Chit Chat Stocks - Why Ryan Bought One of The Best-Performing Software Stocks of All-Time (Ticker: ADBE)

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Starting point is 00:01:28 Now, please enjoy this episode. Welcome into the Chitchat Stocks podcast. My name is Brett Schaefer, and as always, joined by Ryan Henderson. Today, we have another stock research episode for you. last, well, not last week, but a couple of weeks ago, we released an episode that was one of my research reports on a Mexican airport operator, ticker OMAB. Go back and listen to that one if you're interested in that one. But we have a Ryan research report this week, and we are covering Adobe, a company that's turning into a bit of a battleground stock. They're seeing a little bit of a disruption within their industry. And that is potentially why there is a buying opportunity for

Starting point is 00:02:23 the company at the moment, because when there's uncertainty in the stock market, there can be opportunity. We're going to get into it. I'm going to let Ryan introduce the company and we're going to go through in audio slash video format all of his research. How did Adobe get here, their history, business model, valuation, and how he is thinking about the stock today. Before we do that, though and people have been doing this give us a five-star review on apple podcast or spotify that is the easiest and best way to grow the episode and if you want more written stuff if you want the written research report that ryan made for this episode you can subscribe to our free newsletter on substack and if you'd like to chat with us on there it's great it's free they

Starting point is 00:03:08 have a little chat community that we can do without any of the twitter bots interfering All right, Ryan, that's enough intro. Adobe, let's get into it. Yeah, there's a lot of people have views on Adobe without really doing a ton of looking into it. And it does, like you said, it's kind of a polarizing stock, kind of been hotly debated as of late. And the world seems to think that this is one of the most likely losers from AI. from an AI world. And I kind of feel like that's misplaced. So I'm going to dig in a little bit to that. But I guess let's start with some history here. Now, I know most people probably don't care about the early days. And so I'm not going to go super long here. But there are some businesses

Starting point is 00:04:05 that without even doing any research, most investors just assume that they're good businesses. I think Adobe is one of those, or at least it was for me. And this is probably why I'm looking at a chart right now. Total return since its IPO is 37,000%. It's a 300, roughly 70 bagger since its IPO. That amounts to basically a 15% annual return over 35 years. So exceptional returns for investors over its life. That is – I think a lot of people just see that and really I'm one of these people as well. There is something to like here and there has been something to like here, especially for a software company. Sometimes you see that with like a very popular brand. Like I bet you see that with Nike as well and maybe there's some risk that the future isn't quite like the past. But in this case, it gives me some reassurances that they've done so well by investors for so long.

Starting point is 00:05:11 Let's get into, I guess, a little bit about the history. Adobe was founded in 1982 by John Warnock and Charles Geschke. The name came from the Adobe Creek that ran behind Warnock's house. And the original business was selling the PostScript page description language, which Warnock had invented. I'm not going to pretend to be an expert on this topic, nor does it matter at all to today's investment. But the only thing that's important to understand was that PostScript was a page description language that a lot of computer and printer makers wanted. So they signed some big deals with companies like Apple, which is really what got them off the ground.

Starting point is 00:05:51 Then from basically 1986 onwards, they started maybe what could be considered their golden age or the golden era of Adobe, year after year, they were building and acquiring creative software that tons of creative professionals still use today. So 1986, they developed Adobe Illustrator. There is some derivative of that that still exists today. It looks a little different, but it still exists. 1990, they acquired Photoshop. That is the photo editing platform that is basically a verb they acquired frame maker they acquired after effects all these solutions still exist are still used frequently 1991 they developed adobe premiere which is the video editing software 1993 they introduced the pdf yes that is correct the the file type

Starting point is 00:06:43 which adobe actually kept proprietary into until 2008 which i did not know So like I said, not going to go too long on the history here, but the last couple of things I'll add are one, they have been bundling their software since 2003. Two, they've been serial acquirers since the nineties, but really most of their innovation has come internally, either developing software themselves or post-acquisition improving the software. And then three, they started their transition to cloud-based delivery around 2010, which was well before most other companies did that. Now, when I heard that they had done the cloud transition around 2010, my instant thought was, okay, that probably helped profit margins because they don't have to

Starting point is 00:07:30 deliver it in a licensed model. That's not really what you're going to see in the numbers. If you go back and you look at gross margins since 2004, they're basically the same as they were. operating margins. They're like the same as they were, but what it did was it was a major boost to revenue. If you go out and actually look 20 years out. So Brett, you're using Finch out here. If you go to the charting tool, you can actually look up Adobe and see the revenues back to, I believe, 2006. And you'll see that it was from 2006, actually 2005, 2006 to 2014. It was relatively flat. And then the cloud transition started to take hold. And what it did was it increased the order frequency with the subscription model. So people weren't just

