Episode 54 | Inside Adobe’s Investment Value: AI Competition, Slow Growth, and Strong Margins

In Episode 54 of "Market News with Rodney Lake," Professor Lake, director of the GW Investment Institute, analyzes Adobe, a digital experience software-as-a-service company. Lake highlights Adobe’s transition from a licensing to a subscription-based business model, which now accounts for approximately 95% of its revenue. Despite slowing revenue growth rates, Adobe’s gross margins remain exceptionally high at around 89% and net margins are projected to reach 37% for the fiscal year 2025. Management, led by Shantanu Narayen since 2017, receives high marks for exercising disciplined capital allocation and strategic acquisitions. Professor Lake also discusses Adobe’s integration of agentic AI via Firefly and evaluates competitive threats from companies like Microsoft and Figma. However, Adobe’s forward PE ratio of 18 suggests market skepticism about its growth in a competitive AI landscape.

Chapters

• 0:00 Introduction
• 1:28 Business
• 12:26 Management
• 14:18 Price/Valuation
• 17:40 Balance Sheet
• 20:31 Conclusion

Transcript

Thank you for joining “Market News with Rodney Lake.” This is a regular program for the GW Investment Institute where we talk about timely market topics. I'm Rodney Lake, the director of the GW Investment Institute. Let's get started.
Welcome back to “Market News with Rodney Lake.” I'm your host, Rodney Lake. We're coming to you directly from Duquès Hall and the Duquès family studio, right here in the heart of Foggy Bottom. The George Washington University School of Business. This is a GW Investment Institute show. Welcome back to anybody that's been watching on YouTube and listening on Apple or Spotify.
Thank you very much. And again, welcome to any new viewers. So what are we going to talk about today? Today we're going to talk about a portfolio company. If you've been following the show you know that we use the GW Investment Institute framework to break down some of our portfolio companies. Disclaimer. This is entertainment purposes and educational purposes only.
The framework is business, management, price/valuation and balance sheet. BMPB. You can see one of our blogs or listen to one of our old episodes about the framework. We've been using this and our students have been using this now for over 20 years with success. And you can check our website and see some of their letters as well.
And subscribe, by the way, to our newsletter. All right. So what's been happening in the markets? Well, the markets have been up, but today, we're going to talk about a specific company in our portfolio. We're going to talk about Adobe. So we've owned Adobe and we've owned it for a while. The ticker is ADBE.
Now many of you know this company and you've interacted with its products. So, obviously if you've ever opened a PDF, you've probably interacted with with Adobe, but maybe you don't have a subscription. That's the vast majority of their revenue. So, let's jump into this company, let's jump into Adobe, and how they make money, and some of their numbers.
All right. So first, let's get a sense. We always try to tackle the market cap first. How big is this company? Right. What's the market cap? So we're in late July here. Market cap 158 billion. So this is a large company. But again not the Nvidia large company, not the Microsoft, not the Amazons, not the trillion dollar market cap, but still a very large company, $158 billion market cap company. And so let's now let's look at the financials here.
Let's start breaking down on the revenue side. But first, maybe we just detail that most of the money is through subscriptions, right? The vast majority, over 90% of their money, Adobe Creative Cloud is that. So, if you if you have that right, Photoshop is one of the premiere products that they have, for publishing and advertising.
People are in that business, the digital experience, all kinds of, you know, different products that, that, that Adobe has in that suite of products. And now they shifted, you know, not recently, but not that long ago to, you know, from the licensing to the subscription model. And that has really worked. And that has been the growth that has been the biggest part of the revenue, now for a while.
And again, over 90% really, probably over 95% of their revenue was coming in from subscription based, which is great. And that's where you can get a higher multiple with subscription revenue. And so that Creative Cloud suite of products, that's that's really what's in there. And then their AI piece, which is Firefly, I think that's really important. And we'll talk a little bit more about that.
So that's the you know that's the business. That's the products they have. You probably use some of their products. You might have Creative Cloud yourself and use some of those products, if not all of those products, at one point or another. Depends, where you are in the business, for your business or working within a business.
But now let's look at the revenue here again, market cap 158 billion. So let's look at the revenue. So last reported numbers we have, they actually have a calendar year, 12/1 or 11/29 depending on when it falls. So it's that 5/30 is the latest data that we have. So that's May 30th, 2025. So what's the revenue look like, for that? $22.6 billion.
