Adobe Systems Inc. (NYSE: ADBE)

Transcription

1 ` Krause Fund Research Spring 2017 Technology Adobe Systems Inc. (NYSE: ADBE) Recommendation: SELL Analysts Ryan McCuskey Jiaying Cao Joshua Farmer Company Overview Adobe Systems Inc. (ADBE) is a leading application software company. Adobe provides digital media software, digital marketing software, and printing & publishing services. The segment that has driven growth is digital media, which includes Creative Cloud and Creative Document software. Moreover, Creative Cloud subscriptions have grown to 8 million in 2016 are expected to surpass 9 million in We expect Adobe s growth to continue due to its Creative Cloud business and subscribers; however, we do not believe the growth will be sustainable in the next 5 years. Our estimate is that overall growth will fall to 2.9% in Stock Performance Highlights 52-Week High $ Week Low $90.35 Equity Beta 1.03 Average Daily Volume $2.395 M Share Highlights Market Capitalization $63.84 B Shares Outstanding $494.7 M Book Value per share $8.42 EPS (ttm) 2.62 P/E Ratio (ttm) April 17, 2017 Current Price: $ Target Price Range: $110 - $120 Adobe s Future and Overvaluation Extremely large growth in subscription revenue: Subscription revenue in the application software industry has increased significantly over the last decade, since companies are moving towards subscription based revenue models. This large growth has been one of the primary reasons Adobe s stock has been performing so well. However, subscription revenue growth is beginning to mature and slow down, which is very impactful on Adobe and other application software companies who have adopted a subscription based revenue model. Optimistic management team: Adobe s management team is very optimistic going forward, due to their cloud software business1. However, subscription revenue continues to fall. Management may have a positive outlook, but their recent financial performance may suggest otherwise. Intense competition in the application software industry: Competition in the application software industry is very intense. In fact, many firms are making efforts to steal Adobe s customers, and capitalize on perpetual license based models. One Year Stock Performance Company Performance Highlights ROA 9.57% ROE 16.20% Sales 5,854,430 Growth in Subscription Revenue Financial Ratios Current Ratio 2.08 Debt to Equity 0.71 Source: Yahoo! Finance Important disclosures appear on the last page of this report. 1

2 Executive Summary Adobe Systems Inc. is one of the leading firms within the application software industry, designing and producing state of the art digital media and digital marketing software products. In this analysis, we cover a wide array of company-specific information, ultimately to understand the value drivers of Adobe. Moreover, we believe that Adobe is a SELL right now, given their continuous drive to innovate, their strong financial performance, and their current position in the application software industry. Macroeconomic Outlook Gross Domestic Product Real GDP is a measure of how well a country is producing goods and services adjusted for inflation. GDP is calculated by aggregating all of the production of an economy using a specific year s prices. It is a good indicator of strength within the country and can be used to compare growth of global economies. Since the 2008 recession, the economy has recovered in terms of real GDP production with the help of the Fed s quantitative easing policy and since 2010, the annual growth of real GDP on average has fluctuated between %. 2 Employment The employment rate is a measure of the amount of people in the workforce that are actively able and are willing to work. Employment rates are sensitive to economic cycles and are a good indicator of the strength of the economy. The employment rate metric is important to Adobe Systems Inc., and the technology sector as a whole because as high-level talent becomes scarce, and other technology firms are competing for the same talent, it increases labor costs. The current unemployment rate in the U.S. is 4.5% according to the March 2017 employment data, down 5.5% from the peak of 10% unemployment in This is the lowest the unemployment rate has been since April of Source: U.S. Bureau of Labor Statistics We see the unemployment rate remaining steady between 4.4% - 4.7% throughout the remainder of the 2017 year. However, we believe that full-employment will be hard to maintain moving forward due to an increasing participation rate in the workforce compounded with lower Real GDP growth. Due to this we see the unemployment rate increasing to 5.5%-7% by the year Source: U.S. Bureau of Economic Analysis Given the market conditions, we predict a Real GDP growth of 2.1% in 2017 and predict a lower range growth range in the future between 1.5-2% given the strengthening of the dollar and international trade uncertainty. Also, with the current interest rate levels beginning to raise from historic lows, we see the cost of capital financed with debt lowering in the future, depressing Real GDP growth from consistently being over 2%. With the Dow Jones Industrial Average and S&P 500 hitting an all-time highs on 3/1/17 of $ and $ , we see the continual growth off historical highs hard to sustain for the U.S. economy going forward.3 With a large amount of technology firms located in a specific region in San Francisco, we find it important to note the significance of unemployment and wage growth in Santa Clara County, CA. Santa Clara is home to Alphabet Inc, and various other technology firms including but not limited to Apple, Microsoft, Adobe and Intel (3). The various amount of technology firms in the same geographical location competing for the same talent pushes the cost of labor for these firms. According to the U.S. Census, the median household income in Santa Clara ( ) was $96,310, which is 78.7% higher than the U.S. average of $53,889.5 We predict this income to grow to over $100,000 in 2020 due to the growth of technology companies and the need for talent, continuing to increase labor expense in the industry. Important disclosures appear on the last page of this report. 2