Starting point is 00:08:19 nursing those old licenses. Yeah, Brett's showing it there. Revenue started exploding because it changed to this monthly or annual subscription rate where they had to keep up the order frequency instead of just nursing these old licenses and not upgrading. So that was really the power of the cloud transition that they had. All right, that's a good summary. And looking at their revenues today, and looking at their business model, looking at any sort of competitive advantages, I think one thing that stands out is the switching costs. And I don't know if it applies apples to apples across all of their products. But when you look at the PDF, and how it's been integrated across all these different software systems, printing stuff out, anything, that

Starting point is 00:09:08 has become one of the defaults across the world. And I think it would be hard to switch is all I'll say. As much frustration as people have with PDFs, they are probably going to be a part of our lives similar to, you know, Microsoft Word, Google Docs, Excel, stuff like that. And I guess unlike, well, they have some competitive threats we'll talk about that are coming from distinct competitors. But unlike Microsoft, they don't have a big tech competitor in Google trying to give away all their products for free. Yeah. I mean, across the full business, and we're going to talk about what that business is for someone who doesn't know Adobe. There's a lot of different segments.

Starting point is 00:09:54 There's switching costs galore. And I think this is kind of the crux of the argument that I'm going to make today. But I think a lot of investors are saying that the switching costs are being eroded for the whole user base when, in reality, it feels like it's kind of a fraction of the user base and that really its core product is still going to, I guess, survive and thrive. Yeah, that's a good tease. All right, before we get into it, before we get into the stock, valuation, all that stuff, there are some people out there that don't know anything about Adobe's business. they probably heard about it they know what a pdf is most likely they probably heard of the word photoshop but what do they do and why are they generating 20 billion dollars in revenue a year yeah they've got three divisions essentially now all these divisions this is how they're grouped

Starting point is 00:10:50 on a revenue standpoint but if you work at adobe you work within an for the most part you work within an individual product. So if you're a developer, you're a developer at probably Adobe Photoshop, or you're a developer, you're on the product team at Adobe Premiere, but it gets grouped into three different segments. Those three segments are Creative Cloud, Document Cloud, and Experience Cloud. Creative is really the most important by far, and it's what's going to be the focus of today's discussion. This includes software solutions like Photoshop, which is photo editing illustrator which i believe is sort of like digital drawing today i didn't do super deep digging into all these products because there are tons but really some of the big ones are

Starting point is 00:11:36 photoshop illustrator premiere which is video editing software kind of the industry standard for video editing audition which is audio editing lightroom after effects and a whole bunch of other applications. Basically, these are the tools that if you are in a creative professional role, so let's say you work in a marketing department at a Fortune 500 company, or you work for a design agency. If you work in production type of roles at big companies, you are using probably some Adobe product in some way. For example, Adobe Premiere is the industry standard for filmmakers. So these, I mean, they kind of span the globe, but they spanned a lot of different applications. And I guess when I say applications in this case, I mean sort of professions. But really, it's critical to the workflow of these people. you might only need one or two solutions so for example let's say you're a professional

Starting point is 00:12:41 podcast agency you probably use adobe audition maybe you use adobe premiere it's kind of less so for podcasts since the video doesn't need to be like insane video quality uh but like if you're a video or a filmmaker for example you've got adobe audition you've got adobe premiere you've got probably got photoshop for certain animations as well it's easier to just go with the bundle so they bundle all these services together for in my case here it says 36 a month they start to jack that price up after the first year and there's really a lot of price and power in the bundle so that's kind of the first one is that that creative cloud and that is the biggest segment for them the second one is the document

Starting point is 00:13:27 cloud, this sort of encapsulates it's included in the creative suite. So Adobe Acrobat or Acrobat pro is one of the apps that's offered in the creative cloud bundle, I guess, but essentially it's all the apps you would need around the life cycle of a document. So if you need to send PDFs for signature Acrobat makes it really easy. If you need editing, if you need analytics on the document, all that stuff. It's included here with Adobe's document cloud products. The segment alone does just over $3 billion in annual revenue. That does sound like quite a lot, but it's only 15% of Adobe's overall top line. So it's really not that important, but it's a nice addition to the bundle and kind of just provides that much more of a lock-in. If let's say you're using Adobe

Starting point is 00:14:20 Premiere, you're using Adobe Audition, and you're also using Acrobat for sending all your documents, it becomes that much more compelling to keep with the subscription. The last segment I'll mention is the Experience Cloud. This is a very different business. So there are a number of different apps in here, but it's basically enterprise marketing management software. So it helps marketing departments really optimize their messaging. It helps in designing marketing campaigns as well as in the analytics.

Starting point is 00:14:50 So you can imagine a world where this is sort of supplemental, right? Your marketing department can consolidate everything to one supplier from building the creatives with Photoshop to designing the campaign direction with Experience Cloud to reviewing the analytics. Then you adjust it, you revise, iterate, and you deploy the next campaign. And it's all kind of done with Adobe products. I imagine having a foot in the door with all these enterprises through the creative suite helps them kind of upsell this product. I don't really know the competitive landscape super well within the marketing management type platforms. I don't think that's critical to the investment here. Experiences counts for 25% of overall revenue. And I mean, it is a pretty solid business on its own. It grows a little bit slower than the creative agency. But really, this business is the most important thing to understand here is the creative software. That is the most important segment. And most stuff gets lumped into the bundle. So really what's going to define the future of Adobe? It's going to be how many more subscribers do they have to their creative cloud? What's the price that people are paying for that creative cloud? And what's it cost for them to offer that to the customers? Okay. And do you need data on pricing power and how that impacts churn or anything like that? Because I know you talked with someone within the company who actually is a listener of the show. Hopefully, we're doing a good job to you, listener out there.

