The stock markets are starting to pick up a bit again. The shares on the watchlist are picking up too: there are now 35 within 5% of their yearly highs and 55 within 10%. This compares to 18 within 5% and 45 within 10% a couple of weeks ago. My portfolio had a good week and is back near it’s all time highs for the fourth time since volatility picked up late last year – I’m fairly optimistic that this time it can break through and continue its progress.
Given the more bullish conditions, I’ve decided to start reinvesting my cash balance. I’ve been topping up a few existing holdings and have bought one new position in Adobe Systems. Following my recent resolution to hold onto a defensive cash balance until conditions show clear signs of improvement, it seems a bit soon to be reinvesting. However, I think it is justified as I’m going to be injecting some more funds to the portfolio fairly soon.
Adobe is a software provider for business. It has a wide ranging portfolio of products, predominantly focused on cloud-based digital media management (‘Creative Cloud’ & ‘Document Cloud’ services) and to a lesser extent on advertising data analytics (‘Experience Cloud’ services). Over recent years, it has successfully shifted its customers to a subscription model and earns a high proportion of recurring revenues as a result.
Adobe is an extremely high quality business and one that would be near the very top of my list of investments to buy and hold forever. It is a clear technology leader in fast growing markets.
- Business economics: Adobe is a capital light, highly profitable business. It has a reasonable ROCE (currently 21%) which has grown substantially over recent years. The operating margin is high (31%) and also growing substantially over recent years. Its cash flow conversion over the past few years has been exceptionally strong, falling gradually from 400% in 2014 to 150% in 2017, suggesting its profit recognition is likely to be somewhat conservative. The most substantial cash item missing from the profit statement turns out to be very high levels of deferred revenue, presumably arising because under its subscription model Adobe is often paid in advance of the profits being recognised.
- Track record: Adobe has an excellent track record with strong growth in revenues and profits over the last few years. The share price has appreciated fairly consistently over the long term (with the expected blips around the time of the dot.com crash and financial crisis).
- Competitive advantage: Adobe does face some competition across its portfolio of products, but typically this is from more niche single-product suppliers. It is the clear market leader both in terms of the quality of its products, with many being industry standards, and the scope of what it can offer as a one-stop solution in its unified ‘Creative Cloud’ platform. Its dominance has been demonstrated by the spectacular success it has had in transitioning customers to its cloud-based subscription model with very little churn. It looks to have substantial pricing power for its subscriptions. Adobe looks likely to further cement its competitive advantage through continued investment in a one-stop ecosystem of interconnected products supported by innovative data analytics. The smaller ‘Enterprise Cloud’ segment is also growing in importance. Here Adobe has had success in partnering with advertising agencies so far, though it looks to have an increasing strategic advantage in these partnerships through its ownership of the technology and the data.
- Growth prospects: the growth prospects look very promising. All of Adobe’s markets are experiencing strong secular growth and Adobe estimates that the addressable market for its products is many times greater than current revenues.
Adobe’s momentum is excellent, with a steadily appreciating share price near all time highs. There is clearly a lot of demand for the shares, which have suffered relatively little in the recent volatility. Adobe has been consistently beating its earnings expectations for some time now with little sign of slowing down. I think the valuation is reasonable given the growth prospects. My back of the envelope DCF approximation suggests it needs to grow profits at around 18% for the next five years or so to justify the current valuation. This seems very achievable to me based on the current trajectory.