Did Adobe Just Signal a Red Flag for AI Growth Stocks?

Adobe (NASDAQ: ADBE) stock sold off on Friday after the software giant reported record revenue but muted Q2 fiscal 2024 guidance. The stock is now down around 20% since Feb. 1 in what has otherwise been a great period for the broader market and for artificial intelligence (AI) fueled growth stocks.

Let’s dive into Adobe’s results and management commentary to determine if this is a bad omen for the AI theme, or if Adobe’s issues are more company-specific.

Image source: Getty Images.

An AI-driven investment

To some extent, Adobe has always been an AI play. It’s just that the buzzword is being thrown around more nowadays.

The company’s flagship bundle, Creative Cloud, features a suite of applications and tools to help creators design, edit, and interact with different forms of media — namely text, images, and video. However, Adobe’s growth had slowed in recent years, and the company needed a new catalyst to spur investment excitement.

On March 21, Adobe unveiled Firefly, a generative AI tool for Creative Cloud, Document Cloud, Experience Cloud, and Adobe Express workflows. The launch of Firefly and the prospect of monetizing AI helped Adobe stock gain over 77% last year.

Adobe’s recent earnings call marked a momentum change and the harsh reality that although these new applications have a long runway, that doesn’t necessarily mean there will be an immediate impact on its short-term results.

Adobe’s Q2 fiscal 2024 guidance was weak, and the company chose not to give an update on full-year guidance, whereas it had given fiscal full-year 2024 guidance on its Q4 fiscal 2024 earnings call in December. The market hates uncertainty, so it’s no surprise why the bulk of the question-and-answer session consisted of analysts obsessing over quarterly results and fiscal 2024 performance instead of Adobe’s long-term investments and where the company could be three to five years from now.

AI’s measurable impact on Adobe’s growth

Users of Adobe Firefly through Creative Cloud and Adobe Express have already generated 6.5 billion assets like images, vectors, designs, and text effects. Adobe reported record new commercial subscriptions in Creative Cloud and teased new products for Adobe Express with Firefly for mobile, Firefly Services, and an AI assistant for Adobe Acrobat. The company is investing heavily in its product rollout and making noticeable progress across its existing products and mobile tools, and even introducing new products like AI-powered Enhance Speech, which automatically dubs a video into a language of the user’s choice.

That said, if there were ever a time to take quarterly results with a grain of salt, it’s now. Adobe is dealing with a one-time $1 billion charge for terminating its acquisition of Figma, a deal announced in September 2022. What’s more, a lot of the investments in product innovation probably won’t be felt for several years.

On the earnings call, Adobe clarified that it is focused on acquiring as many users as possible. The idea is that with good customer acquisition and retention, Adobe can monetize its user base over time. Adobe was one of the pioneers of the software-as-a-service (SaaS) business model, and it is sticking to its roots in how it approaches AI.

A key part of the earnings call was when Adobe CEO Shantanu Narayen expressed the differences between experimentation and monetization on its platforms. In many ways, Adobe is still figuring out what will stick with users. It does no good to invest billions of dollars in tools that users either won’t use or that the company can’t justify price increases for down the line.

That leads us to the most significant challenge with Adobe, which is making money from AI. Since Adobe is a subscription business, it has to support increased capital expenditures by growing its customer base and revenue per user. A comparison would be Netflix, which has to justify price increases by making its service more valuable to consumers through quality shows and content spending.

The good news is that Adobe’s customer base is mostly businesses and, to a lesser extent, students and individual creators. So it isn’t that dependent on the strength of the consumer. If its customers can use AI-based tools like Firefly to do their jobs faster and better, then price increases should be absorbed naturally. But it would be a mistake to assume this is a given.

A sizable buyback program

Adobe’s investment thesis is all about consistency. Gradual growth from reliable subscription revenue fuels innovation and an underrated capital return program.

Over the last 10 years, Adobe has reduced its outstanding share count by 9.2% despite its stock-based compensation soaring over 400%. It just announced a new $25 billion stock repurchase program over the next four years. At a market cap of around $227 billion at the time of this writing, simple math tells us that Adobe plans to reduce its share count by 11% or so over the next four years, which is more than double the rate over the last decade.

Buying back stock spreads earnings over a smaller number of shares, which boosts earnings per share (EPS) and makes Adobe a better value. It’s a way to artificially boost EPS even when the underlying business isn’t posting the best organic growth.

Adobe isn’t in that position; in fact, its organic growth is quite good. But the company’s decision not to update its full-year guidance indicates growth may not be as good as investors hoped when Adobe was hovering around a 52-week high just six weeks ago.

Reeling in expectations

Adobe didn’t signal a red flag for AI growth stocks, but it did remind investors of where their focus should be, which isn’t on the next quarter or year, but on how AI enhances the overall investment thesis. Adobe has a clear, straightforward way to monetize AI, which makes it one of the more intriguing long-term plays out there.

Even after selling off, Adobe isn’t a cheap stock. It’s better not to focus too much on trailing earnings because of the Figma one-time impairment. For fiscal 2025, analysts expect $20.30 in EPS, which would mean a price-to-earnings ratio of 24.6. But that’s based on full-year earnings seven quarters from now.

Adobe isn’t a screaming buy, but the market is underestimating its growth potential. Adobe is worth adding to a watch list or even opening a starter position in. But if Adobe undergoes a prolonged sell-off, the valuation will look too cheap to ignore.

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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Adobe and Netflix. The Motley Fool has a disclosure policy.

Did Adobe Just Signal a Red Flag for AI Growth Stocks? was originally published by The Motley Fool