3 Exchange Rates USD to JPY Rate Exchange rate can suggests how much a dollar worth in other currencies. Exchange rate is not only important for firms operating in the global, but also essential for domestic companies, because domestic companies also need to compete with foreign companies in the US. We focus on the US dollar index, and several major foreign currency exchange rates, based on Adobe s global market. Besides America, Adobe has 28% revenue in EMEA (Europe, the Middle East and Africa) and 14% revenue in APAC (Asia-Pacific). The United States has only 53% of the total revenue in So almost half of their revenue comes from overseas market, which is affected by the exchange rate. As the US dollar strengthens, their overseas revenue shrinks, Adobe has hedged their currency risks, which partially offset the negative effect.6 Source: Marketwatch.9 Adobe has 7% of its revenue in Japan, so USD to JPY rate is important for revenue in APAC. USD to JPY rate is raising with small waves, but decrease in first 6 month in It came to a peak at the end of 2016, and is now decreasing. We forecast a USD to JPY rate of 120/$ in 6 month due to the strengthening dollar and weakening Yen. We forecast a rate of 113/$ in 2-3 years. Because the Bank of Japan will have a policy to control the currency market and revalue the Yen.10 EUR to USD Rate Source: Adobe 10-K The US Dollar Index (DXY) Source: Marketwatch.11 Euro and British pound has the biggest effect in Adobe s revenue. They together had over 86 million dollars negative effect on total foreign market in EUR to USD exchange rate stay high since 2015, means dollar is appreciating recently. Besides, Brexit has also caused Euro to depreciate. We forecast a EUR to USD rate of $0.9524/Euro in 6 month as dollar continue increase value, and a $0.9804/Euro in 2-3 years. GBP to USD Rate Source: Marketwatch.7 The US Dollar Index (DXY) is measures the US dollar with a basket of foreign currencies (Euro, Japanese Yen, Canadian Dollar, Swedish Krona, Swiss Franc).8 However it ignores some currencies that have become more important recently. The DXY suggested that the US dollar is appreciating in general in recent 5 years. We forecast a 105 in 6 months and 110 in 2-3 years, since dollar is strengthening. Source: Marketwatch.13 Important disclosures appear on the last page of this report. 3

4 British pound has effect of negative 36.2 million on Adobe s foreign revenue.14 GBP to USD rate has increasing since It change from 0.7 dollar per pound to 0.8 dollar per pound since Brexit, and now maintain around 0.8 dollar per pound. As the Brexit processing going, we forecast a rate close to 0.82 to 0.84 dollar per pound in 6 month. After the process settled down, we assume the range will go back to near 0.7 dollar per pound in 2-3 years. Industry Analysis Adobe Systems Inc. falls into the application software industry, within the technology sector. The application software industry is a sub industry in the technology sector, where companies develop software for either individual or corporate users that helps them perform various tasks, such as managing their relationship with their customers, maintaining finances, to helping with daily operations. Application software companies have recently been primarily driven by their subscription revenue and cloud software businesses. Moreover, subscription based revenue models are dependent on users who renew their subscriptions each year. Firms that dominate this industry are Microsoft, SAP SE, Oracle, and Adobe. Many firms within this industry have seen large growth, especially Adobe with their large growth in cloud subscribers. In fact, Adobe has shifted its business model towards a subscription based model rather than a license based model. Source: ZDnet.com15 The SAAS market has become the most used and accepted in the application software space due to the easy adoption without companies changing their IT infrastructure. We see this showing tremendous value as more and more companies are implementing software services within their company. Additionally, we believe that growth of application software companies will primarily stem from their cloud based products. Cloud Revenue Growth Within the application software industry, revenue streams from software products and services, through either a subscription or perpetual licensing model. Business Segments Product Lines for this industry include software products for business functions, big data collection, and financial performance. These lines serve almost all industries from automotive to healthcare. More specifically, one of the major business segments in the application software industry is has recently been cloud software. The cloud based market is comprised of three main segments: Infrastructure-as-a-service, Platform-as-aservice, and Software-as-a-service. Moreover, the software-as-a-service segment comprises most of the market spending as shown below. The SAAS market is expected to continue to grow at an expected rate of 19% per annum until Source: Statista (5). As the chart shows, software-as-a-service revenue has increased significantly from 2010 to The increase has been related to the demand of new features and companies forcing consumers to pay for subscriptions to get the latest features.16 We see the cloud segment maturing in the near future, since it has seen very large growth recently. This maturity is illustrated by one of the leading firms in the cloud segment, Adobe, whose profits are starting to fall. Important disclosures appear on the last page of this report. 4