Starting point is 00:16:23 But do you have any data on that? Because I know that's very important for this business. And that's the idea with some of these software companies that have this large lock-in where you're providing so much value to these marketing agencies, production agencies, whatever they are, that you can increase prices by, say, 5% a year, and you're not even getting close to the value you're providing these customers. I don't have any specific numbers. I hear a lot of people complain that Adobe takes price. They're obviously not super forthright about it. They're not going to be like, oh, we gained 15% revenue growth from prices this year. they try to be discreet and really there's a lot of different mixes in terms of like what enterprises can subscribe to that affect it as well so there's sort of a mix shift i suspect and apologies to any like super diehard adobe listeners that know like the average annual price increase but i i don't think it's out there i don't think it's like publicly disclosed I would guess it's probably gone up around 4% roughly a year, not on a systematic basis, but if you average it out over time or the last decade, I would guess that's about where it's at. All right, let's talk about –

Starting point is 00:17:50 There is pricing. There have been price increases. Okay, let's talk about the threat of AI, the elephant in the room. This is the narrative that everyone's worried about. Adobe, as I'm sitting here today, well, I don't think they've gotten back. Yeah, they haven't gotten back to their all-time high set in late 2021. Now, during the bear market of 2022 for a lot of these software companies, they went through a 60% drawdown. There was the whole deal with the Figma acquisition, which I'm sure we're going to get into.

Starting point is 00:18:26 But as we sit here now, they are still in a 33% drawdown while stocks across the board, especially QQQ constituents, which I think Adobe is likely a part of, are hitting all-time highs. Ryan, the threat of AI is clearly causing some worry among investors. What is this threat? Why are they worried about it? And how are you thinking about it from what you've read, talked with people or talked or excuse me listened to the management team yeah this is kind of why i think the valuation has been crushed lately and adobe is still down i believe 40 from its 2021 highs and there's kind of two ways to think about it the one that a lot of people are concerned with is this text to image or text to video ai models potentially

Starting point is 00:19:23 hurting Adobe's business. If you don't know what I'm talking about, basically you can ask some of these LLMs or conversational AIs to build you an image or a video, and it does a pretty decent job. So, you know, I could say, you can even do this with Adobe. Actually, they have a product for this as well. It's called Firefly. I could say, give me a picture in a dark room of some guy podcasting with a light next to him and it'll pop it up pretty quickly. This is a little bit of a risk. I think it eats away at the low end consumer, but I think it is extremely overblown for a couple of reasons. Number one, it isn't perfect. So it'll give you a rough start on the idea that you want. And for some people, that's probably all you need. I see people tweet out

Starting point is 00:20:13 certain images that they obviously just generated with ai i i had a friend reach out um that i connected with through blue chippers club actually and he said i use this he works at a school and they needed some level of like just animation for their students for like a sporting event type of thing he is not a professional photo editor um but if he can just tell ai to produce you know, some explosion in the background with the student's image playing basketball or whatever. Like that's the kind of use case where this is great for, that's fine. But for professionals, if you're a creative professional and your job is defined by this, that is not enough. And from what I've gathered, that last mile of performance for these models is really the

Starting point is 00:21:07 hardest part. So I think it's going to be a while before you have something like this that really, really eats away at Adobe, if at all. And I suspect it won't actually. The other part, Firefly, which is their version of this text-to-image, text-to-video AI model, the company that is best positioned, and I'm not an AI expert, but I think the company that is best positioned to offer a truly, truly phenomenal text-to-video or text-to-image model has to be the one with the best data on it and the best data to feed it, which in this case, I think would certainly be Adobe. And then the last thing I'll mention, I don't think you're going to get a whole bunch of people that just automatically switch to an AI model completely. I think what you're

Starting point is 00:22:07 going to get is, especially in the creative professionals type of use case, you're going to get little AI enhancements to their daily workflow. So somewhere in those apps, it's like use AI for this, adjust the warmth of the image using AI or whatever it is. There's going to be these little enhancements that make it the life easier for a creative professional, but it's not going to do the job of a creative professional. I think we're seeing this all over the place with these like additive AI improvements. So in that regard, I think the AI risk is very overblown. And frankly, we've seen these models have been out for a while now. We've seen no proof in the numbers that creative professionals are just outright switching.

