October 26, 2024: In its 3rd Quarter of FY 2024 ending August 30th, Adobe beat earnings and revenue expectations, both those of analysts and its own.  For no rational reason, the stock price fell up to 10% after the earnings call. The media attributed this to disappointment of analysts with lower-than-expected company guidance for the Fourth Quarter of FY 2024 revenue, of $5.5 to 5.55 B. 

Did it make sense to sell the stock based on this guidance?  Should we worry that the company will miss its standing full FY 2024 guidance? At the end of FY 2023, Adobe gave FY 2024 revenue estimate of $21.3 to $21.5 Billion.   This was updated to a raised estimate, at end of Q2 2024.  The updated FY 2024 guidance is $21.4B to $21.5B (midpoint is $21.45B)

Total revenue in the first three quarters of FY 2024 is $15.899B.  So if Adobe meets the quarterly guidance for Q4 2024 of $5.5B to $5.55B, FY revenue would be anywhere from $21.399B to $21.449B, very likely enough to meet the FY 2024  guidance of $21.4B to $21.5B. Especially when we bear in mind that over 10 years from 2014 to 2023, Adobe has beat its annual revenue guidance 7 of 10 times.

Zooming to the big picture of Adobe’s business growth over time, we see quarterly yoy revenue growth consistently at 10% or better over the last 10 years. Annual revenue growth slowed to 10% in 2022, 2023 and 2023, having been over 20% from 2016 to 2019.   Annual revenue quadrupled from $4.796 Billion in 2015 to $19.409 Billion in 2023.  The years from 2012 to 2014 were marked by a transient period of slowed revenue growth because of the shift from perpetual license sales of the software, to cloud distribution of software paid by subscription.  Instead of receiving revenue for perpetual licenses as an upfront payment, revenue was now spread out over serial subscription periods.  However, the economics of software subscriptions distributed from the cloud mean lower priced software packages with a more limited app selection can be targeted at a much more diverse, larger number of more precisely defined market segments. Demand and usage can be monitored in real time and in response, software SKUs can be designed and released much more responsively than previously, when comprehensive updates of a full suite of software on CDs had to be distributed to brick and mortar stores.  This meant that revenue could ultimately reach a higher level of growth, targeted to a larger Total Addressable Market (TAM).  It is possible that Adobe’s revenue growth slowed in 2022 because once growth had accelerated to meet the new TAM demand, the growth rate slowed to reflect intrinsic market growth.  On the other hand, the slowing in revenue growth might well have been caused by the contemporaneous interest rate increases, fears of recession and consequent slowing in business spending.

I have not done the research to find the answer to this question.  It is not our job to forecast or explain changes in the economy and whether they affect the company.  Our business is to examine whether our investment of choice is maintaining and strengthening its competitive advantages, and extending them to the evolving markets in order to perpetuate its growth Ad Infinitum.

The AI revolution presents a surge in market demand. Adobe is exploiting this by integrating AI capabilities into its current applications and developing new AI-first applications.

Generative AI facilitates and accelerates content creation, its processing into final product, and its targeting to personalized market segments at scale. It makes this work more accessible to a wider range of knowledge workers. 

As described in the earnings call and recent investor conferences, Adobe is executing its strategy of Integrating AI into its flagship Apps. Multiple Adobe Firefly AI powered features have been integrated into the Creative Cloud applications. The online platform Adobe Express incorporated generative AI in 2023 to accelerate and ease content creation using the Creative Cloud apps. In the Document Cloud, the Acrobat AI Assistant enables users to quickly extract value from documents

The strategy is to use the AI features to streamline repetitive tasks and accelerate workflows within the apps, removing the pain points and some of the learning curves of content creation.  As Adobe leadership have repeatedly described over the past year at various investor presentations,  AI integration increases customer acquisition, retention and profitability.  Usage of Firefly Generative AI in the apps continues to accelerate, crossing 12 billion generations since launch. Usage of Adobe Acrobat AI Assistant grew 70% quarter over quarter.

Adobe Express is a streamlined, user-friendly, AI-first platform in which Firefly AI capabilities are made immediately available to utilize Adobe creative applications.  Adobe Express showcases the power of AI integration in the exemplary flagship creative applications, to attract and retain new, non-professional users. In the business environment, Express empowers knowledge workers who are not professional graphic design content creators, for example in marketing, sales and others, to customize branded content for the final intended business marketing application.  Adobe’s AI-powered features are designed to be commercially safe because all AI models created and used in Adobe software are guaranteed to be free of 3rd party intellectual property.