5 Developments and Trends A big trend, that has been in the software industry for a while is the strength of competition. From startups to established firms, the industry faces new competition regularly. Although the strength of competition is high, it is important to note that of the 39 companies in the S&P 1500 software industry, only 1 has been founded since 1999 (Salesforce). This is due to the importance of established relationships that the companies with large market caps have with clients and their larger budgets for top talent, advertising and research. The growth cycle of the smart application is entering maturity, meaning normalized growth and companies will start having to relying on artificial intelligence for growth in the application software industry. Artificial intelligence is in products such as Google Assistant, Amazon Alexa and IBM Watson. Another trend is the shift towards a subscription based model rather than a license model, as mentioned earlier. Subscription models that application software firms are starting to implement will be useful in smoothing out cyclical fluctuations with the economy and providing a constant revenue stream. The long-term value the constant revenue stream however means that there will be a short-term fallout of cash. Market and Competition The best firms positioned in this industry are ones that have prominent market share and have a competitive edge on their peers. Furthermore, many firms have also merged or acquired others to gain exposure to different markets. For example, Salesforce.com acquired Demandware to increase its customer platform. Additionally, regarding Salesforce.com, it is ones of the largest customer relationship management companies in the industry (Salesforce.com). However, with regard to overall market share in the application software industry, salesforce.com has a relatively small presence compared to its peers. Source: Bloomberg As the pie chart below illustrates, firms such as Microsoft, SAP, Oracle, IBM, and Salesforce.com have a large presence in the application software industry. The other classification is comprised of many different smaller firms within the industry. Furthermore, the degree of market share is based on each firm s revenue from application software. Catalysts for Growth/Change There are several factors that drive Application Software industry growth. Hardware demand, upgrade cycles and transition to cloud based applications will be the most important drivers in the Application Software industry. Hardware Demand Software is always bound with hardware, if new hardware is introduced, software also needs to be updated with the operating system. The more hardware sold, the more software demand is generated. As tablets become a convenient and popular choice to gradually replace laptops, Adobe s team developed application for tablet users. Upgrade Cycle Application software is more user based. The operating system is always updating to adapt to user s needs and brings better user experience with new features. Software needs to follow both hardware and operating system upgrades. For example, when Apple updates its ios system, other application software also needs to update. Currently, as the technology develops at a high speed, and the upgrade cycle will also speed up. Moreover, upgrade cycles are increasing with the innovative nature of the technology industry. For example, Microsoft tends to abandon old operating systems after 5 years, which means that older programs may not be supported anymore.17 These upgrade cycles are the result Important disclosures appear on the last page of this report. 5

6 of consumer demand for new products with unnecessary features. As the upgrade cycles continue to increase, consumers will be forced to upgrade. We see the upgrade cycle continuing to grow significantly as technology firms continue to innovate and release new software. Transition to Cloud Based Applications As more information generate, users are not satisfied with hard disks to transmit and store data. Cloud based application will be more acceptable in the future.18 With cloud based application, people can work anywhere and in any device, which reduce the data transport and occupation in their own hardware. Adobe did a great transition from single application to cloud services, and you can easily change your work from any device close to you. Mergers and Acquisitions New Initiatives for companies in this subindustry include mergers and acquisitions in order to diverse products through acquiring pure-play businesses. For example, Oracle purchasing Net Suite and Salesforce acquiring Demandware. Another initiative for firms in this industry is the transition to implementing artificial intelligence in their products as the smart product or app is maturing in the product life cycle. Porters Five Forces Threat of New Entrants: Low The competitive nature of the application software industry makes it difficult for new firms to sustain success. In fact, if a new firm does not maintain a technological or marketing edge on its competitors, or if the firm can t reach a large enough scale, then it will be an acquisition target for its competition.19 Threat of New Substitutes: Low Bargaining Power of Suppliers: Low The bargaining power of suppliers in the application software industry is very low. Application software companies are reliance on their software development, but not so much the purchase and supply of physical goods. In fact, application software companies are often their own suppliers. Industry Rivalry: High The competition is very high in the application software industry. Firms are constantly trying to maintain an edge on their competitors and sustain a large market presence. For example, many customers have become angry about Adobe s switch to subscription model, so firms like Quark Inc has gained attraction with it QuarkXPress layout software products.21 Key Investment Positives & Negatives Positives Software has the most weight in the technology industry, and also one of the most competitive industries in the world. Although it is also very concentrated, the 4 largest companies dominate 73.96% of the market.22 For the sub-industry, Application Software has almost limitless opportunities to develop. Every new task can generate a set of software potentially.23 Negatives Software in general is relatively mature in the technology sector. For example, most other software operates on Windows and ios systems, Adobe has covered most design area, etc. Unless new areas are developed, new investments in big companies will only be a strategy of maintaining current performance. There is not much room for new growth.24 Most firms in the application software industry have a niche market, and produce their own unique products. Substituting between application products, such as Creative Cloud, is not very likely since Adobe provides its own unique services. Bargaining Power of Customers: Moderate The bargaining power of customers is moderate, due to the fact that customers can pressure application software companies to release newer versions of their applications. However, firms can also utilize subscription models to force customers to continuously renew their subscriptions, if they want to use new features, giving firms some leverage over customer bargaining power.20 Important disclosures appear on the last page of this report. Company Analysis General Information Adobe Systems Incorporated is a pure play company in Application Software. It provides digital media and digital marketing products, and services for users on creating, managing, delivering, measuring, optimizing and engaging with different content via various media, devices and operating systems. Adobe s products and services cover digital media, digital marketing, and print and publishing business segments. 6