So what's the growth on that number? 10%. And what are our projections? So again, one of the things that we care about is obviously where the companies come from, only as it pertains to what we think, now and how it informs our decisions. Is there a catalyst? Is there something that's going to change, that's going to help us make a decision about what we do today about the, you know, two years out, three years out, five years out, what we think the company is going to do.
So if you look at 20, the projection here for 2025 full year, which is 11/30 again for them, 23.5 billion 9.6 growth rate, 25.8 billion for the next year in 26, 11/30/26 9.5. So these are not tremendous growth rates, right. But it's a huge company, 22 billion in revenue, is a lot of revenue. And so when you talk about, you get to these big numbers, obviously it's harder to grow those numbers at that scale.
And so but let's now look at where they came from. Just to have some context. So 21, you were at 15.7 billion, at 22 17.6, 23 19.4, 24 21.5 and then again, we said 22.6 for the 5/30 number. The full year projected at 23.5 for 25 and 25.8 for 26. And you're talking, you know, you had better growth rates in the beginning.
They're 22%. Then they fell to 11.5 and from 21 to 22, and then 10.2 in 23 and 10.8 and 24 and 10.6. So, you know, dropping down now, they're below single digits in the projection, 9.695 for the full year this year and for 26. All right, so when we think about okay, when we're starting to think what's you know, scoring for the business just on the revenue side.
Well, first the compilation of the revenue SaaS business. That's great. More than 95% of their revenue coming in from subscription based revenue. People saying, you know, I want all the Creative Cloud or I want this portion of the Creative Cloud and buying that on a reoccurring basis, that is great revenue to have. It's very sticky. People keep re-subscribing.
It's not a one time purchase and then you got to worry about a product or service refresh. It is a ongoing feature. That's great. And so when we get to valuation, you know you can get a higher multiple for that number generally speaking. So but we'll talk about that when we get to the price valuation. But again, good business model, good revenue numbers, declining growth rates okay.
But you know we have to put that all into context. Next up here, what is what are the margins? So we saw declining revenue growth here not declining revenue declined revenue growth gross margins for this business. This would be in the exceptional category 89.2% for 5/30. So what's that been over time? Is this an outlier? No. You go back, in 21 88, 22 87, 23 87, 88.
This is software as a service. That's why it's such a great business right. Your cost of delivery, the marginal unit zero effectively, or very close to it, depending on how you're going to count it. And the projected to stay at 89.9, 89.8, 25 and 26 respectively. So that's fantastic. So gross margins are very good, have been very good.
Continue to be very good. Projected to be very good. All that's great. What's happening on the net margin. Well 21 was a let's get to where they are now 30. 30. That's fantastic. So 30% net margins. Very good business. So let's go back and think about what's happening before. If you look at 21 30% gross margins, 22 27, 28 in 23, 29 in 24, 30, they're picking back up very good.
And then 37 and 37 projected for full year 25 and 26. So that's good news. So you see on the top line we've had a decline in the growth rate. So the top line is growing from 20 projected through, you know May to go from 22.6 to 23.5. And that's a, you know 9.6 overall growth rate year over year.
But that's a decline, right, in the growth. It was ten plus a little bit more. Now it's you know dip in below that. So again revenue growth but a declining rate. So second derivative lower. But our gross our gross margins remain super strong near 90%. This is sort of in a category by itself or rarefied air. This is above Nvidia.
This is above Visa for example. Some of the other companies we've talked about so very rarefied air. So again when you collect 90 plus percent of your revenue as a SaaS model, cost of delivery very cheap, right. Very good business. And now they're integrating this Firefly, this agentic AI into their business. And people are using that also, high margin business as well and likely has something to do with the increase, net margins moving forward or projected net margins moving forward.
So that's all very good. And when you think about, you know, okay, well how can you have this? Well, the cost of delivery. And then but let's look at free cash flow and CapEx as well in the business. So when you talk about okay, well what's the CapEx in the business? So this year 178 million. So this is not these are not enormous numbers to be putting into this business.
And so, if this is very capital light, right, you're going to generate cash flow from operations of projected 9.6 or through 5/30, rather 9.6 and 178 billion 178 million rather very big difference, in CapEx. That's that's nothing. Right. And then so you're generating a lot of free cash flow, this business 9.4 billion in free cash flow, very good. And if you go back, you're talking about the largest year, in the past 348 million in CapEx in 21.
And that's been, sorry, that's in 21 and 22 442 million. So these are not huge numbers compared to the size of this business. So they're generating a lot of free cash flow. So if you look back 6.8 billion of free cash flow in 21, 7.3 billion at 22, 6.9 in 23, 7.8 in 24, 9.4 5/30/2025 projected 9.2 and CapEx going to, you know, projected at 271 million and then 320 million next year, with 10 billion in free cash flow and their full year.