In fact, as stated by David Wadhwani, President of the Digital Media Business, With Express, “we’re on a multi-year strategic journey to dramatically expand our reach across customer segments.” As go-to-market activities are ramped up, Express is targeted to individuals, Education, Teams and Enterprises. As a result, Q3 saw 70 % yoy growth in cumulative exports. Over 1,500 businesses and millions of students were onboarded.  Exports are a relevant indicator of customer acceptance of the product, because if the user created and exported content to another application, that means that Express was used to finish the content product.

In the Adobe Experience Cloud Adobe Sensei has evolved as an AI assistant in the Adobe Experience Platform URL.  This facilitates usage by providing guidance and streamlining tasks. It is based on LLMs of Adobe product facts and best practices, as well as AI models of customer data and goals.

Firefly Services is a comprehensive set of generative AI and Creative services that automates workflows using the suite of apps in Creative Cloud and Experience Cloud.  It takes over repetitive and labor intensive tasks to accelerate production of content at scale, facilitating personalization or modification for specified target audiences.  In addition, customers using Firefly Services can order Firefly Custom Model Integration. Custom models are trained on customer’s branded assets to create campaigns that match a brand’s specific style. 

In Adobe GenStudio, AI is natively integrated with Creative Cloud  and Experience Cloud (including Adobe Experience Manager and Experience Platform) apps to empower marketers to quickly plan, create, store, deliver and measure marketing content and drive greater efficiency in their organizations.  GenStudio was released to beta testing at Adobe Max last year and was just released to general availability as GenStudio for Performance Marketing at Adobe Max 2024. 

Adobe has Competitive Advantages Particularly in the Enterprise.

The integration of the Creative Cloud and Experience Cloud apps means they mutually reinforce their competitive advantages of switching cost.  This integration serves the customer desire to streamline and simplify usage and execution.  As Anil Chakravarthy, President, Digital Experience Business, stated, “Through the integration of Experience Cloud and Creative Cloud, Adobe is uniquely positioned to combine the right content, data and journeys in real time for every customer experience.”   Enterprise customers of Creative Cloud apps are disincentivized from using alternatives to Adobe Experience Cloud software, when this is already integrated into the comprehensive suite of content creation and marketing applications.

Adobe has a large installed base in enterprises. It has high gross and operating margins, with relatively low cost of goods sold. Fixed costs such as R&D are greater than the Variable Costs of goods sold.  For instance, in 2023 R&D was $3.473 Billion, and Total Cost of Revenue was $2.354 Billion. Total Revenue was $19.409 Billion.  This means it enjoys scale advantages.  For instance, developing and integrating AI software into its market dominating Creative Cloud generates a relatively high return, expanding usage across its installed base, while attracting new users.  This would be seen as a healthy Return on Invested Capital (ROIC) in the financial accounting.  The various small younger companies which are introducing generative AI to produce raw content, are faced with the prospect of raising capital and spending heavily on development, including acquiring datacenter infrastructure and attracting software engineers, and when they have created a product, then fighting to win customers in a competitive market. While some of them may prosper in the battle for casual content creators, in the enterprise, they are limited by the switching costs, captive customers that Adobe has nurtured for decades.

Indeed, AI strengthens Adobe competitive advantages.  As described above, AI Assistant in Adobe Acrobat in the Document Cloud, the AI assistant in the Experience Cloud, and Adobe Express AI integration, make the products more accessible by more people in an enterprise or other user group.  For example, In Adobe GenStudio, content produced initially by professional marketing creators using Creative Cloud flagship apps, is subsequently modified and finalized for targeting to specific market segments using Adobe Express, by non-professional marketing or other staff in the enterprise.  This means that more people in the enterprise become habituated to the Adobe software suite, and are disincentivized from switching to alternative creative solutions.  This strengthens the network effect competitive advantage against potential competitors.

Adobe combines competitive advantages of network effects and switching costs.  With its large installed base, it commands a high return on investment of the fixed cost of development of innovation such as AI, relative to the scale of its market share.  This confers economies of scale.

As long as Adobe continues its culture of profitable innovation, which it has since 1982, It will continue to defend and extend its domination of its markets.