7 As it first promoted in 1983, it began with the Adobe PostScript technology and was licensed to printer manufacturers over the world. Later, it stepped into desktop software applications and launched Adobe Illustrator, Photoshop, and Acrobat desktop software. Aside from developing and releasing its own software solutions, it also acquired different software, and worked on technology collaboration or agreement with other companies, in order to develop a more complete work suite. Adobe s products face a competitive environment with short product life cycles and frequent changing in industry standards and introduction of new products. This requires the company to discover new customer needs and develop or acquire new product line frequently. In fiscal year 2016, Adobe generated revenue of 5,854.4 million. Including 3,941 million in Digital media, 1,736.6 million in Digital market, and million in Print and publishing. The total revenue has increased by 22% over FY2015. (Sources: MarketLine25 and Adobe 10K ) Products and Markets Key products and services Digital media solutions Digital imaging software Vector graphics software Professional page layout software Video editing tool Animation and creative compositing software Digital publishing solution Portable document format (PDF) creation and conversion Digital marketing solutions Brands Creative Cloud Photoshop Illustrator InDesign Adobe Premiere Pro After Effects Dreamweaver Animate Adobe Digital Publishing Suite Typekit Behance Acrobat and Document Cloud Adobe Analytics Adobe Target Adobe Social Adobe Media Optimizer Adobe Experience Manager Adobe Campaign Adobe Audience Manager Adobe Primetime Source: Adobe 10-K 2016 As the pie chart indicates, the main sources of revenue for Adobe is digital media, which we expect to continue to grow significantly. We then believe growth will level off at a 2.9% growth rate in In Adobe s income statement, however, the company reports their revenue by Subscription, Product Revenue, and Service and Support Revenue. Since Adobe released the Creative Cloud by subscription in 2012, subscription revenue growth rapidly and has become its major revenue stream, it will be easier for Adobe to report its revenue in this way.28 Subscription Revenue generated by the subscription of Adobe Creative Cloud, which contains most of its major design products, such as Photoshop, and Illustrator. Product Revenue mainly comes from people who purchase its old version of single products, which can be used for the rest of the life, once they purchase them. Since Creative Cloud is provided on subscription basis, once you subscribe it, you can use all products it provide in the suites, beyond the restriction of device, it is a trend that people move from single product to a more convenient cloud suites. This reflect people s demand for transiting to cloud based application in the whole industry, as the diversification of devices. (Source: MarketLine27) Adobe s revenue generates from: - Digital media (67% of the total revenues in FY2016) - Digital marketing (30%) - Print and publishing (3%) Source: Adobe Valuation Model Important disclosures appear on the last page of this report. 7

8 Earnings Analysis For fiscal year 2016, Adobe reported their revenue to be $5.85 million, which represents a 22% growth year-overyear. The revenue and net income growth was driven by the strong performance and growth of Creative Cloud revenue, Adobe document cloud subscriptions, and strong revenue for Adobe Marketing Cloud. Source: Adobe Valuation Model The first chart above shows the growth rate by segment in subscription. We can see their subscription revenue suddenly increase after their switch to a subscription-based model, especially in Digital Media and Printing and Publishing. At the end of fiscal year 2016, the subscription revenue gradually enters a more steady growth trend, but the growth rate is still as high as 50%. Digital Marketing kept growth at a rate close to 20%. So in our forecasting, we keep the Digital Marketing growth rate at 20%; for both Digital Media and Printing and Publishing, we applied a steady reducing growth rate, from 33% to 8%. From the second chart, we can see the overall revenue growth rate for Subscription, Product, and Service & Support. We noticed that Product revenue has a negative growth rate, and has been decreasing rapidly since After the release of Creative Cloud, the amount of people purchasing single products decrease. In our model, we build a -41.7% (in 2016) decrease of percentage of total revenue into forecasting, and at the CV year 2022, the percentage of Product Revenue in total revenue will be close to 0%. The Service and Support revenue is growing steadily every year, so in the model, we forecast it as a 7% of total revenue. After taking out the percentage of Product and Service, we get the percentage of Subscription, and use the total Subscription revenue divided by the percentage of Subscription, we forecasted the total revenue (See Revenue Decomposition). Geography: Source: Statista29 As the chart illustrates, Creative Cloud subscriptions have grown significantly since It is estimated that subscribers will surpass 13 million in We believe short term growth will be primarily driven by the rapid increase of subscribers. The company achieved record Creative Cloud revenue of $886 million in Q4, while also achieving annual Creative Cloud revenue of $3.2 billion; furthermore, this equates to 38% year-over-year growth in Creative Cloud revenue. Similarly, Document cloud revenue for the quarter was $191 million, while the annualized recurring revenue was $475 million. Furthermore, Digital media also generated $4 billion of annualized recurring revenue. Moreover, there was an increase of $316 million in net ARR from Q3 to Q4, because of the adoption and retention of Creative Cloud and Document cloud across various customer segments (Earnings Call Script). Managerial Guidance The success of Adobe has been the result of manager s ability to predict the future accurately. Moreover, in the 4Q earnings call, it was stated that Adobe has been utilizing artificial intelligence technology and machine learning. 30 Additionally, management has been able to create a unique corporate culture. They have achieved this through increasing diversity among their employees. Source: Adobe 10-K 2016 Important disclosures appear on the last page of this report. 8