Starting point is 00:22:55 What I do think is a larger concern, and this impacts my expected growth rate for Adobe, is this, there's been, I don't know if it's recent, but it feels kind of recent, this proliferation of different point solutions that are taking away the lower end customer. Here's how I'm kind of thinking about it. It has never been easier to build software. Building valuable software is kind of a different discussion, but getting a product off the ground has never been easier. Thanks to AI, thanks to APIs, thanks to open source work, someone can build a point solution that competes with Adobe in some way relatively quickly. I'll use some personal examples.

Starting point is 00:23:38 We use Riverside right now. we use it to record and edit our podcast. It is great. And it competes directly with Adobe audition. The software was built in 2020 by two dudes. And within four years, they had more than $30 million in revenue. That is a point solution, stealing potential users away from Adobe. Would we be power users? Would we be an enterprise? No, but that is, we are kind of the lower end customer that these little point solutions can eat away at. Here's another example, Canva. We use Canva to build our thumbnails for YouTube that competes with Photoshop. Does it compete with the person that, that works at CBS that needs to work on these animations for football

Starting point is 00:24:21 commercials and NFL games or whatever? No, uh, they're probably not using Canva. They're using Adobe Photoshop or Adobe Lightroom, Illustrator, Premiere Pro, all that stuff. But for the low-end customer that competes with Photoshop. Canva does a really good job. Another one, which is kind of a different avenue and it's a little more well-funded, but Figma, which was the company that Adobe tried to acquire for $20 billion, competes with a product that Adobe offers. It's called Adobe XD. Figma, I don't use it myself, but it's used at a lot of startups and it's basically from what I understand, like web design, um, web design software, where you can kind of go from, uh, idea to design to code relatively quickly. Uh, it's really very popular

Starting point is 00:25:17 within a lot of developer, uh, communities and all of these, they serve the individual customer or the freelancer fairly well. They work great for startups as well. I kind of think of this as like G suite to Microsoft's Microsoft office, where they're offering it to the lower end customers. It's free products, not, not free, but usually freemium model in some way. Um, and they give a little more free benefits to users than Adobe does. Uh, but that doesn't mean that the Adobe enterprise seats can't grow. So that is where I think there's the biggest risk to Adobe is these point solutions eating away

Starting point is 00:26:07 at the individual customer. I don't think it breaks the thesis, but I do think that the vast majority of user growth from here on out will come from additional enterprise seats. And where will those come from? Like not, sorry, sorry. are there more for them to go after can they steal share have they been stealing share in enterprise are they working internationally is it more of a autodesk type thing where they're

Starting point is 00:26:39 kind of going after people that are cheating with them and using old licenses or not paying or using pirated software i know that's a lot of questions there but it kind of gets back to where will the user growth be or is that not something that you're too concerned about So my guess – I haven't seen any numbers on this, but my guess is just about every creative agency in the world and most marketing departments at large enterprises have Adobe in some way. So there's saturation there. But those enterprise customers themselves will grow. They will probably add more seats over time. So I suspect that's where the growth is going to come from is the customers themselves adding more seats to their deals or potential probably pricing power from there as well.

Starting point is 00:27:31 The user growth, I think, is going to have to come from the enterprises growing. So I don't know if they're really stealing share necessarily, since they probably are pretty much saturated, especially in the US. I don't know about internationally, but they're so big. I imagine they're quite – they've said that they've been growing seats. um so like the majority of price the majority of revenue growth over the last year i believe came from uh seat growth as opposed to price growth so there's been i mean things it's coming from somewhere my guess is that the enterprises themselves are growing and adding seats and there has been like the problem is they're a little bit vague with all this stuff and that kind of gets into some of my moat discussion um it's not totally clear where it's going but there seems to be just very little price sensitivity from the enterprise customers and there seems to

Starting point is 00:28:30 be very little risk to that core enterprise offering that is interesting we were adobe bundle subscribers the reason we used it as a kind of startup small business was that someone had a college email and even with the college email it was i think 60 to 70 bucks a month and when we realized there were we were going to switch to riverside we really wanted to just eliminate them um as best as possible just because this point solution was more affordable for us i know that we're not going to impact their bottom line but it would be a concern for me i guess but it would be the same concern i would have over the microsoft office suite and i get the same sort of reaction, I don't know, in my mind that, I mean, I don't know, isn't this stuff

Starting point is 00:29:23 just going to get given away to for free or at a super cheap price? But if you look at Microsoft office revenue, it just goes up and to the right. So it's another one of these. And again, you talked about the people complaining about price hikes. It's one of those where if you're a, I'd a beginning investor and you go, well, customers are very upset with this company or customers gripe about price hikes. That's not actually a negative sign. That's usually a positive sign because for one, usually with a company like Adobe, they actually are providing much more value than what they charge their customers every year. And two, it means they're switching costs, which is very important and leads to the next topic here, Ryan,

Starting point is 00:30:13 the moat discussion, the competitive advantages. We're using the framework that I guess is getting more and more famous as one of the Buffett frameworks, which is, will Adobe's moat be wider, the same, or shrinking five years from now? What did you think after analyzing the company? And how does it relate to valuation? All right, listeners, we've got a new sponsor here at Chit Chat Stocks, and their name is Blue Chippers Club. Blue Chippers Club was recently started by two friends of ours with the goal of building a tight-knit community of stock-focused investors.

