Adobe (NASDAQ: ADBE) stock is down a whopping 54% over the past 12 months. A general compression in software stock valuations and concerns about Adobe paying $20bn for its largest acquisition to date have resulted in the dramatic sell-off.
Yet the company remains an established leader in the digital media space, with eye-popping gross margins and plenty of profits. So should I take advantage of this dip and buy Adobe stock today?
A high-quality stock
Adobe went public on August 20, 1986, at a split-adjusted share price of $0.17. With a price of $299 per share today, I don’t need a maths degree to see that the stock has been an extreme market-beating winner.
These few outliers are what drive a large part of all stock market returns. And these are exactly the type of companies I like to personally own shares of in my portfolio.
A strong business
Adobe is the maker of image-editing Photoshop software and the Acrobat document-creation program. The company originally created the PDF file format in 1993, which I’m sure most people have interacted with at some point.
One of the things that has always stood out to me about Adobe is its extremely high gross margin, which stands at 88%. This leads to a very healthy operating margin of around 35%. So this isn’t some disrupted legacy player in the SaaS space. It’s a best-of-breed software powerhouse.
And its recent Q3 results back this up. Revenue was up 13% year on year to $4.43bn, which was a record high for the company. It produced over $1.5bn in free cash flow, while annual recurring revenue in its digital media business has now surpassed $13bn.
However, these solid figures were overshadowed by its announcement that it plans to acquire software company Figma for $20bn. This would be a 50/50 cash-and-stock deal.
An enormous acquisition
Adobe’s acquisition of collaborative design specialist Figma would be the largest-ever takeover of a private software business.
On the surface, it seems it’s overpaying for its smaller peer. Figma is free-cash-flow positive, but it only produces $400m in annual recurring revenue. That means Adobe is paying 50 times Figma’s annual recurring revenue, which is clearly very pricey. This is definitely a risk worth considering.
On the flip side, it could eventually be seen as a smart acquisition. That’s because the buy gives the bigger firm almost 70% market share in collaborative design and prototyping software. The explosion of remote working and the digitalisation of most industries should provide multi-decade tailwinds for this type of software.
Plus the quarterly $1.5bn of free cash flow now being produced by Adobe would offset the cash side of the Figma acquisition in a little under two years.
Will I buy the stock?
At a current price-to-earnings (P/E) of 29, any worries I may have had about the valuation of the stock have now been eased. This is the cheapest the shares have looked in years.
I’ve largely been focusing on the FTSE 100 this year, scooping up quality high-yield stocks while the going has been good. But the sell-off in established software names in the US has caught my attention. As such, I’m now promoting Adobe stock to my buy list.
Ben McPoland has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
Motley Fool UK 2022