9 Competition Overall, Adobe faces intense competition. With high industry standards, products are updated in short life cycles, resulting in new products that are entering frequently. In the digital market segment, the company s competitors including Apple, Autodesk, Corel, Microsoft, etc., and lower-end offerings via app stores at smart devices. In the digital marketing segment, Adobe Marketing Cloud is competing with Google, IBM, Oracle, Salesforce.com, SAP, etc., in various market areas. The print and publishing offerings also compete with large-scale electronic and web publishing systems, XML-based publishing firms and lower-end desktop publishing products.31 To compete in the market, Adobe is focusing on develop cloud-based offerings available on subscription basis. Although the development of smart devices provides opportunities to a lot of low-end offering competitors, this is also an opportunity for Adobe to develop its products in smart devices. Through the launch of Adobe Creative Cloud in digital media, Adobe realized its transition from computer desktop to cloud-based applications, through which users can shift conveniently from one device to another without interruption. Similarly, Adobe Marketing Cloud is the solution for the digital market. Besides pushing out cloud-based products, Adobe will also enhance and integrate existing products, provide new products time, meet customer needs, protect customer information, extend core technology into new products. (Source: MarketLine32) Research & Development Research and development expenses were $976.0 million, $862.7 million and $844.4 million for 2016, 2015, and 2014, respectively. They develop their software internally, and acquire products and technology by others by investing in their stock. The increase in research & development costs between 2016 and 2015 was primarily due to an increased headcount, which increased the costs related to compensation and benefits for more people. The research & development expenses consist primarily of salaries and benefits for software developers and expenses related to facilities and computer equipment used in software development. The corporate headquarters, research and development activities, data centers, and other significant facilities are conducted in the San Francisco, which is near a major earthquake faults, where future operating results can be severely hindered if a catastrophic event occurred. In-process research and development of acquired companies is integrated into their tangible and intangible assets based on the estimated fair value at acquisition. Foreign Sales and Earnings: Outside of the United States, Adobe engages in business transactions in U.S. dollars and other currencies. Moreover, they utilize foreign exchange derivatives to hedge foreign currency revenue, which reduces their foreign exchange risk. Financial Metrics of Competitors Market Cap Share Price Sales Net Income EPS P/E P/S P/B Adobe (ADBE) 64.31B ,854,430 1,168, SAP SE (SAP) B ,270,000 3,833, Salesforce.com (CRM) 59.29B ,391, , Oracle (ORCL) B ,000 8,901, Microsoft (MSFT) B ,320,000 16,798, Source: Yahoo! Finance33 Furthermore, we gathered various multiples that we view are most relevant in the application software industry. We only gathered the data for top firms in the industry, ultimately to gain a better understanding of Adobe s relative value compared to its competitors. Overall, we believe that competitors within this industry will continue to put pressure on each other to innovate in order to sustain longevity. Other Topics Important disclosures appear on the last page of this report. When the dollar strengthens and the hedged foreign currency assets decrease, and thus their overall market value of their financial hedging instruments increases. The company has decided to primarily use forward contracts in the future, rather than option contracts, ultimately to hedge their revenue in foreign currencies more efficiently. Moreover, at the end of 2016, all of the company s foreign exchange contracts were worth $891.2 million (Adobe 10K 2016). If the dollar strengthens, given the current economic status of European and Asian countries, then it can drastically benefit Adobe. Major Stockholders The major stockholders in Adobe are individual investors. There are roughly 1,125 holders of Adobe s common stock. However, it is difficult to estimate how many total shareholders there are because many of the shares are held by brokers or institutions, on behalf of stockholders.34 9