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Starting point is 00:31:59 I think Adobe has a strong moat, but I do not think it will be larger in five years. You mentioned that we were a good use case where it wasn't delivering enough value to us. But if you are a creative agency where people are literally hiring you specifically to come up with designs or videos or whatever, or you're in the marketing department of large enterprise, Adobe is delivering way more value than what you're paying for it. And it's directly obvious in the revenue line. Like a creative agency, if you pay whatever, a hundred bucks a month per seat, you've got five people and you're generating whatever, a million dollars in revenue, like you need Adobe and it's a pain in the butt to switch, especially if you're using a lot of different applications. Like if you use Audition and you use Photoshop and you use Premiere, you are getting tons

Starting point is 00:32:55 of value out of that bundle. If you only use Audition like we were, or Premiere, maybe you're probably overpaying and there's other solutions out there. So you have a whole bunch of employees that need these products in order to function, in order to work at their maximum capacity. um and if you work in those industries adobe's kind of it's in this you're stuck with it for life bucket if you ask me where you likely trained on it in college so for example for us we were not training on adobe premiere in college that's something we didn't care about and we had other studies but if you were in marketing or design or something like that you were probably training on adobe products you probably put the adobe products on your resume and the company that hired you probably required you to have that on your resume they probably had maybe a keyword search across

Starting point is 00:33:56 the resumes for their job applications that said if it doesn't have photoshop on there don't even consider it so yeah and now everyone at your company uses it and so when you talk about oh okay let's adjust this here let's change this here why don't you share that file with me oh i can just go in and access the same folder like it's sticky it it's spreads within the organization it's very sticky it takes time to get adjusted to it like there are there's a learning curve here with a lot of these platforms that i think most people don't talk about and do you really want to spend the time switching cost is way bigger at the enterprise level than the nominal dollar value like you're probably at least we haven't hit that yet what's that we

Starting point is 00:34:43 haven't hit it we haven't hit that threshold yet eventually you'll find out but perhaps it's much higher than today perhaps it's double or even triple the price and that gives them you know quite a bit of room to grow prices at a single mid single digit rate for 10 to 20 years yeah i mean if you are i keep going back to these creative agency examples because it's kind of like the obvious use case, but isn't it way more risky to you to switch platforms and try to find a whole bunch of point solutions that you have to get acclimated to over two to three months? And you're probably not delivering the same output at the same speed and you're risking your revenue line just to save a couple bucks a month per seat. And frankly, if you're using a lot of

Starting point is 00:35:31 different solutions, you might not even be saving that much money. If you're going point solution by point solution, it probably amounts to something similar close to the Adobe bundle. So I just think the time switching cost is huge. So there is a big moat. However, if Adobe is truly losing sort of the low-end customer today, which kind of feels like it's the case, I don't have any specific numbers. They don't give these numbers out. So it's a little hard to parse but and i would love to be proven wrong here actually since i full disclosure i'm going to talk about this here in a second i have a starter position in adobe i would love to be proven wrong here but i think the rising prominence of point solutions like figma like

Starting point is 00:36:18 canva like riverside etc i think that's a long-term risk to both adobe's moat and their growth rate These solutions, they attract the individual users like us. They become important to startups. And then they can even spread within larger organizations. For one, the startups get bigger. If the startups get bigger and you've been a critical piece of their workflow, they'll probably stick with you because you've been helpful to them over time and you're delivering a lot of value. But also they can spread even within bigger organizations. Like if you are on a small team within a big company and you've got a budget to go out and finish a project, you might go with a point solution over Adobe and then, hey, that worked really well. Let's go out and use that in our other projects as well with other team members. So it can spread within larger organizations, too. I do think when push comes to shove, if you've got duplicate software, people are probably going to stick with Adobe because it helps more people across the company. But I think the point is that if you are losing sort of that lower-end customer, or at least you're losing some of the potential lower-end customers you could have had, you can't say that your moat is getting larger. there's just no way to say that yeah and for reference here just pulling up a quick on a google search and canvas private so they don't have robust data on them they are estimated to be

Starting point is 00:37:54 doing two billion dollars in annual revenue so significantly smaller than adobe but that's probably two billion dollars adobe could have had yeah it honestly would have made all the sense in the world it made all the sense of the world for them to go after figma um as an acquisition candidate that price was a bit rough yeah 10 times revenue but 10 no no this is canva not figma oh that did two billion dollars in revenue how much was figma doing oh i think a lot less at the time oh but i'm not sure it was startup so yeah i mean the other thing that's probably important to think about here is that gets lumped in the creative suite you get a whole bunch of pricing power there the distribution advantage with adobe is pretty big i mean i'm yeah that was kind of a

Starting point is 00:38:52 large 2022 they were doing 200 million dollars but this is some sort of ai overview thing and It looks like now, according to a 2024 CNBC Disruptor article, they're doing about $600 million, give or take. Still quite a premium. Yeah, and I think that was the big concern, and that's why the stock dropped so much. On that news is, okay, is Adobe going to have to spend $100 billion to retain its moat? What's interesting is that the regulators told them they couldn't acquire this company. Who knows if that was a good or a bad thing for shareholders? I guess time will tell.