11/30/26 so very good. Those metrics are fantastic, right? Capital light business. You're putting in, you know, even let's say let's look out again where what do what you think is going to happen in the future 2026 328 million, that we're going to have to put in this business and it's going to pump out 10 billion and free cash flow.
Well, that that's a great business. If you don't look at anything else, you just look at those numbers. And so business wise you know right now there are some challenges. Right. And so what's going to happen in the agentic AI world? They have their own Firefly. And there are certainly threats to their business and competition. You know from people like Microsoft which are big players.
Right. And then some piecemeal players, depending on what service, that you're using or product that, that you're using. And so there is real competition. And it is up to the management team to figure that out. But right now, even with those threats, probably gaming this business in eight, I would give it a nine. Probably never not sure we'll ever give anybody a ten, but nine and a half, sometimes ten maybe.
But giving this an eight and not a nine because of the threats. Right. What's happening? And until we really figure out as analysts, business people and certainly our students need to figure this out, you know, these threats, I think, are real threats. They seem to have their own version, obviously, or they do rather on Firefly on the agentic AI piece.
Are they going to outcompete? Are they going to be able to keep, their market share time will tell. And something we'll have to watch and something we have to make decisions on. And so I'd say a solid eight on the business. All right. Next up, management. Shantanu Narayen. And I'm sure I didn't pronounce that right but has been with the business since 2017, really fantastic.
You know led the transition to this subscription based model. They haven't done really big acquisitions. But they've done smart acquisitions. Frame.io is an example on the video side. So really high scores here for managing their business. And if you look at those gross margins and you look at those net margins, you look at the deployment of the agentic AI with Firefly, and the uptake, the uptake with their customers with that.
That's all very good. He's been there. So you have a steady person. Almost eight and a half years. He's been there since 2017. So that's very good. And so giving management a very good score here on the capital allocation. They've been very smart. They've been very disciplined. They haven't gone out and bought, you know, a bunch of crazy properties.
They've been, you know, the tuck in acquisitions more or less of what they have done. To supplement, again Frame.io. And the video side, you know, some small ones on the AI side. So I think they've been very disciplined around capital allocation. And they've been very disciplined on the cost, and the right amount of CapEx. And so really high scores here for management, for running the business, especially, for transitioning the businesses from transitioning the business.
Excuse me, from the one off license to the subscription model. Again, over 90% of the business is that way right now. And so very good. Management, you know, you can probably give an 8 or 9 here, for management. Again, strong capital allocation skills made, very good on cost control, disciplined capital allocation on acquisitions as well as CapEx and growing the business.
And so eight here, for the management. All right. Moving on to the price valuation. Now, we talked about, you know, what's happening. You know, you have these crazy numbers. You have 90% gross margins. You have 30%, net margins right now. You would think, okay, this deserves a really high multiple. And right now that is absolutely not the case.
So if you look at the forward PE, you're trading at 18 times. And so this certainly says that the market has concerns about Adobe, and it's way forward. And if you look at, okay, where does that really show up? Well, it shows up in the growth rates, right. Again, top line revenue growth is projected.
But that second derivative, which is the growth rate is slowed down. Right. And now it's going down to single digits. And I think another big concern which we mentioned when talking about the business is what's happening with the AI world. They certainly have Firefly and they have their tools. And agentic AI and they have made great progress there.
But the market's seemingly on the valuation side is not giving them a lot of credit for that. So I think the market will need to see more progress there. But this company is not expensive. 18 times the market's trading closer to 23 times the S&P. So that's that's well below that. And if you look at Autodesk, you know, as partly a competitor.
Right on on one aspect, you know, they're trading at you know, 50 times as an example, rounding it. And so not expensive, but real threats are in there. Something that you have to be concerned about is how they make this transition from where they are now to this agentic AI world. And are people just going to leave this platform?
They certainly have a good creator, creator base, good loyal customers. But, you know, does the price override all of that? And even if they can keep some of those customers, does it really hurt their margins, over time and hurt their revenue, you know, their revenue numbers and growth. Certainly it's already showing up.
That's really important. And I think, Figma is another competitor that you should be aware of as well. And so, but that valuation, you know, it's certainly not expensive. And so, we own it. And so it'll be up to our analysts to figure this out, for this fall for the GW Investment Institute. Excuse me.