10 Moreover, major holders are institutions and mutual fund owners hold about 92.30% of common stock; on the other hand, 0.38% are held by insiders and 5% by owners. Dividend Payout Policy They did not declare or pay out any cash dividends for FY2016 and FY2015. Moreover, they do not anticipate to pay out any dividends in the foreseeable future. Significant Real Estate The most relevant real estate information, with regard to recent transactions, is that they sold a building and land with a total carrying value of $36.3 million, at the end of S.W.O.T. ANALYSIS Strengths - Strong growth in subscription revenues Adobe s subscription growth rapidly since it release Creative Cloud, although the growth rate is decreasing, it still close to 50% at In the feature, we forecast it will gradually enter a steady growth stage, and in our model, we built a gradually decreasing growth rate into it. In Digital Media, the increasing amount of digital image and video demand leads by more access of digital camera and other new devices bring more users to their imaging and video offerings. - Broad offering for products and services Adobe has developed a lot of products by themselves, but also acquire other companies and merge their product into Adobe s own cloud-based suites. Once users subscript the cloud suites, they have access to all of them in the suites. This provide a great deal for people who need a lot of them, and also keep the loyalty from users. If they has subscribe it, they will be less likely to turn to another company s product, they will be more likely to use products already provided in the suite. Besides, it will be easier for them to move from one software to another, from Photoshop to Illustrator, for example. Opportunities - Growth in demanding of the market The increasing of demand from new devices provide great opportunity for Adobe to develop its mobile terminalbased products. As they has already move to cloud-based subscription, they embraced this big opportunity and a part of their growth will generate just from this natural growth of demanding. So there growth will be optimistic in the near future. - Opportunity in digital marketing The market has an increasing demand for optimize customers experience, and Adobe s digital marketing is focus on provide this solutions. Their solution focused on features for both web and mobile analytics, social marketing, targeting, advertising and media optimization, digital experience management, cross-channel campaign management, audience management, advertising and realtime bidding technology, premium video delivery and monetization. 35 During , their digital advertising has increased about 76%.36 Threats - Intense competition In Digital Media, device, hardware and camera manufactures try to bundle their own software for free. As Adobe transfer to cloud-based offering, they also face competition in other smart phone and tablet applications. Since the cost of developing applications on mobile terminal is much cheaper than on computer, a lot of new photo and video editing offerings from small business provide a much cheaper or free price for users. For unprofessional designers, there are a lot of substitutes in mobile device market. In Digital Marketing, the Adobe Marketing Cloud also faced competition from big companies like Google, IBM, Marketo, Oracle, salesforce.com, SAP, SAS, Yahoo!, Verizon, and Teradata. Companies offer product and services together can bundle them together as well. - Limited room for future growth Weaknesses - Debt obligations Adobe has a high leverage. They have a debt ratio of 0.42 in They have 1.9 billion senior notes outstanding at the end of 2016, 900 billion dues in 2020 and 1 billion dues at Although it will bring tax benefits, it also means risk. Important disclosures appear on the last page of this report. The biggest switch Adobe did is shifting from productbase to cloud-base, but their products didn t change that much. In fact, they just put every related product they have into Creative Cloud or Marketing, so that different software can have a better compatibility. The increasing of their subscription revenue partially comes from the original product revenue, rather than new growth. Before this transition in 2011, it has a product revenue of 3.4 billion. Although the subscription revenue in 2016 has 10

11 exceeded this number already, we still need to consider what actually creates new value for Adobe. As a result, we estimate the revenue in a more conservative way. We suggest that after 2019, it will get into a more steadily growth stage. Their market is nearly mature in digital market. Without introduce new product, they will probably maintain it performance, and their growth will only come from the natural growth of demand from market. - Foreign exchange currency fluctuations Since Adobe have nearly 50% of its revenue comes from oversea market, without appropriate hedging, their foreign revenue will shrink as dollar strengthening. They also need to prepare for any economic changing in foreign market. Through our economic and industry outlook, and current company specific factors, we implemented various assumptions regarding Adobe s future financial performance and its intrinsic and relative stock price; our rating is a SELL due to the results of our valuation model and assumptions we have going forward for Adobe. Moreover, we used a discounted cash flow model, economic profit model, dividend discount model, and a relative valuation. Revenue Decomposition Adobe s revenue growth has primarily stemmed from its subscription revenue, which is divided into three segments: digital media, digital marketing, and printing and publishing. The digital media segment has primarily driven revenues through Adobe s innovation in its Creative Cloud and Creative Document businesses. We believe that revenue growth will primarily stem from Adobe s digital media and digital marketing segments, while it s printing and publish segment will eventually decline. Subscription Revenue Digital Media Valuation Discussion The growth of the digital media segment has been driven by Adobe s Creative Cloud and Document Cloud subscriptions. Subscribers have grown from 1.44 million in 2013 to a projected 13 million in This large growth has been the result of Adobe s shift from a perpetual license based model to a subscription model in Moreover, we expect growth to slowly fall overtime, as Adobe s digital media business starts to mature. We expect growth to fall from 48.84% in 2016 to 33% in 2017, gradually falling to 8% in Our logic behind estimating a decrease in high growth to a steady growth is because digital media revenue has fallen significantly over the last 3 years. We believe gradually decreasing the growth will capture the overall maturity of Adobe s digital media business, as well as the industry competitive nature that is steering customers away from Adobe s subscription model. Since 2014, Adobe s digital media subscription revenue has fallen from % in 2014 to 48.84% in Overall, we estimate this high growth to decline to a lower, steady rate in the next 5 years. Digital Marketing Digital marketing has shown consistent, steady growth over the last 4 years. Digital marketing is driven by Adobe s Marketing Cloud software subscriptions with corporate users. We estimate that this growth will remain constant throughout our forecast period, since it has remained stable since adobe s move to a subscription model in Moreover, we expect growth to remain at 20% throughout our forecast period. This estimate is optimistic with regard to Adobe s digital marketing business; however, digital marketing seems more stable than digital media, which is why we assumed growth would remain stable for the next 5 years. Printing and Publishing In our outlook for printing and publishing subscription revenue, we used the same intuition that we used in forecasting digital media subscription revenue. Overall, printing and publishing subscription revenue has fallen significantly since Adobe s switch to a subscription based model. In fact, printing and publishing subscription revenue has fallen from a 272% growth rate in 2014 to a 51% growth in We decided to decrease printing and publishing revenue at the same rate as digital media, slowly decreasing revenue growth from 33% in 2017 to 8% in We believe that the maturity of Adobe s subscriber growth, and recent performance of digital media, illustrates an overall trend in how well printing and publishing will perform going forward. By slowly decreasing growth by about 10% each year until it reaches a more sustainable growth of 8%, we can capture the overall trend of subscriber growth maturing. Product Revenue Product revenue is revenue that is driven by their perpetual and term-based software products.38 We Important disclosures appear on the last page of this report. 11