Starting point is 00:39:29 over the long run but either way i do agree with you these point solutions well they don't eliminate adobe's mode it seems like they're obviously a threat and the fact that canva does two billion dollars in revenue that's nothing to sneeze at yeah yeah i mean that's like you said that's two billion in revenue i'm sure adobe would have liked to have so it's yeah it's hard it's kind of hard to contextualize like i don't think it's affecting their enterprise customers very much at all at least the ones where like i'm sure there are some enterprise customers that were kind of not making full use of it maybe it's just not important to their business but the enterprise customers that use

Starting point is 00:40:18 this on a daily basis there's just no price sensitivity there it's just i mean there's some price sensitivity obviously eventually but i think they can increase prices at a single digit rate probably for a long time single digit percentage for a long time yeah as long as they copy and replicate whatever these new competitors come up with i know canva had quite a bit of innovation there and part of their offering is almost like a google docs versus a microsoft office one where it's cloud-based and in your browser but that makes it limited and you know there's pushing push and pull and give and take on that and then as well these ai solutions if they're able to copy that and make that actually more valuable for the adobe subscription it reminds me of and this is

Starting point is 00:41:08 maybe more relatable for all of our listeners and if you're an older listener you'd be shocked to hear this but ryan and i for the podcast you know company it's just the two of us we don't have any sort of microsoft office subscription we pay microsoft no money each year and you would think oh well isn't that mean microsoft office is dying people can just use google docs for free or much cheaper but microsoft office revenue keeps growing year after year after year i think adobe versus some of these other point solutions you maybe make a similar argument yeah that's the other thing i didn't think about like why does microsoft office grow well uh to some degree it's because the entire world runs on excel and yeah you could maybe shift that you could probably replicate a

Starting point is 00:41:58 lot of the work you do in excel on sheets but do you want to do you want do you want all that work you've previously done to shift over to sheets well the price the price to charge hasn't hit that level yet but no and i i think adobe is probably the same way you've spent all this time adopting or creating files in these different softwares like one there is sort of the sweat equity right the work you've put in to like know these softwares intimately well and you just don't want to have to retrain but also there's probably some like actual friction involved in like porting over a lot of these files so part of it's you just don't want to lose what you already have as well let's talk about valuation how fast do you think they can grow earnings how are you looking at it

Starting point is 00:42:50 i know you said the moats maybe not as rock solid as it has been and that's why the stock prices come down but how are you looking at value in the company clearly you bought a starter position so you like it at least a bit what are the numbers take listeners through how you analyzed the stock over the last 10 years adobe has grown its revenue at 18 roughly annually and earnings per share they've grown at 37 annually that that's part of a little bit of anomaly there but basically margins have expanded a bit over the last 10 years over the last couple of years revenue growth has slowed to just over 10 and analysts are projecting just over nine percent top line growth over the next few years over the next five to ten years i don't think the revenue for individual

Starting point is 00:43:42 users will grow much at all would would honestly be my guess like they can't really they actually kind of we saw this kind of commentary in the latest conference call someone asked about pricing sensitivity for customers across the board like are you seeing any pricing sensitivity and management kind of gave a long-winded answer of saying not for the enterprise but yeah for for the lower end customer we kind of need to we need to find a way to deliver more value at a cheaper price point for them um so if they can revive like that segment and they can start really kind of gaining share again within the lower end customers that'd be great but for sort of a base case i think you have to assume that that business does not grow all that quickly and if

Starting point is 00:44:32 they keep taking price then they risk more user growth enterprise though that is where i think the majority of their growth will come from. I suspect the number of seats will continue to increase and there will be some continued pricing power. So I guess what I think is achievable is if we just assume growth comes from the enterprise alone, I think Adobe will be able to grow revenue by about 8% per year and margins will probably creep up a little bit more. So call it maybe 10% earnings growth per year if you deliver those numbers and what's that has the shares outstanding look yeah that's part of it if if the valuation stays where it currently is they're probably going to spend all their free cash flow on buybacks that's at least what they've they spent like i

Starting point is 00:45:26 think like 150 percent of their free cash flow on buybacks over the last year maybe not that much but more than a hundred percent. So if we assume the multiple stays consistent price to free cash flow stays at 25 times over the next five years, they would be repurchasing around 4% of their stock each year. That means you're probably getting around 14% annual per share earnings growth over the next five, 10 years. I think those are reasonable assumptions, right? 8% revenue growth, 10% earnings growth, buy back 4% of your shares each year. Obviously that depends on valuation. So you get per share EPS, you get an EPS growth of 14%. Do those seem reasonable to you? Yeah, it seems reasonable. The thing with Adobe is for me, what makes it a little uncertain

Starting point is 00:46:21 is if someone said, okay, is it going to grow 4%, 8% or 12% annualized revenue growth over the next 10 years i i wouldn't know what to choose i'd be very comfortable saying it's going to grow more than four percent i think they could grow by four percent price alone probably more than that well maybe that's where the uh opportunity is and for any reference on the numbers i mentioned free cash flow i know software companies people worry about that sbc and impacting that repurchase number but if we look at ev to ebit it's barely higher the one i'm showing right here is 25.4 So not that much different. Finchat.io is the complete stock research terminal for fundamental investors.

