerful new AI capabilities in Photoshop, such as a one-click Delete and Fill tool to remove and replace objects, and a new Photo Restoration neural filter that instantly fixes damaged photos; a Share for Review service in Photoshop and Illustrator that enables designers to easily collaborate with key stakeholders.”

About Document Cloud:

“In Q4, Document Cloud had record revenue of $619 million, which represents 19% year-over-year growth and strong net new ARR of $123 million, with ending ARR growing 23% year-over-year.
Q4 highlights include: new Acrobat functionality for SMBs, […] new capabilities between Document Cloud and Creative Cloud […]; scan innovation […]; strong organic growth in both traffic and searches for PDF capabilities, which serve as a critical funnel to Acrobat web; significant growth in Sign transactions within Acrobat […]; outstanding growth in API transactions.”

Key customer wins for Document Cloud included BioNTech, Cigna, Deloitte, Mitsubishi Electric, Raytheon, Shell Information Technology, and the US Department of State.

About Figma and the regulatory review:

“we’re excited about the pending Figma acquisition, which represents a tremendous opportunity to accelerate the future of creativity and productivity for millions of people. […] The transaction is being reviewed globally, including by the Department of Justice and the Competition and Markets Authority in the UK. We are currently engaged in the DOJ’s second request process. We expect that the transaction will also be reviewed in the EU. We continue to feel positive about the facts underlying the transaction and expect to receive approval to close the transaction in 2023.”

Anil Chakravarthy - President of Digital Experience explained:

“Adobe Experience Platform processes 29 trillion segment evaluations per day and executes a response time of less than 250 milliseconds, illustrating the impact of its real-time capabilities at scale.”

Key customer wins for Document Cloud included BlackRock, Chipotle, Delta Air Lines, DFS Group, Disney Parks, Elevance Health, GM, Office Depot, Publicis, Santander, and Wells Fargo.

Dan Durn - EVP and CFO, talked about macro headwinds:

“In 2022 we experienced significant headwinds from the strengthening of the U.S. dollar, increased tax rates and the impacts from the Russia-Ukraine war. Despite those headwinds, in fiscal ‘22 Adobe achieved record revenue of $17.61 billion, which represents 12% year-over-year growth, or 15% growth in constant currency on an adjusted basis.”

On cash management:

“We now intend to use cash on hand to repay the current portion of our debt on or before the due date, which we expect will reduce our interest expense in fiscal year ‘23. In Q4 we entered into a $1.75 billion share repurchase agreement, and we currently have $6.55 billion remaining of our $15 billion authorization granted in December 2020 which goes through 2024.”

4. What to watch looking forward

Figma on the horizon

In September 2022, Adobe announced it would acquire Figma for $20 billion in cash and stock.

The key numbers from the announcements were as follows:

$400 million in ARR by the end of 2022 (+100% Y/Y), which is about 2% of Adobe’s annual revenue.
Dollar-Based Net Retention was greater than 150%. It means revenue from existing customer grows on average +50% Y/Y, net of churn.
There are an estimated 4 million free users, but that number was not mentioned in the press release.

My tweet below summarizes my thoughts at the time.

App Economy Insights @EconomyApp

Figma raised ~$330M in 2021 at a $10B valuation. If Figma had gone public in 2021, it would probably have collapsed 50%-80% since then, like other software stocks. Yet, $ADBE is paying $20B today. 🤔 50X FY22 ARR for a 150% DBNR.

Figma had raised $330 million at a $10 billion valuation in 2021. But by September 2022, all 2021 valuations in the software space had contracted by 50% to 80% (and that’s still the case today). Even a private company like Stripe saw its valuation get a 64% cut by T Rowe Price in the past year.

By 2021 standards, Adobe paid at a nosebleed valuation.
By 2022 standards, it’s the most expensive deal on the planet by far.

For perspective, even Snowflake, the fastest-growing cloud software business with a net revenue retention rate of 165% (well ahead of Figma), is trading at 20 times forward revenue.

So there is no doubt Adobe overpaid by a factor of 2-to-4X. The more interesting question is if that price was worth paying anyway.

Since then, Adobe has shaved more than $30 billion from its market cap. So new investors are essentially getting Figma for free. Adobe is trading at its valuation close to the March 2020 lows (which is true of most cloud software stocks at this time).

The Figma acquisition could be a game-changer for a few reasons:

Figma is a popular collaboration tool among designers, allowing them to work on projects together in real time. By acquiring Figma, Adobe has gained access to a new user base and can potentially expand its reach in the design industry.
Figma's real-time collaboration feature complements Adobe's existing suite of design tools, such as Photoshop and Illustrator. This acquisition allows Adobe to offer a more comprehensive design workflow solution to its customers.
The acquisition of Figma could help Adobe stay competitive in the design software market as more companies are beginning to offer collaborative design tools.
The acquisition allows Adobe to diversify its product offerings and potentially tap into new revenue streams.

Overall, the acquisition of Figma by Adobe is significant because it allows Adobe to expand its presence in the design industry and offer a more comprehensive design workflow solution to its customers.

According to Politico, the US Department of Justice began an in-depth antitrust review of the Figma deal.

Beyond Figma

Figma could be a tailwind for the growth of Creative Cloud (again close to 60% of Adobe’s revenue). But Adobe’s future is not all about Figma.

Management has clearly laid out the future growth drivers across its three main segments:

Creative Cloud: Product-led growth with new users and retention as core drivers.
Document Cloud: Business workflows, sign APIs, SMBs, and direct sales.
Experience Cloud: Momentum with Adobe Experience Platform (AEP).

What shareholders should question is the core reason why Adobe’s management has been so desperate to close the deal with Figma (based on the price paid).

After all, you only buy something at any price when you have no other choice.

Is Adobe’s moat more fragile than management lets us believe?
Was Figma a threat that justified overpaying by more than $10 billion?
Could the deal unlock a lot more value over time via a sum of the part?

That’s it for today!

Stay healthy and invest on!

Disclosure: I am long CRM in the App Economy Portfolio. I share my ratings (BUY, SELL or HOLD) with App Economy Portfolio members here.

📑 Adobe: Before Figma