12 ultimately see product revenue, as a percentage of total revenue, falling to almost 0%. More specifically, we have product revenue falling from 7.97% of sales in 2017 to 0.54% of sales in This decline is due to the fact that Adobe is shifting all of its focus on its subscription revenue. Services & Support Revenue Services & Support revenue is driven by Adobe s consulting, software maintenance, and technical support of their cloud solutions and licensed products.39 Overall, services and support revenue has performed very consistently throughout the last 4 years, since Adobe adopted a new business model. In forecasting services and support revenue, instead of looking at the year-over-year revenue growth, we instead looked at the average historical percentage of revenue that is from services and support, which we calculated to be 7%. Given the consistency of this line of revenue, we estimated that services and support revenue will remain a constant 7% of total revenue through the forecast period. Given that this line of revenue stems from Adobe s support of their application software products, we believe that services and support revenue will remain stable going forward. Cost of Goods Sold Adobe breaks down cost of goods sold by its three streams of revenue: subscription, product, and services & support. Cost of goods sold has slightly changed in recent years due to the increase of data center costs, which resulted from an increase in transaction volume of cloud services.40 However, COGS has remained stable over the last decade. In order to forecast cost of goods sold, we took an average of cost of goods sold as a percentage of sales, and then kept cost of goods sold as a constant percentage of sales going forward. Moreover, we estimate that cost of goods sold will remain at 14.21% of sales going forward. Keeping COGS as a constant percentage of sales will maintain consistent profit margins going forward, and will account for the increases in costs associated with revenue growth going forward. Selling and Administrative Expenses Adobe divides sales and administrative expense into two accounts: sales & marketing and general & administrative. Both accounts have not had much fluctuations at all over the last decade. In fact, we noticed a trend where sales & marketing and general & administrative expenses were around 32% and 7% of sales, respectively; moreover, when Adobe shifted to a new model in 2013, sales & marketing and general & administrative expenses rose to 39% and 10%, respectively. Recently they have normalized and decreased back to historical percentages. Therefore, we assumed that keeping both accounts as a constant percentage of sales, based on a historical average, is most logical going forward. Moreover, we expect sales & marketing to be 34.25% of sales, and general & administrative to be 7.60% of sales going forward. Research and Development Research and development costs are related to the salaries of software developers, research facility costs, and expenses related to computer equipment used by developers. Moreover, research and development costs have gradually risen in value over time, however, as a percentage of sales, it has remained stable. We therefore forecasted research and development as a constant percentage of sales going forward. More specifically, we estimated that research and development will remain 5.7% of sales throughout our forecast period. Capital Expenditures In our forecast of capital expenditures, we looked at managerial guidance regarding future property, plant, and equipment investments. Moreover, management has stated that capital expenditures will decrease slowly over time as their investments towards property, plant, and equipment decreases. These decreases are due to debt obligations that are due in 2020 and Moreover, we estimated an average historical value of capital expenditures to be $157,317. We then slowly decreased the value of capital expenditures from 2016 to 2022 by $10,000 throughout the forecast period, until we arrived at a more normal level of capital expenditures, according to historical levels. Continuing Value Growth Assumptions Our CV growth for NOPLAT and EPS are estimated at 2.9%, which is where we see long-term growth of GDP in our macroeconomic outlook. We believe that Adobe is very profitable in the short-term, with revenue growth equaling 10% in 2022; however, we know that Adobe s growth will slow significantly and won t grow faster than the economy in the long-run. In the continuing year, we estimated ROIC to be 25.02% and ROE to be 22.13%. Our ROIC is a function of NOPLAT and Invested Capital calculations, which primarily stem from our growth assumptions. Additionally, our ROE is a function of our net income and stockholders equity. One Important disclosures appear on the last page of this report. 12