Starting point is 00:47:06 They have robust financial data on more than 100,000 stocks globally. That includes more than 10 years of income statements, balance sheet, cash flow, and even company-specific segment and KPI data. Want to see Amazon's advertising revenue? Finchat tracks it. Like to track NVIDIA's data center business? They've got that too. The breadth of FinChat segment and KPI data is truly one of a kind.

Starting point is 00:47:28 You can go to FinChat.io slash chitchat to get 15% off any paid plans. If you sign up today, you'll automatically get two weeks of FinChat Pro for free. No card required. Again, that's FinChat.io slash chitchat. The link will be in the show notes. Yeah. So today it trades at an EV to EBIT of 25 times. Let's say it drops to 20 times.

Starting point is 00:47:54 which I think it's fair, probably even I would think a little bit conservative. You're still getting roughly – getting a double-digit percentage return annually with those numbers. So I think my assumptions feel safe, and the return is solid. I'm comfortable with those numbers. yeah i mean that's fair it won't if revenue growth i don't know slows down a bit it's not gonna kill the business i think it's probably priced into be a very low single digit grower at the moment at least compared to what the market's trading i know it's a bit of a we don't like to just go oh it's trading below the market average and should grow above that you want

Starting point is 00:48:44 absolute returns you don't make money on relative returns but i think that makes sense it's just Compared to other companies, maybe it's just me not knowing the industry that well, or maybe it's this AI threat or the point solutions threat. I get a little bit worried about being confident in the higher that revenue growth number goes. Let's get into the final conclusion here, Ryan. I guess we already teased it, but you are buying. Why are you buying and what is your position size and why did you size it that way? Yeah. And let me just be clear. I have bought and I do like it, but I don't love it. So I'll probably keep the position relatively small. I've got a 2% to 3% starter position right now.

Starting point is 00:49:34 I think the forward returns look pretty good. I don't have a ton of confidence in the business. And frankly, there just isn't enough granularity with some of the numbers. And it feels sometimes when they're talking about the lower end consumer it feels like they're beating around the bush so it gives me some concern there um so i'm probably going to keep it just as a starter position for the time being but i kind of build out these starter positions and then over a few months try to figure out like do i want to make it bigger or do i want to cut it um i think it kind of stays in the middle there i don't really want to make it bigger at the moment but i will say the my best investments ever have come for a long illustrious career no sorry my best

Starting point is 00:50:29 investments ever for the last six years have come from when a great business and one that has been deemed a great business for a long time so for the last 10 20 30 years analysts have looked at it a whole bunch of analysts smarter than myself have looked at it and thought there's some great characteristics here and they've proven it with the growth in the business and and uh growth and cash flow to shareholders my my favorite investments are when the companies like that stumble for a little for for just a little bit of time where uh the narrative turns and for some reason that business that has been so great for so long um all of a sudden the future looks shaky i think those those tend to catch my eye and adobe seems to fit into that bucket

Starting point is 00:51:21 i'm probably still going to keep it small uh but i'm very comfortable owning some shares here Okay, a couple of thoughts before you change or excuse me, close out this episode. For any listeners, what are your various position size ranges? I know you like to do tracker positions. So would that be like a half a percent or even just one share or half a percent or lower as the starter? This two to 3% is full five to 6%. And then I don't know what would be extra full, but something that I don't know.

Starting point is 00:51:55 there's a, there's one or maybe two you have in there that might be over 10%. Is that how you look at it? Or do you, do you go about it a different way? No, I mean, if I had like a perfect list of companies that I all want, wanted to invest in all of them, I would maybe have like perfect buckets, but I'm still kind of building it out right now. So what I try to do is start a position, keep it below 3%. And a starter position is not just saying it's not like a tracker it's not a pure tracker stock it means i am interested i like what i've seen so far but some work still needs to be done or i need to see a little bit of valuation uh improvement in the sense that the valuation comes down uh so i keep it small for

Starting point is 00:52:43 that reason i'd say large position is seven percent plus there's a couple that are kind of in that mid range that are like 5%, 6% that I've been trying to add to over time. I think one of the ones that's in that bucket right now that I can think of is Remitly, the Mexican airport that you pitched, Del Centro, Norte, I believe, OMAB. That's kind of in that bucket where I've been adding to it a little bit here and there. But yeah, the biggest are 7% plus. And usually those get there on their own. Or I try to let them get there on their own.