And where does it sit in our portfolio and how much they should have, how much we should have invested in this company, how much we're concerned about that. Again, on the business side, they're definitely making progress. And to give them credit, to give the current management team credit as well. They did make the transition from licensing to subscription.
Now, can they make this transition from, you know, pre-AI world to post-AI world, and carve out their space and keep their territory, and importantly, reestablish some growth, and keep those high gross margins and elevate those net margins. I think that's going to be super important. So when you talk about the valuation, you can probably give the valuation again.
You're about 18 times on the forward. You can probably actually give this a seven. So not not bad at all. All right. So let's move on to the balance sheet. And then we'll pull everything together here at the end. All right. So balance sheet here. The balance sheet, you know, no huge concerns at the moment.
So if you look at the balance sheet, cash and cash equivalents at 5/30, you're talking about 5.7 billion and 6.5 billion of debt. So really, you know, but let's use a round number, about a billion of, of, net debt here. Not a huge concern, right. If you made it 5.5 and 6.5 about a billion in that debt, rounding it, for ease.
So, you know, on a, on a, you know, generating 9.4 billion of free cash flow and projected 9.2 for the full year, a billion and net that really not concerned. Right. And so with those high gross margins, those high net margins and, you know, low CapEx and generating lots of free cash flow, not super concerned there. You'd like to have net cash, generally speaking, for the Investment Institute companies.
We certainly prefer that. It's something that, you know, we, you know, helps us sleep at night. So, but this balance sheet, you know, your sleeping okay at night, not not too concerned. And one of the other metrics that we'd like to check is what's the interest coverage ratio. Right. If they have debt. Interest coverage ratio here about 40 times.
So we like ten plus, for our companies. And in this case they're 40 about 40, 39.9 right now. So 40 times, interest coverage ratio. And remember, that's Ebit, interest before interest and tax over interest expense. And so how much earnings do they have to cover their interest expense. About 40 times right now. So really not worried about that.
So we're sleeping okay at night with this company and its balance sheet. Love to see them in a better position. And if you can we look at the balance sheet over time. They've been fairly responsible. Management. You can say that cash and cash equivalents in 21 was 5.7, 2021 and 4.6 in debt. And so the kind of the reverse situation of where they are now, let's say about a billion in net cash, net cash then, and then 22 6 and 4.
And so, cash and debt. So cash, you know, you know, net cash position. Excuse me. And then 7 and 4 in 23. So net cash and then 7 and 6 cash and debt. So net cash and so really, it's just recently that they've gone to this net debt position, but again, high interest covered ratio, not super concerned.
So sleeping okay at night. One of the things that we're watching is this. And so we'll give the balance sheet an eight. Maybe an eight and a half here for that. And so, you know again good. Like it to be, you know, slightly better but good and, and again generating a ton of free cash flow.
Not really worried. Eight, eight and a half. All right. So let's pull it all together. So on the business side you know we're going to give you know remit revise the some of these scores here. But on the business side let's let's actually ding them a little bit more worried about the the threats. That's a seven. The management I'd say is an eight.
Good. Things to watch for. They have another big transition to make on the AI front. On the valuation side, I think that's a solid seven again, with some concerns. Certainly cheap. It could be cheap for a reason. And on the balance sheet let's say eight. So overall, you know we could probably give them seven and a half depending on how you want to settle the scores.
And I would really probably push that down to a seven and make the scores reflect that. And so I would probably be conservative on all of those scores a little bit more. Why is that? You know, why would I do that? Well, concerns about and the things that we should be looking for and the things that we need to have our analyst check out is what's happening on the business side.
You have declining growth rate on the revenue, something that we need to be concerned about. The other pieces is the agentic AI they have deployed that Firefly is good is working. Customers are picking it up. But lots of competition out there, including from people like Microsoft and so heavy hitters that they're going up against. Gotta watch out for that. Next up here is you know, do people just leave the platform, because they get picked off not just for Microsoft, but all these other smaller competitors.
And so you certainly get a bit worried about the big ones. You got to worry about the small ones. And then I think that's something to look out for. The other part is, you know, how are they going to grow this business? On the top line, just in general, you know, is it going to be through acquisition or are they going to go out there and buy companies?
And so we really gotta watch the capital allocation from management on that. Balance sheet. Not a huge concern, but something to watch. So that's, what we need to look out for for Adobe again, portfolio company for the GW investment Institute. Our analysts will be checking it out and checking out some of those concerns. But some of those opportunities in our portfolio, we'll see what happens at this fall as the semester gets start pretty soon.
Thank you for watching this episode for “Market News with Rodney Lake.” We'll see you on the next one. Thank you.
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