13 important thing to note is that Adobe does not pay dividends, nor does it plan on paying any in the future, therefore retained earnings grows significantly; with retained earnings growing, as a symptom of a nondividend paying company, our stockholders equity grows significantly as well. However, our revenue also grows steadily, and thus our ROE remains between 20.55% and 23.41% in our forecasting years. WACC We estimated the weighted average cost of capital through using the capital asset pricing model for the cost of equity, and analyzing long-term default premiums of companies rated similar to Adobe to estimate the cost of debt. Furthermore, we calculated a WACC of 7.40%. We also used an effective tax rate of 24.1% in our WACC calculation, as well as the yield on the 30-year Treasury bond as the risk-free rate. Our WACC of 7.40% is the product of our assumptions relating to our cost of equity and cost of debt. We believe our relatively low WACC is a symptom of our low cost of equity, which is due to our conservative outlook for the expected market returns over the riskfree rate. Cost of Equity As stated earlier, we used the capital asset pricing model to estimate the cost of equity. First off, we used the current yield on the 30-year Treasury bond as our risk-free rate, since we are discounting long-term cashflows. Secondly, we extracted our equity beta from Bloomberg, which was Lastly, we used Damodaran s estimate for the equity risk premium, which is 4.51%. We believe that a 4.51% equity risk premium captures the geometric historical average of equity risk premiums. The cost of equity we calculated is 7.55%. Cost of Debt In estimating the cost of debt, Adobe did not have any long-term bonds outstanding that captured the enough risk. Therefore, we used Bloomberg to calculate the default-premium on long-term bonds that have similar ratings to Adobe. We calculated the cost of debt to be 4.285%. Discounted Cash Flow and Economic Profit Model We utilized a discounted cash flow and economic profit model to estimate an intrinsic stock price for Adobe. Given the assumptions that we built into our model, we calculated an adjusted intrinsic stock price of $ We believe this price most accurately reflects the true value of Adobe s stock. Adobe is trading at $ as of April 18, 2017, thus we believe Adobe is overvalued. In fact, we were conservative in our equity risk premium assumption, which lowered the WACC; if the WACC was higher, Adobe s stock price would be even lower, thus further supporting our SELL rating. Dividend Discount Model Since Adobe does not pay out dividends, the dividend discount model is not an adequate model to use for valuation. However, we calculated an adjusted stock price of $ Though we believe that Adobe s stock is overvalued, the dividend discount model is not what lead to this conclusion. Relative Valuation In our relative valuation model, we estimated the 2017 and 2018 P/E and PEG ratios for various comparable firms, and used those ratios to back out a relative stock price. In choosing our comparable firms, we choose based on industry, growth, and size. Moreover, we believe these variables are most important in finding a relative value for Adobe. Our relative valuation backed out an estimated stock price of $ and $ for 2017 and 2018, respectively. With regard to our PEG ratio analysis, we backed out stock prices of $ and $ for 2017 and 2018, respectively. Furthermore, we believe the most accurate measure of relative value for Adobe are stock prices we backed out from the industry P/E ratios. We believe this value is an accurate measure of Adobe in the application software industry. Sensitivity Analysis CV Growth of NOPLAT and Beta We analyzed our stock price based on the CV growth rate of NOPLAT and beta. We believe these two factors are very important in our cash flow estimation and discount rate, thus we wanted to see the effects of both. In short, we found that the highest stock price resulted from a low beta and high CV growth of NOPLAT, which was $ In contrast, we found that the lowest stock price was when beta was the highest and CV growth of NOPLAT was lowest, which was $ We concluded that a high CV Important disclosures appear on the last page of this report. 13

14 growth rate of NOPLAT will mitigate the changes in beta. Equity Risk Premium and Cost of Debt Given the assumption we made about our equity risk premium, and since Adobe did not have any long-term bonds outstanding, we decided to test the equity risk premium and cost of debt. We noticed as the equity risk premium grew, the stock price fell significantly. This is indicative of the capital asset pricing model. In contrast, we also noticed that the cost of debt did not have much influence on the stock price, whereas the equity risk premium impacted the price significantly. Risk Free Rate and Beta Though we had tested beta against the CV growth rate of NOPLAT, we also wanted to see the effects beta had compared to the risk free rate. Beta had a much higher influence on the stock price against the risk free rate, than it did against the CV of NOPLAT. Additionally, the risk free rate also influenced the stock price significantly. We concluded that the implications of the cost of equity are very large on our valuation, thus our WACC assumptions are very sensitive. Subscription Growth and COGS as % of Sales We tested the subscription growth against COGS as a % of sales, essentially to see how growth and cost of goods sold affect our valuation. We found that the stock price was impacted by the COGS as a % of Sales to an extent, but subscription growth had a significant impact on the stock price. For example, if subscription growth would have been 43% and COGS at 6.6% of sales, as we forecasted COGS, then our stock price would have been $ Thus, our valuation is very sensitive to growth. Subscription Growth and CV ROIC Additionally, since we save the effects of subscription growth compared to COGS as a % of sales, we wanted to see subscription growth against CV ROIC. Our CV of ROIC is dependent on our NOPLAT and invested capital calculations. In short, we found that CV ROIC does not affect the price very much either. As we saw earlier, our growth assumption significantly impacted the stock price once again. We concluded that growth is one of the most influential assumptions we have made in our model. Important disclosures appear on the last page of this report. 14