Starting point is 00:53:24 They don't always, but yeah. Ideally, I'm trying to let the winners run here. Okay. Last question. I guess it's two because it goes both directions. What are you going to be tracking to size up your position to a full position? And what are you going to be tracking that will cause you to sell your position? Yeah, that's a good question.

Starting point is 00:53:45 Uh, I'd say if revenue dip below, if revenue growth dip below like 5%, I was wrong. Uh, cause my guess is that they can continue to grow revenue, high single digits, at least relatively easily. Um, so if revenue growth dips below 4%, I was wrong or 4%, 5% that area. If we start to see more and more concerning commentary about the low-end customer, I'd probably kind of maybe start pressing the brakes a little bit and maybe consider selling. in terms of what i'm looking to buy part of its valuation uh it got pretty cheap earlier it's kind of come up a bit but if it got below 20 times ebit it feels like a nice two-foot hurdle for me to jump over a one-foot hurdle when i don't think this is going to have

Starting point is 00:54:46 the most upside of all the companies in my portfolio but i think it can generate especially at anything below 20 times EVA, I think it can generate double-digit returns, and I'm fairly comfortable making those assumptions. Yeah, and that's why I asked you about sizing it up is given, you know, this isn't, I guess I always use this example because I wish I bought it as a starter position, Rocket Lab, where it's high risk, high reward, you know, it potentially could be a 10-hundred bagger over a short amount of time, but there's a risk it goes to zero. So you want to make it to maybe a 1% position in your portfolio.

Starting point is 00:55:25 But with Adobe and its long-term track record and consistent revenue growth, maybe it comes down to the valuation. And 25 times is not expensive for a grower like this, but it's not dirt cheap. Would you say something in the 15 to 20 times range is kind of what you're looking for as long as nothing else has changed about the business? Yeah, probably. Yeah, I mean 15 times would be great. the it's it's difficult because it feels weird putting such a mature business as a starter position but i do think these are the i do think it can get cheap enough over time where i can add to it i probably would be adding a little more if it were as cheap as it was when i first bought

Starting point is 00:56:10 like i think it was around 21 times i'd maybe feel a little more inclined but yeah it's bumped up quite quite a bit the last few weeks hold on to your horses a lot of stocks have just been ripping higher yeah i wonder if it goes the way of google a little bit where this is like everyone thinks this is like the biggest ai loser and maybe it gets an ai multiple re-rating because everyone adopts firefly or something it seems unlikely that would be nice that would be nice Yeah, I think a lot of these companies that have the resources to invest in AI-type initiatives that enhance their existing products that are already exceptional value to a lot of customers, those are probably some of the companies that are most poised to benefit from AI improvements. Yeah. All right. And I'm showing this chart here just because I mentioned the valuation. It is important for a consistent repurchaser like Adobe, where they're not kind of an opportunistic repurchaser. If you look at when their valuation was more elevated, the shares outstanding came down at a linear rate, but not that much. But in recent years, the stock has gotten much cheaper from an earning yield perspective. So if it gets down to 15 to 20 times, they can retire probably 5% of the shares outstanding every year.

Starting point is 00:57:30 And if Ryan's thesis still holds, well, your long-term returns are going to be even better. All right, Ryan, I think that ends things for us today. Anything else before we close out? No, I think that's it. It's surprisingly, for one of the best-performing software stocks of all time, a bit of a boring business, like predictable, I should say. it feels fairly predictable um at least the numbers have been pretty consistent over time and and they if you look at some of those revenue charts for adobe it's a very very simple looking staircase up and to the right uh for a lot of the arr numbers so it i think they have an easy

Starting point is 00:58:16 formula with wonderful applications that people get a lot of value out of and it it tends to spread from the organizations themselves growing, the customers themselves growing. So yeah, I think that's it. Yeah, the cloud transition was the last test and that really turned into an opportunity for them. It's been linear growth ever since. This AI uncertainty,

Starting point is 00:58:38 people think that it's going to cause a whole wrench in the mix. If they, I don't want to say complete it or solve it or it's not an issue, maybe we just see consistent revenue growth over the next decade as well. All right. That's going to do it for this episode. Again, subscribe to the free newsletter to get Ryan's research report. It'll come out usually the day of, kind of depends on my schedule,

Starting point is 00:59:01 but I get it out there. And then if you want to discuss the episode, we'll be doing that in the Substack free chat community that we have along with every single episode. As a disclosure, we are not financial advisors. Anything we say on this podcast is not formal advice or recommendation. Ryan, I or any podcast guests may hold hold securities discussed in this podcast may have held them in the past and may buy, sell or hold them in the future. Thank you, everyone, once again, and we'll see you next time. Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad?

Starting point is 00:59:51 I get it. I'm Siyaya and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently, that's how I roll. So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem.

Chit Chat Stocks - Why Ryan Bought One of The Best-Performing Software Stocks of All-Time (Ticker: ADBE)

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