Did Adobe just signal a red flag for AI growth stocks?

Adobe (ADBE -13.67%) Stocks sold off on Friday after the software company reported record earnings but muted Q2 fiscal 2024 guidance. The stock is now down nearly 20% since February 1st, which has been a great period for the broader market and artificial intelligence (AI) boom.

Let’s dive into Adobe’s results and management commentary to see if this is a bad omen for the AI ​​theme, or if Adobe’s problems are more for the company.

Image source: Getty Images.

AI-powered investing

To some extent, Adobe has always been an AI play. It’s just that the buzzword is spreading more these days.

The company’s flagship bundle, Creative Cloud, offers a collection of applications and tools to help creators design, edit, and interact with various forms of media—text, images, and video. However, Adobe’s growth had slowed in recent years, and the company needed a new catalyst to encourage investment.

On March 21, Adobe unveiled Firefly, a creative AI tool for Creative Cloud, Document Cloud, Experience Cloud, and Adobe Express workflows. The launch of Firefly and the prospect of monetizing AI helped Adobe stock gain more than 77 percent last year.

Adobe’s recent earnings call marked a change of pace and the harsh reality that even though these new applications have a long runway, that doesn’t mean they will have an immediate impact on short-term results.

Adobe’s Q2 fiscal 2024 guidance was weak, and the company chose not to provide an update on full-year guidance, while it provided full fiscal 2024 guidance on its Q4 fiscal 2024 earnings call in December. was The market hates uncertainty, so it’s no surprise that much of the Q&A session focused on analysts looking at quarterly results and fiscal 2024 performance rather than Adobe’s long-term investment. Why was that involved and where the company could be three to five years from now? .

AI’s Measurable Impact on Adobe’s Growth

Adobe Firefly users have already created 6.5 billion assets such as images, vectors, designs and text effects through Creative Cloud and Adobe Express. Adobe reported record new commercial subscriptions to Creative Cloud and teased new products with Firefly for Adobe Express for mobile, Firefly Services, and an AI assistant for Adobe Acrobat. The company is investing heavily in its product rollout and making significant improvements to its existing products and mobile tools, and even introducing new products such as AI-powered Enhance Speech, which itself Automatically dubs a video into the user’s preferred language.

That said, if ever there was a time to take quarterly results with a grain of salt, it’s now. Adobe is dealing with a one-time $1 billion charge to close its acquisition of Figma, which was announced in September 2022. Moreover, many investments in product innovation may not be realized for many years.

On the earnings call, Adobe made it clear that its focus is on getting more users. The idea is that with good customer acquisition and retention, Adobe can monetize its user base over time. Adobe was one of the pioneers of the software-as-a-service (SaaS) business model, and it remains true to its roots in how it approaches AI.

A key part of the earnings call was when Adobe CEO Shantanu Narayan explained the difference between experiences and monetization on its platforms. In many ways, Adobe is still figuring out what will stick with consumers. There’s no point in investing billions of dollars in tools that customers either won’t use or that the company can’t justify the price increase.

This brings us to the most important challenge with Adobe, which is making money from AI. Because Adobe is a subscription business, it must support increased capital expenditures by growing its customer base and revenue per user. There will be a comparison. Netflixwhich has to justify price increases by making its service more valuable to customers through quality shows and content costs.

The good news is that Adobe’s customer base consists mostly of businesses and to a lesser extent students and individual creators. So it does not depend on the power of users. If its customers can use AI-based tools like Firefly to do their jobs faster and better, the price increase should be naturally absorbed. But it would be a mistake to assume that this is a given.

A large buyback program

Adobe’s investment thesis is about consistency. Incremental growth from reliable subscription revenue fuels innovation and a low rate of return on capital program.

Over the past 10 years, Adobe has decreased its number of shares outstanding by 9.2% despite increasing its stock-based compensation more than 400%. It just announced a $25 billion stock repurchase program over the next four years. At a market cap of about $227 billion at the time of this writing, simple math tells us that Adobe plans to shed 11% or more of its stock over the next four years, double what it did in the last decade. is higher than the rate.

Stock buybacks spread earnings over a smaller number of shares, increasing earnings per share (EPS) and giving Adobe better value. It’s a way to artificially boost EPS even when the underlying business isn’t posting the best organic growth.

Adobe is not in that position. In fact, its organic growth is very good. But the company’s decision not to update its full-year guidance indicates that growth may not be as good as investors had hoped when Adobe was hovering at a 52-week high just six weeks ago.

Drowning in expectations

Adobe didn’t signal a red flag for AI growth stocks, but it did remind investors where their focus should be, which is not on the next quarter or year, but on how AI will evolve. Increases the overall investment thesis. Adobe has a clear, straightforward approach to monetizing AI, making it one of the more interesting long-term plays out there.

Even after the selloff, Adobe isn’t a cheap stock. Better not to focus too much on the trailing earnings due to Figma’s one-time failure. For fiscal 2025, analysts expect EPS of $20.30, implying a price-to-earnings ratio of 24.6. But that’s based on full-year earnings seven quarters from now.

Adobe isn’t a screaming buy, but the market is underestimating its growth potential. Adobe is able to add to a watchlist or even open a starter position. But if Adobe goes through a long sale, the price will look too cheap to ignore.

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